The repo market is one of the largest in the world. It has experienced dramatic growth over the last 30 years, mainly because it provides a cheap source of funding for financial institutions. It allows for the borrowing and lending of cash, using securities as collateral. Though a derivative, it trades over-the-counter (OTC), it is regulated, highly liquid and transparent. It became more efficient when central counterparty clearing (CCP) was introduced through the Fixed Income Clearing Corp. (FICC) 15 years ago (see “Change is good," below).
The swaps market is even larger, more liquid and efficient, but it’s mostly unregulated with limited access. Most significantly, there is no CCP. But that is changing and soon will change more dramatically.
The need for change
The repo market changed voluntarily 15 years ago, migrating to a CCP in the late 1990s. This change was influenced by the need to reduce dealer balance sheets and counterparty risk. A repo matched-book business made a bank appear more leveraged. Banks and broker-dealers needed a CCP to net assets and counterparty risk.
Swaps, on the other hand, do not affect a bank’s assets. The transactions are off-balance-sheet. Instead of exchanging actual assets, swaps are a commitment to exchange cash flows. It always was in the banks’ interest to keep the swaps market closed to protect revenue, spreads and customers. But change in the swaps market recently was mandated by the Dodd-Frank Act. The swaps market, especially interest rate swaps, will migrate to a CCP.
There are parallels between the repo market of the past and the swaps market today. The future of the swaps market and its migration to a CCP will look like the repo market’s migration 15 years ago.