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Should corporates and banks beware of repo?

Quantitative easing, Basel III and low interest rates are causing a 'perfect storm' in the repo markets. Some banks seem to be retreating from repo while others are jumping in feet first. Will corporates benefit from this and how will the situation pan out in the longer term?

An article in the New York Times recently warned “caution is needed” for those banks that are gaining more exposure to repo lending.

Some big banks are pulling back from repos – the market for repurchase agreements, a form of short-term collateralised lending that principally helps nonbank financial groups fund themselves and their clients. JPMorgan Chase, Credit Suisse and UBS were named as some of the banks that have cut their repo assets by between a quarter and two-thirds in the past five years. But others, such as Wells Fargo, Nordea and the Sumitomo Mitsui Financial Group, have been “bulking up in repo”.

The repo market in Europe was worth €5.6 billion in June this year, while the US repo market is seeing daily lending of almost $4 trillion. Both markets are seeing significantly lower volumes than in 2007-8 but the European market has seen a gentle upswing in the past year. However, Reuters Breakingviews columnist Dominic Elliott warns:“regulators need to take care the repo grenade doesn’t blow up in the hands of non-experts.”

The Basel III effect

So while the effect of Basel III is being felt in the repo market, the low-interest rate environment and higher than usual liquidity levels caused by quantitative easing (QE) are also affecting the market. This is being seen in the European repo market, where a mismatch in supply and demand is occurring, caused by the changing appetite of banks for certain types of counterparties and transactions. Moreover, some banks are finding it difficult to comply with Basel III and make a return.

According to Euroclear, the impact of Basel III’s Net Stable Funding Ratio (NSFR) on secured and unsecured lending is complex and at times contradictory, but its penalties for short-term transactions with interbank counterparties are already reshaping the repo markets. An article on the organisation's website stated: “Specifically, the NSFR is driving banks to look for cash for longer periods from non-financial counterparts”

Corprates beware

This is having an impact on corporates, some of which report that banks are asking them to agree to longer tenors. If banks are to succeed in this, they will have to offer corporates incentives to take on this extra financial risk.

A consequence of this is that the market could become more resilient, with improved valuation techniques and better margin management from the banks. Euroclear says there are already examples of banks “constructing transactions more efficiently and developing new structures and products in an effort to draw in liquidity from non-traditional repo market participants with increasing appetites but cautious natures”.

Other factors will also affect how banks operate in the repo markets. TARGET2-Securities (T2S), for example, will enhance banks' ability to move collateral around Europe. However, the cost of trading in the repo market is rising and the effects of Basel III on the repo market are only just beginning to be seen.

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