Securities Finance Times feature article
With the CRR2 leverage ratio requirements now in effect, Frank Odendall, head of securities finance products and business development at Eurex, assesses whether the European repo market will move towards a new orthodoxy
The leverage ratio continues to be one of the most widely discussed prudential measures implemented since the Great Financial Crisis of 2007 and 2008. Proponents of the leverage ratio praise the measure as an essential prudential backstop in environments benign economics and a defense against creative quantitative modellers, a weak governance model and underfunded supervisors. The leverage ratio is considered the perfect tool for an imperfect prudential framework. Its critics denounce the measure for its reliance on accounting standards, its arbitrary calibration, its lack of risk sensitivity and the perverse incentives for risky behavior it creates. There is now a growing chorus calling for its removal outright, arguing that many of the objectives of the leverage ratio measure are now achieved with the standardized production floor introduced as part of the final Basel III rules, which uses more credible standardized approaches.
Repurchase agreements (repo) are probably the product most unduly penalized by the leverage ratio regime, aside from perhaps prime residential mortgages. Some would argue that this is an unintended consequence of the application of accounting measures in the leverage ratio calculation which accounts for repos on a gross basis, while collateral received is not accounted for. Others will argue that this is exactly what was intended, given the use of repo to create significant, if not infinite, leverage in the financial system. Regardless of your camp, it is difficult to argue about the importance of the repo market and the crucial role it plays in the smooth functioning of the global financial system.
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In June 2021, the second version of the Capital Requirements Regulation (CRR II) for the European Union went live. The revisions included a change reflecting a Basel Committee recommendation that the leverage ratio should be calculated using average measures, rather than point measures, for inputs that may exhibit volatility over reporting periods. This was a polite way of saying that regulators should take action to prevent institutions from “window dressing,” a practice in which firms adjust their trading activity ahead of key regulatory or external reporting dates. to make their performance measures prudential and statutory. look better than they would in the normal course of trade. While markets should be a simple function of supply and demand, these nuances around regulation can have profound effects on market structure and dynamics. The dysfunction of the European repo market at the end of 2016 and the collateral scarcity effects during the fourth quarter of 2021 are just two examples among many of the complex interaction of regulation and markets.
Under CRR II, the leverage ratio measure must now also be calculated and published based on a daily average of securities financing transaction (SFT) exposures, rather than period-end measures. European regulators have lagged behind their US and UK counterparts in implementing the daily average, which may partly explain why such a significant change has largely gone unreported. The 2017 landmark report on the operation of the repo market by the Committee on the Global Financial System—J Cunliffe, “Repo market operating,” CGFS Paper No. 59—provided an illustration of the market impact of average requirements and timely reporting and disclosure. The report includes charts, reproduced below, showing the average daily repo positions of primary traders for firms subject to US and UK leverage ratio rules alongside firms not subject to US and UK leverage ratio rules. leverage ratio.
Prior to 2012, both charts showed steep declines in trading volumes sometimes coinciding with the end of the quarter and the end of the year. For companies subject to US and UK leverage ratio rules, these periodic declines begin to ease from 2013, broadly consistent with when US banks began publishing daily reports and managing in under the leverage ratio regime. For companies not subject to US and UK leverage ratio rules, where leverage ratio calculation and disclosure was always based on end-of-period spot measurements, the lows continued. What is sobering about the chart is the downward trend in repo usage, as measured by trading volumes. A leverage ratio regime based on the average, rather than the spot, resulted in a “new normal” for repo trading, the impacts of which still reverberate today.
With the leverage ratio measures based on the daily average of SFTs currently in effect in Europe, the question then becomes what the new normal will look like for the euro repo market and, more generally, for the European repo market. retirement. Although it’s too early to tell, this raises several other questions about how companies should respond to these upcoming changes. At Eurex, we work with our sell-side and buy-side client institutions to shape this new normal.
While repos are reported on a gross basis as part of the leverage ratio, offsetting cash liabilities against cash claims is permitted by regulation, but subject to a stringent set of criteria. The criterion that payables and receivables must be with the same counterparty is quite difficult in the repo market, as buy-side customers tend to be segmented into natural cash takers and natural cash providers.
Clearing houses are well placed to solve this problem. By inserting the clearing house between the buy-side liquidity takers and the liquidity providers, the repo broker is well placed to apply balance sheet netting as the broker faces the clearing house on both long and short positions. Eurex, in partnership with Clearstream, offers integrated trading, clearing and settlement services for repos. This maximizes opportunities for balance sheet netting, opening the door to capital efficient trading strategies such as special trade funding with Eurex GC Pooling. For more information, see our white paper “Innovations with balance sheet netting solutions for repo trading”, available at www.eurex.com.
Leverage ratio constraints can also be managed using Eurex’s ISA Direct clearing models, which provide the buy side with direct access to cleared repo markets, facilitated by a broker (clearing agent) that covers default fund and default management bonds. Buy-side clients can maintain or even improve their access to repo liquidity, while allowing the clearing agent to act as a liquidity provider or withdraw from the trade flow to control their exposure to leverage. In addition, the buy side would of course also benefit from other typical advantages associated with central counterparties (eg risk mitigation, operational efficiency and price transparency). This model has immediate risk-weighted asset (RWA) benefits, as well as potential leverage ratio benefits from balance sheet netting for banks if buy-side funding through ISA Direct is also funded through the clearing house. Further details are available in the white paper “Capital efficients through direct access repo clearing models for the buy-side”, published on the Eurex website.
It is perhaps no coincidence that buy-side entities have begun to take the central clearing of US Treasury repos more seriously through the DTCC-sponsored Fixed Income Clearing Corporation (FICC) program, as U.S. banks were not only required to report, but to discharge, minimum additional leverage ratio requirements on a daily basis beginning in January 2018. Central clearing volumes of U.S. buy-side repos increased from 20 billion in 2017 to over $400 billion by the end of 2021, according to data from the US Federal Reserve. Eurex has recently launched an extension of ISA Direct which is aimed specifically at buying clients who would otherwise not be eligible to become a clearing member (eg hedge funds). Under the ISA Direct Indemnified model, buy-side clients can directly access the cleared repo, with the help of a clearing agent who provides indemnity to the clearinghouse.
In summary, the change in the basis for calculating the leverage ratio from spot to daily average measures for SFTs under CRR 2 will have a lasting impact on the euro and European repo market if the experiences of the US and UK markets in are an indication. On the one hand, the change may help to stabilize the volatility of liquidity levels at the end of the period. On the other hand, market liquidity could trend towards a new normal based on new average costs of capital, which could drive up overall trading costs. The Eurex Cleared Repo Market offers a number of solutions to help companies optimize their transactions and navigate the new normal.