The International Capital Markets Association (ICMA) has written to the European Central Bank (ECB) with a “concern that rising dysfunction in the [repo] market could imperil the transmission of monetary policy. The conditions can largely be attributed to a disequilibrium situation of excess liquidity in the Euro banking system and a scarcity of high-quality, liquid collateral. The resulting risks are accentuated by constraints on bank intermediation.”
Signed by Bryan Pascoe, ICMA chief executive, along with the co-chairs of the Asset Management and Investors Council Executive Committee, Commercial Paper & Certificates of Deposit Committee, European Repo & Collateral Committee and Secondary Market Practices Committee, including Yannig Loyer, global head of trading, securities financing & derivatives at AXA Investment Managers, the letter’s signatories note that an environment of excess reserves and collateral scarcity has been “the norm for a number of years”, but only trigged major market dislocations a few times such as at year end and at the end of Q1 2020.
Their concern is that a new monetary policy cycle and associated market volatility makes dislocations more likely.
“The market focus and associated pricing for 2022 year-end is already indicating such concerns, as is the persistent widening of asset swap spreads of short-dated high-quality euro securities. For example, we have observed the 3-month Bubill-EURIBOR spread invert to around 60bp (reaching 100bp in early September), while the swap spread for the on-the-run Shatz has become ever more deeply inverted to around 110bp (having reached 120bp last month). Meanwhile, German General Collateral over year-end is implying a rate for the ‘turn’ of between -10% and 12%, while the USD/EUR FX Basis Swap is also implying a rate of around -14%. The recent September 2022 quarter-end, which saw the widest quarter-end dislocation between collateralised and uncollateralized rates since the introduction of the euro, has only added to these concerns.”
An example cited was the imbalance being created is that when the ECB deposit rate rose by 75bps but repo rates tightened. ICMA recommended several policy changes.
The first reflects the Federal Reserve’s Overnight Reverse Repurchase Facility which was described as a “useful pressure valve” although in the Eurozone there would need to be bank intermediation for end users to access the facility and allowing funds and CCPs to access a facility may be needed.
Secondly, it noted the Swiss National Bank’s initiative to issue tradable Treasury Bills, either through auction or private placement, with a Eurosystem bill-issuance program providing similar advantages to the repo facility without tying up bank balance sheets in the process of intermediation.
The association also identified pressure points around bank reporting dates and times of heightened volatility which affect bank balance sheets and available risk capital to support market intermediation.
It noted that a “targeted recalibration of the leverage ratio, such as for certain transactions counterparty types, or the ability to re-allocate capital buffers to supporting liquidity provision, particularly at such times, could contribute to both market stability and resilience.”
As these are based on non-ECB rules the letter added having the ECB support for such a change would be welcome.
Reacting to the ICMA letter, Sabine Farhat, head of securities finance product management at Murex, said, “ICMA is rightly outlining wider industry worries surrounding current conditions in the Eurozone repo markets. You only have to look at the consistent widening of asset swap spreads on short-dated euro securities to see that investors are already making their concerns known. There are also longstanding issues around capabilities for liquidating repo collateral in the event of a cash borrower’s default. The problem is that securing pre- and post-trade collateral in this market can take time due to highly manual processes.”
She continued, “To help overcome some of the challenges outlined by ICMA, such as collateral scarcity, market participants first and foremost need to ensure they are operating collateral management in a centralized manner. The availability of collateral is crucial to minimizing costs, and creating greater need for sourcing capital efficiently through repo markets.”
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