• Three regulators (Chicago Fed, FSB and the BoE) have recently written about repo clearing.
• About 33% of repo is currently cleared. The FSB states that 74% of uncleared repo operates with a zero haircut.
• That combination explains why repo is in focus for regulators.

In today’s blog I cover cleared repos through a swaps lens thanks to the Chicago Fed, and then look at what the FSB and BoE are worried about in repo (SPOILER: risk management and liquidity in times of stress).

Swaps vs Repo

Here is a great paper that compares swaps pre- and post- clearing mandates to repo markets. I read it through my own particular lens – what can we learn from the swaps clearing mandate and how might it play out differently in repo?

• Estimates put current clearing adoption in repo markets at 33% – with most trading in non-central cleared bilateral repo (NCCBR) or tri-party uncleared repo (with BoNY as the custodian).
• The upcoming repo clearing mandate in the US is expected to increase clearing adoption to 77% of the market.
• This is consistent with swaps where we saw less than 50% of swaps cleared prior to 2012 clearing mandates.
• That has increased to 87% of new trades in covered instruments (IRS, OIS, FRAs) but trading continues in uncleared Rates products such as Swaptions and Cross Currency Swaps, whilst Inflation swaps see trading in both cleared and uncleared.
• Swaps also introduced an execution mandate via SEFs, but trading has largely remained dealer-to-client and relationship driven.
• Anonymous trading in swaps is now possible and becoming more popular amongst hedge funds. But many counterparties continue to trade on a relationship basis via “RFQ to few”.

With that “swaps” context stated, let’s move to repo.

Liquidity and Funding

For the repo market, the Chicago Fed paper highlights:

• Repos are collateralised and mainly overnight. Credit shouldn’t be a huge driver to clear your repo trades.
• Market risk – i.e. the price risk you face in liquidating between counterparty default and replacing the market risk – is equally minimal. The underlying collateral is typically highly liquid and expected to be replaced within a day (not like the 5-10 days assumed for swaps).
• Liquidity/funding risk is the talking point here.

This is also where current FSB focus sits (paper here). They are concerned that leverage is building up in repo and that when (not if) it unwinds, it will have broad-based impacts on funding markets.

In swaps, the problem pre-GFC was uncollateralised exposures. But remember that repos are already collateralised.

So a repo clearing mandate is trying to solve a different problem to the one in swaps – standardising risk management in a market where leverage can build up cheaply.

And with the BoE also worried about repo liquidity in times of stress, maybe a centralised CCP can help there via more transparency and more predictable default management practices.

Cross Currency Swaps

I traded Cross Currency Swaps – which, like repo, are funding trades. Are there comparisons between the two? Certainly. Price and trading dynamics for funding products are very different to trading “outrights”. The benefits of clearing for a funding product will arise from:

• Multilateral netting – reducing settlement risk, freeing up balance-sheet.
• Reducing complexity.

These will increase trading capacity. But we will hear the same old push-backs from market participants:

• Multilateral netting only benefits dealers. I call “false” on this. Dealers will benefit, but in such a competitive market, these benefits will be passed on to clients by way of better pricing/more availability.
• People will worry that clearing centralises risk (market/funding/liquidity – take your pick). I take transparency and predictability over leaving default risk to be managed separately across competing interests.
• Not all of a trading book will be cleared. True – but uncleared infrastructure will still be maintained (at a cost). This is why change in financial markets is so hard.

CCP Basis

Cross Currency Swaps are also a basis product. And the Chicago Fed helpfully highlight that liquidity and funding concerns played out in the swaps market via the development of a CCP basis, where economically-equivalent swaps trade at different prices at CME and LCH.

True. And this can also play-out in repos, but is more likely to show along different axes. Whilst swaps generated a new “basis”, repos already see pricing differentiated along two axes. Maybe clearing will simply shine a brighter light on the different prices experienced across:

• Cleared vs uncleared. Which side of the balance sheet will be more completely captured – borrowers (hedge funds) or lenders (MMFs) – by the clearing mandate?
• Overnight vs term vs open repos. Will they all trade at the same price whether cleared or uncleared? It could be argued that rollover risk will be easier to manage in clearing thanks to a larger pool of credit-checked counterparties.

Stability

Swaps clearing mandates and UMRs were a regulatory response to poor risk management pre-GFC. They increased netting, reduced uncertainty and increased volumes as a side effect.

But whilst increased volumes can be a good thing, the Bank of England are concerned with market stability. With the March 2020 and September 2022 gilt-market stresses front of mind, their response to their own discussion paper on gilt repos includes some notable push-backs regarding concerns about pro-cyclicality and complexity in cleared repo.

So will we see a Gilt repo clearing mandate?

Mandates vs Haircuts

A key issue for the BoE is risk management in uncleared repo. The FSB state that >74% of the uncleared repo market operates with a zero haircut:

Data like that makes it unsurprising that the BoE is concerned about the Gilt market!

• Other BoE worries include:
  • Lack of dealer intermediation capacity.
  • Credit risk limits.
  • High leverage of hedge funds.

Whilst the BoE highlight the benefits of clearing (transparency, risk management) I don’t think they focus enough on the settlement risk reduction arising from increased clearing.

Overall, they stop well short of suggesting a clearing mandate is the right way forward. In the absence of a mandate, I am concerned that clearing adoption will top out at 50% adoption. That would be consistent with swaps pre-2012 and across other repo jurisdictions:

Internationally

Are the US and UK right to pursue such “local” solutions? The FSB take a look at global repo markets and have some concerns of their own:

• 40% of repo outstanding is cross-border. The FSB see contagion risks across jurisdictions as a result.
• Three further FSB concerns are:
  • Leverage at hedge funds.
  • Demand for margin (and hence liquidation of repos) in times of stress.
  • Concentration across custodians and market participants.
• Contagion risks from repo market stresses include:
  • Rapid deleveraging in other asset class.
  • Withdrawal of credit risk more generally.
• The FSB pin these contagion risks largely on the fact that 70% of outstanding notional is uncleared.

In Summary

• I can see why regulators are worried about repo.
• Risk management in uncleared repo reminds me of swaps pre-clearing mandates and UMRs.
• But the problem being solved in repo is very different to the one “solved” for swaps.
• Swaps clearing removed uncollateralised, unmargined derivatives exposure. These were long-dated, complex to manage and would typically be considered as “wrong-way risk”.
• Repo clearing is trying to standardise funding markets that are already collateralised, but that are still vulnerable to excess leverage and liquidity stress.
• Repo will remain cross-border, but it looks like it will not reform globally in the same way that swaps did.