In January 2009, the TMPG announced plans to institute a steep penalty for fails – a charge of 300 basis points – making a fail the equivalent of covering a short at -3.00%. Once Fixed Income Clearing Corp (FICC) was on board, the whole market was assured to adopted it. The new practice also included allowing for margin calls on fails.
Clearly, the Fail Charge has created a more fluid Repo market and became a mechanism to price failing securities – negative Repo rates. Since the Fail Charge began, there has been no period of market-wide protracted fails. Yes, there are fails in individual issues, like 10-Year Notes, but those fails remain a temporarily phenomena.
10. New Regulation: Dodd-Frank, Basel III, FTT, And FSB
Over the past few years, new regulation has chipped away at many aspects of Repo market stability:
- Dodd-Frank Section 165 applies to foreign banks in the U.S. and it means that 26 foreign banks will need to hold more capital in the U.S. It was estimated it will create a $330 billion reduction in the size of the U.S. Repo market.
- Since 1985, the Repo market has been exempt from the “automatic stay” provisions of the U.S. bankruptcy code. This means is that Repo transactions can be immediately liquidated once a counterparty is in default. A report from the Securities and Exchange Commission (SEC) in July 2013 put the “automatic stay” exemption for Repo in doubt under certain circumstances.
- There’s talk about a Leverage Ratio being imposed on banks by Dodd-Frank, which will require them to hold a minimum of 5% capital on all of their assets (including Repo) compared to estimates of about 1% currently.
- Basel III – Additional Capital Required For Repo - the Financial Times estimated that $180 billion in additional capital is needed moving from Basel II to Basel III, estimating the average capital set aside for Repo trades will be about 2.5%.
- Financial Transaction Tax – The FTT could possibly put some European banks out of the Repo business. There are 11 EU member countries, led by Germany and France, who have pledged to move forward with it, but implementation looks doubtful after EU legal experts view the tax as illegal.
- Mandatory Repo Haircuts – In August 2013, the Financial Stability Board (FSB) in the U.K. released a negative study on securities re-hypothication. The FSB solution is to require mandatory haircuts on securities financing, and so far from what I’ve read, the proposed haircuts do not exceed those already imposed by the market.
Here’s what it all means:
- Some Repo matched-books will be eliminated
- The financing business will book significantly more trades with central counterparties (CCPs) and exchanges going forward.
- More Repo business will evolve between end-buyers (e.g. money funds) and end-sellers (e.g. hedge funds) – effectively eliminating some of the middle-men in the Repo market.
- Regulatory Arbitrage - Wherever there’s a regulation, there’s a loophole or an exemption. There will be increased Repo market-making activity away from large banks to entities that can better compete in the securities financing markets.
- Shrinking Repo Market - Many pundits have projected that the Repo market will shrink drastically. Added regulation and capital requirements will certainly mean a smaller market, but claims of a major hit to the Repo market are deceiving. As more Repo business is done direct, it will appear the Repo market is shrinking when fundamentally it is not.