10 events that changed the repo market

From the Federal Reserve to Dodd-Frank, the repo market has evolved

By 2001, the simplicity and speed of electronic execution had won out. The vast majority of repo trading volume had emigrated to Brokertec. The voice brokers remained important for market color, but in a fast paced market, trading with a single click and the ability to leave orders was a major efficiency improvement. 

6. Elimination of Repo Market Squeezes 2006

Before 2006, squeezes were common in the Repo market. In fact, in many trader’s eyes, the sole purpose of the Repo market was for squeezes. Large dealers would accumulate large amounts of a Treasury issue and control it in the financing market – moving rates up and down by adding and removing supply from the market.

This strategy worked for many years, however, by the early 2000s, regulators became more conscience of manipulation in the Repo market and tried to let the dealer community know they didn’t like it. First, they required dealers to submit “large position reports” of how much of a particular Treasury issue they owned or controlled. That was suppose to wave a flag, saying, “we’re watching you.” It was still a game of cat and mouse. The cat could chase the mouse around the market, but as long as the mouse had a place to hide, it kept coming back.

Then, the Treasury Department set out to do something about it in 2006, when James Clouse, a Treasury official, on Sept. 27, 2006 called Repo market squeezes “an exercise in monopoly pricing.” He clearly wanted to clean up the Repo market. The Fed met with the 22 Primary Dealers in November 2006, and when the dust settled, one Credit Suisse and two UBS Repo traders had been fired and no blatant dealer squeezes have occurred since then.

7. Negative Repo rates 2003-06

Before 2003, negative rates in the Repo market were quite rare because market participants always had the option to “fail” (fail to deliver the agreed upon trade). A fail had no costs, or at least, the costs were nominal.

The “big break” for negative Repo rates came in 2003, when the 3.625% 5/13 failed for four months, between August and November. It took an extreme event like that to illustrate the true cost of fails, or at least, show the costs of fails over a long period of time. There was still no Fail Charge and failing was still the equivalent of 0.0% interest rate, but this time, it was different. Broker-dealers began accumulating a regulatory net capital charge, fails became assets on the balance sheet, labor costs in the back-office increased, and at times, the fails were annoying good customers. One issue that quickly became apparent was that no one could call margin against the fails.

To help dealers clean up problem fails, the Repo market devised the Guaranteed Delivery (GD) Repo trade. The “seller” was supposed to have the securities in their “box” and would guarantee delivery by the end of the day. Later in 2005, the Repo market tweaked the GD Repo trade, but this time the seller was required to pay a penalty if they failed to deliver. It was a better way of trading negative rates because it created a cost for not completing the trade. The Bond Market Association officially adopted the new type of trade in April 2006, calling it a Negative Rate Repo (NRR).

8. Broker averages and indexing

For years, the Repo brokers compiled averages of where Specials and GC traded on their screens each morning, they became known as the “10 o’clock averages.” As Brokertec emerged as dominant trading platform for Specials, the “Brokertec 10:00 average” became the standard currency for describing where an issue traded. As the “average” became more popular, dealers began quoting trades with their customers at fixed spreads off the average, for example, using the Brokertec average + 5 basis points for for long positions and Brokertec – 5 for short positions.

As the whole idea of Repo market indexing began to emerge, it was realized that averages became the equivalent of a “floating rate” for the Repo market. Of course, once there’s a fixed rate and a floating rate the next step is a swap between the two rates. At some point in the near future, formalized Repo interest rate swaps will be standard trading mechanisms for managing short term interest rate risk.

9. Financial crisis and the “Fail Charge”

During the height of the Banking Crisis in 2008, the amount of fails in the Treasury market were astronomical. The Treasury put pressure on the bond dealers to institute a mechanism to finally deal with the fail problem.

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