Federal Reserve Governor Daniel Tarullo gave a speech last week on liquidity regulation at The Clearing House 2014 Annual Conference. He laid out some pretty big themes, including the value of regulation, why Lenders of Last Resort (LOLR) matter and why the Federal Reserve was created to begin with. He also talked about recent actions in strengthening liquidity regulation in the financial system. His conclusions were that regulators are preparing to be broad-sweeping in their capture and regulation of financial market liquidity wherever it may occur.
With BNY Mellon’s new Liquidity Aggregator tool hitting the market last week, we got to thinking about what pre-trade collateral and liquidity management tools would look like and what it will take for the market to adopt these tools.
An article in Bloomberg BusinessWeek, “EU Weighs Curbs on Banks’ Use of Client Assets as Collateral” by Jim Brunsden last week, discussed a move that could have some serious ramifications for repo.
An article in the June 1, 2012 Business Week by Jody Shenn and Lisa Abramowicz, “Cantor Plans to Enter Shrinking Shadow Banking”, took us by surprise. Cantor Fitzgerald is starting a repo conduit called Institutional Secured Funding. For those who aren’t familiar with repo conduits, they are classic shadow banking. Traditional repo conduits allow securities dealers to obtain financing for the weird, wonderful and illiquid by repo’ing in those assets and issuing asset-backed commercial paper (ABCP) to fund themselves. Ratings agencies rely on the credit worthiness of the repo bank to support the repo conduits’ rating and could pretty much care less about the collateral. So the paper that goes in can be stuff that otherwise might not be eligible in tri-party shells or for bi-lateral repo trades.
A new opinion piece from Woodbine Associates published on April 4, 2012 “Beyond Volcker: Seeing the Forest through the Trees” caught our eye. About half-way into the piece the author addresses the impact of the Volcker Rule on market liquidity.
Late last year the CFTC proposed changes in the rules governing how Futures Commission Merchants (FCMs) invest client cash. Those rules — 30.7 and especially 1.25 – become infamous post MF Global. The evolution of those rules is well known. In December 2000 the CFTC allowed FCMs to invest client money is securities beyond US Govies and Munis, including “…general obligations issued by any enterprise sponsored by the United States, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interests in money market mutual funds…” in the mix. In 2004 and 2005 the rules were again amended, one change allowed internal repos between the FCM and an affiliated broker/dealer. The rest is history.
The LTRO continues to attract attention. With another tranche coming up on February 29th, pundits relish in writing about how much money the banks will make by buying sovereign debt and funding it via the LRTO. We are sure some banks, encouraged (or not) by government officials, will make that “free lunch” investment. (We would be remiss if we didn’t draw a parallel between the LTRO financing and MF Global’s sovereign “Hail Mary” play.) But it is hard to believe that any bank beyond the most desperate will use all that cash just to buy sovereign debt.
Securities Lending Times had a great comment out this morning: securities lending and repo came up the Association for Financial Markets in Europe (AFME) liquidity conference yesterday. A group of economists were discussing deleveraging in financial markets and brought up, without any apparent prompting, that securities lending and repo needed to regain some lost activity in order to support other parts of financial markets. This is extremely interesting to us for the following reasons:
On January 20th we posted “Is the collateral upgrade trade a red herring?“. This isn’t the first time we have written about the complexities of collateral swaps. Last October we posted “Derivsource: Collateral Transformation, Silver Bullet or Smoke and Mirrors”. We too questioned the maturity mismatch between long dated swaps which need collateral posted in CCPs for years and the short term nature of the Securities Lending business. We wrote,
Euromoney just published an interview with IMF Economist Manmohan Singh. A link is here. Singh has written extensively on securities financing, collateral chains, shadow banking, and re-hypothecation — all things near and dear to us. We have referred to his writings in Finadium research pieces (here is a link) as well as other www.secfinmonitor.com posts (including this one where his paper was cited for things he never really wrote….a link is here). He knows what he is talking about. We’ll summarize what we think are the interesting parts of the interview and do a little editorializing.
If you were wondering where all that corporate cash is going, according to a January 9, 2012 article in Reuters by Douwe Miedema (a link is here) it is going into the repo market. Afraid to lend the cash to banks in unsecured deposits, corporates are, more and more, investing in repo. The article quoted Frank Reiss from Euroclear, “Companies in the past were… happy to deposit cash on an unsecured basis to a bank for an interest payment…Now following the crisis, we have seen that companies are engaging in repos secured with collateral against the cash they are lending.” The article said “…Based on his daily practice, Euroclear’s Reiss estimated that up to 25 percent of the triparty market was on behalf of companies, a massive and sudden rise from the 2 to 5 percent where it had traditionally been….” That is a big shift in tri-party. We wonder if this pattern has been repeated in the US too?
As our first post of the year, it is appropriate to come back to one of our common threads: collateral. The WSJ article from Dec. 29, 2011 “Europe’s Banks Face Pressure on Collateral” by David Enrich and Sara Schaefer bring up some excellent points about what happens when everyone wants collateral to secure their cash loans: you run out of it. It used to be that banks thought in terms of unsecured borrowing and investment banks saw the funding world through secured glasses. No more. Everyone is now forced to collateralize and everyone is a repo trader.
We can commiserate with ISDA in their post ”Sad Proof” dated November 7th complaining that the New York Times article entitled ”Sad Proof from Europe’s Fallout”
pinned the fall of MF Global on derivatives. IDSA was factually correct when they wrote “…MF Global did not use derivatives to make its bets on European sovereign debt. As the company stated in its third-quarter earnings release on October 25th: ‘As of September 30, 2011, MF Global maintained a net long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity (repo-to-maturity), including Belgium, Italy, Spain, Portugal and Ireland.’ So it seems clear that MF’s European sovereign debt holdings were just that, bond positions financed via repo transactions. Repos, of course, are NOT OTC derivatives. (They’re also not listed derivatives.) They are basic tools of corporate finance commonly used to finance cash bond positions….”
An article in P&I today falls into the “what we always knew but still nice to see in the mainstream press” department. Institutional investors are engaging in repo and securities lending for liquidity funding purposes given incredibly low or even negative returns on cash investments.
Today on the the Federal Reserve Bank of New York’s Liberty Street Economics blog there is an interesting post about the theory behind short term debt markets freezing up in crises. Of particular interest to us is the author’s reference to the repo market seizing up when Bear Stearns went belly up. The author, Tanju Yorulmazer, quotes Fed Chairman Bernanke, “Until recently, short-term repos had always been regarded as virtually risk-free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-term unsecured obligations. In March, rapidly unfolding events demonstrated that even repo markets could be severely disrupted when investors believe they might need to sell the underlying collateral in illiquid markets.” (May, 2008). There are some lessons still to be learned. The full post after the break.
The Fed has posted an interesting research note on how banks use internal liquidity from different jurisdictions to manage capital. While the original article posted in July 2011, there are some useful insights for today.
The Basel Committee is working on criteria to decide what counts as a liquid asset, but secretary general says no decisions have yet been taken on how – or whether – to change the LCR.