The coming revolution in repo
08 November 2022
State Street’s Travis Keltner and Kevin MacNeill argue that uncertain global financial market conditions, the rise of P2P business models and technological developments in the industry mean that repo markets could be poised for their biggest leap forward
Image: stock.adobe.com/spainter_vfx
Liquidity in financial markets is often taken for granted. Like water, we do not typically think much about it until it is not there. But with a changing interest rate environment unleashing greater volatility in global markets, liquidity is re-emerging as an important consideration.
Recent turmoil in the UK market underscores the point. As interest rates suddenly rose in response to announcements about new fiscal policy measures, bond values slumped and pension funds scrambled to cover collateral demands, resulting in a liquidity squeeze that forced the Bank of England to step in.
While those conditions were UK specific, the global buy-side has become all too familiar with liquidity stressors in a macro environment dictated by unprecedented events and rapidly changing trends. That has implications for repo markets, where each day approximately US$4.5 trillion is traded in the United States (over US$3 trillion in US treasuries alone) and close to double that globally.
To understand why, let us start with what these markets do. The market for repurchase agreements (repos) makes up a crucial part of collateralised money markets by providing buy-side firms with funding options for their changing investment needs.
These markets facilitate the flow of cash and securities and have implications for intra-bank loan activity and monetary policy more broadly. In particular, the repo market allows investors that need cash — both in well-functioning and stressed markets — to convert assets temporarily instead of selling outright, which can be disruptive, especially when buyers are scarce.
In the US, prolonged low rates during the COVID-19 pandemic made it difficult to find value and fund opportunities on the short-end of the curve. Conversely, the current environment of unprecedented rate hikes and prolonged inflation uncertainty has flooded cash into overnight markets, while associated collateral supply remains sparse in comparison. The Fed’s Reverse Repo Facility (RRP), a key player in the US treasuries repo market, has ballooned since the start of 2021, reaching all-time highs above US$2.3 trillion this year.
The influx of cash and rapidly rising rates provide opportunities for the buy-side, but not all firms have access to every outlet, like the Fed RRP. Also, the Fed RRP is just overnight repo against US treasuries. Opportunities exist for the buy-side to expand into a broader set of collateral types and maturities. Unlocking new liquidity outlets for the buy-side in repo markets has implications not just for money markets, but for the economy more broadly.
Peer to peer (P2P) models can help. P2P models allow buy-side firms to transact directly with non-dealer counterparties to capitalise on identified trends in a changing market. When the buy-side has the power to negotiate among themselves, opportunities can be customised under a broader set of options to more closely fit each firm’s needs.
P2P platforms such as Airbnb and eBay already have unlocked tremendous value in many sectors of the economy. They can do the same for repo markets by increasing visibility and options for buy-side firms via an intuitive, sleek platform. More importantly, advances in technology support the design of automated front-to-back solutions, especially critical for financial markets, and provide real-time intelligence.
The benefits could be significant and include:
• A ready ability to send and receive indications of interest to a broad counterparty set for price transparency.
• Integrated messaging supporting settlement and collateral management, enabling more firms — who otherwise lack the necessary infrastructure — to engage.
• Broad participation by firms lacking the requisite infrastructure themselves to readily interact.
• Opportunity for lower costs for buy-side participants. Traditional repo intermediaries (i.e. dealers and banks) may incur material balance sheet utilisation costs, which is not-unreasonably passed along to counterparties in the form of less-favorable spreads.
As State Street and Finadium outlined in April, overall costs are expected to be lowest in a P2P model, in which the intermediary costs are removed or reduced. Under an indemnified P2P model, buy-side counterparties transact directly and a bank or insurer guarantees either or both the repo buyer and seller that the repurchase price and collateral securities will be returned in the case of a counterparty default. A fee for this protection is passed along in spreads, but the overall cost that is passed along is expected to be less than in traditional repo models. This also offers the same peace of mind that the buy-side has come to expect when transacting with traditional counterparties.
Lastly, a P2P platform in the repo market could, over time, be used to include other markets such as the securities lending market and, eventually, with the adoption of blockchain technology, markets for digital assets.
The repo market has been evolving since the late 1970s, but the confluence of an uncertain global economic and financial market environment, the rise of P2P business models, and technological developments in the financial industry mean it could be poised for its biggest leap forward yet — and bring other related markets along with it
Recent turmoil in the UK market underscores the point. As interest rates suddenly rose in response to announcements about new fiscal policy measures, bond values slumped and pension funds scrambled to cover collateral demands, resulting in a liquidity squeeze that forced the Bank of England to step in.
While those conditions were UK specific, the global buy-side has become all too familiar with liquidity stressors in a macro environment dictated by unprecedented events and rapidly changing trends. That has implications for repo markets, where each day approximately US$4.5 trillion is traded in the United States (over US$3 trillion in US treasuries alone) and close to double that globally.
To understand why, let us start with what these markets do. The market for repurchase agreements (repos) makes up a crucial part of collateralised money markets by providing buy-side firms with funding options for their changing investment needs.
These markets facilitate the flow of cash and securities and have implications for intra-bank loan activity and monetary policy more broadly. In particular, the repo market allows investors that need cash — both in well-functioning and stressed markets — to convert assets temporarily instead of selling outright, which can be disruptive, especially when buyers are scarce.
In the US, prolonged low rates during the COVID-19 pandemic made it difficult to find value and fund opportunities on the short-end of the curve. Conversely, the current environment of unprecedented rate hikes and prolonged inflation uncertainty has flooded cash into overnight markets, while associated collateral supply remains sparse in comparison. The Fed’s Reverse Repo Facility (RRP), a key player in the US treasuries repo market, has ballooned since the start of 2021, reaching all-time highs above US$2.3 trillion this year.
The influx of cash and rapidly rising rates provide opportunities for the buy-side, but not all firms have access to every outlet, like the Fed RRP. Also, the Fed RRP is just overnight repo against US treasuries. Opportunities exist for the buy-side to expand into a broader set of collateral types and maturities. Unlocking new liquidity outlets for the buy-side in repo markets has implications not just for money markets, but for the economy more broadly.
Peer to peer (P2P) models can help. P2P models allow buy-side firms to transact directly with non-dealer counterparties to capitalise on identified trends in a changing market. When the buy-side has the power to negotiate among themselves, opportunities can be customised under a broader set of options to more closely fit each firm’s needs.
P2P platforms such as Airbnb and eBay already have unlocked tremendous value in many sectors of the economy. They can do the same for repo markets by increasing visibility and options for buy-side firms via an intuitive, sleek platform. More importantly, advances in technology support the design of automated front-to-back solutions, especially critical for financial markets, and provide real-time intelligence.
The benefits could be significant and include:
• A ready ability to send and receive indications of interest to a broad counterparty set for price transparency.
• Integrated messaging supporting settlement and collateral management, enabling more firms — who otherwise lack the necessary infrastructure — to engage.
• Broad participation by firms lacking the requisite infrastructure themselves to readily interact.
• Opportunity for lower costs for buy-side participants. Traditional repo intermediaries (i.e. dealers and banks) may incur material balance sheet utilisation costs, which is not-unreasonably passed along to counterparties in the form of less-favorable spreads.
As State Street and Finadium outlined in April, overall costs are expected to be lowest in a P2P model, in which the intermediary costs are removed or reduced. Under an indemnified P2P model, buy-side counterparties transact directly and a bank or insurer guarantees either or both the repo buyer and seller that the repurchase price and collateral securities will be returned in the case of a counterparty default. A fee for this protection is passed along in spreads, but the overall cost that is passed along is expected to be less than in traditional repo models. This also offers the same peace of mind that the buy-side has come to expect when transacting with traditional counterparties.
Lastly, a P2P platform in the repo market could, over time, be used to include other markets such as the securities lending market and, eventually, with the adoption of blockchain technology, markets for digital assets.
The repo market has been evolving since the late 1970s, but the confluence of an uncertain global economic and financial market environment, the rise of P2P business models, and technological developments in the financial industry mean it could be poised for its biggest leap forward yet — and bring other related markets along with it
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