European repo volatility could be new normal

European repo volatility could be new normal

Unprecedented volatility and dislocation across Europe’s repo market could become a common occurrence, experts at the ICMA claim.

The crucial short-term loan market, used by banks and investors, “effectively broke down” last year, Richard Comotto, a senior visiting fellow at the capital markets trade body, said on Tuesday.

“That’s something that did not happen either during the Lehman crisis or over the sovereign bond crisis,” he added in his 'post-mortem' study of the market. 

“There is a very real concern that the market behavior over the 2016 year-end will not be a one-off event.”

Repos, or repurchase agreements, are critical sources of funding for many institutions. Dealer banks sell securities with a promise to repurchase at a later date. 

Often activity is reduced around the calendar year-end, meaning markets tend to be thin and more volatile.

However, conditions at the end of 2016 were extreme.

Capital requirements and leverage ratios have reduced repo market activity, and thereby the supply of collateral. 

Meanwhile asset-purchases by the ECB have escalated stress across the market and increased the premium paid for High Quality Liquid Assets (HQLA).

"The shortage has not been much relieved by the Eurosystem’s securities lending arrangements," according to Comotto.

Some buy-side firms were able to leverage bank relationships and negotiate some last-minute repo liquidity, albeit at a cost.

Others, unable to access the repo market, could only resort to buying short-term assets at distorted levels.

One asset manager told Comotto it was like "watching a train smash in slow motion; you could see it happening, but could do nothing about it.” 

Defining long-term behavior 

At this stage, ICMA's Comotto says it is difficult to divine how the change in the composition of the repo market will affect its long-term behavior.

"One the one hand many market-users, particularly traditional liquidity providers, have been structurally deleveraging in response to their own increased risk aversion and regulatory pressure to reduce leverage and increase liquidity buffers. 

"On the other, there is evidence of a migration into the repo market by banks and non-banks who have traditionally relied on unsecured money markets."

Speaking at the Deutsche Borse GFF summit in Luxembourg last month,  Yves Mersch, member of the ECB’s executive board, said there is "no doubt" that European repo markets today are operating in "unprecedented territory.” 

"Banks and other market participants report a decrease in market making activities and collateral scarcity in repo-markets," he added. "The perception of a challenging environment can therefore not be denied."

However, Mersch said that market stress should fade with the continued economic recovery and players will adjust their business models over time amid a new regulatory environment.

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