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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
intraday credit usage will reach, and may even fall
below, the Task Force’s benchmark of 10% of daily
tri-party repo volume.Tri-party reforms in the U.S.
are bringing the market into closer alignment with
the European tri-party repo model. In Europe, they
trade true term repo, and the need to unwind tri-
party repo daily has been avoided by the use of direct
substitution and margining.
Unlike the U.S. where tri-party repo accounts for
nearly two-thirds of the market, tri-party repo in
Europe has historically been a much smaller part of
the overall repo market with estimates showing it at
only 10%-12% of dealer and bank repo activity. The
focus of repo transactions also differs. According
to ICMA, European tri-party repo is normally used to
manage non-government bonds and equity (although
the proportion of government bonds has more than
doubled since the crisis), whereas U.S. tri-party is
focused on Treasury and Agency debt.
There is also a broader set of tri-party repo
participants in Europe. Beyond the two U.S. clearing
banks, JP Morgan and Bank of New York Mellon, there
are other banks that also participate in the tri-party
repo system including Citi, Six SIS, and Monte Titoli
via their X-Comm system. There are also two large
International Central Securities Depositaries (ICSDs)—
Euroclear and Clearstream. Unlike the clearing
banks, these ICSDs are not principals to any repo
transactions. They are also purpose built to offer
fully automated systems for selection, allocation and
substitution of collateral related to repo—eliminating
the need for the daily unwinding / rewinding process.
The way in which collateral is treated by these tri-party
repo agents in Europe remains a concern for many
asset owners. European tri-party agents, particularly
the ICSDs are allowed continuous substitution of
collateral. Further, in many European countries the re-
use of collateral is permitted. In some countries, like
Switzerland, full re-use is permitted, while in others
re-use is limited to a specific system (e.g., Euro GC
Pooling segment of Eurex Repo).
In 2009 the FSB, through the Committee on Payment
and Settlement Systems, commissioned a Working
Group on European Repo Market Infrastructure.
The group observed that during the crisis, some
European tri-party repo service providers and other
key parties took a number of risk-reducing actions,
including requiring higher quality collateral, excluding
less liquid assets such as MBS, ABS and CDO, and
increasing margin and haircut levels—either at the
request of clients or on their own.
In their September 2010 report, the Working
Group highlighted seven key concerns about the
European repo markets and made suggestions for
potential reforms around intraday credit extension,
transparency, protection against counterparty credit,
processes for liquidating, the use of high-quality
collateral and risk management best practices
3
.
Following that report, the FSB established an effort
to focus on Securities Lending and Repos to further
assess financial stability risks and form policy
recommendations. In August 2013, the FSB published
their final Policy Framework that largely adopted the
recommendations made by the Working Group
4
.
At the core of the recommendations is a requirement
for increased transparency through reporting from
counterparties, CSDs and CCPs. It is proposed
that data would be captured by new national trade
repositories and then aggregated monthly at the
FSB. The framework also highlights guidelines for
collateral reinvestment and re-hypothecation, haircut
methodologies and floors, and the use of CCPs.
While these are currently policy recommendations,
expectations are that national regulators will finalize
their positions later in 2014 with an implementation
timeline to shortly follow.
It remains to be seen whether these reforms will
be sufficient to overcome reluctance to consider
clearing CCPs for a broader set of securities lending
transactions. The potential to use CCPs for collateral
optimization in addition to centralized clearing may
begin to soften opposition, however.
“ The central clearing party idea makes me nervous. I’ve seen a
little bit of the due diligence on the OTC entities and it’s scary.
I’d rather have bank risk than clearing house risk. I think there
is still a little bit of doubt in everyone’s mind about the CCPs,”
— Asset Owner—Money Manager
“ Collateral is a good thing used to offset risks in the system, but
regulators are starting to see collateral itself as a new risk because
so much of it moves through the system so quickly. What if the
music stops? There is a sense of wanting to slow things down
and make it more difficult to move collateral around, which
could be considered a push, while at the same time regulators
are trying to encourage more collateralization, which could be
considered a pull,” — Industry Trade Association
“ Throwing collateral around 100 times per day adds risk
into the equation. That’s an operational risk we still see,”
— Asset Owner—Institution
3. http://www.bis.org/publ/cpss91.pdf
4. https://www.financialstabilityboard.org/publications/r_130829b.pdf