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Concerns About Sponsored Repo Miss the Mark

By Josh Galper, Managing Principal, Finadium, Special to DTCC Connection | November 21, 2019

Concerns About Sponsored Repo Miss the Mark

We’re confused why Risk and Bloomberg have both written articles lately pointing fingers at sponsored repo as a new reason to worry about repo stability. It is a new transmission mechanism and one that deserves study, but we think these articles bring a level of concern that is unwarranted.

In “Plumbing problems in the repo market and “All clear? Structural shifts add to repo madness,” authors in Risk Magazine made a link between sponsored repo and concentration of market liquidity. “Ironically, a service designed to solve the leverage ratio problem and take the pressure off dealer balance sheets may have concentrated liquidity in the hands of a small group of sponsor banks and approved borrowers.”

Bloomberg’s “Repo Fragility Exacerbated by a Hot New Corner of Funding Market” offers a headline that says, “worry about me,” and is similar to recent repo headlines of the last two months that echo the word crisis across the hillsides. Is this clickbait or genuine concern? Hard to say.

While these articles contain many factual accuracies, it seems to us that they whip up a level of worry that is unwarranted. What they get right is that sponsored repo is driven by overnight trades and not term; Bloomberg quotes Credit Suisse’s Zoltan Pozsar as saying that sponsored repo is “concentrating funding risk in overnight transactions rather than longer-term ones.” Is that taking previously more secure term trades out of the market? Pozsar thinks so, but data from the Office of Financial Research’s bilateral repo pilot project found that 65% of UST repo was under seven days anyhow. Most banks are already considering their Net Stable Funding Ratio figures. We don’t think either intuitively or from the data that even if sponsored repo were shortening terms that it would matter much when other parts of the market remain active. This article and others miss the point that while growth has been fast, sponsored repo is not the only game in town.

Pozsar is spot on correct in the Bloomberg article on the impact of a funding shortage due to cash stepping out of the market on any given day: “If the money doesn’t come in and it goes out — maybe there’s a large settlement day, there’s a large tax payment day — when the money goes away you literally hit an air pocket. And if there’s no one to lend into that air pocket, you have a problem.” We fully agree and have said so ourselves. The core issue remains the same: the huge mismatch between balance sheet restrictions and the amount of UST being issued in 2019 and projected for next year.

Both articles also mention concentration risk in the sponsored repo market, focusing on the number of sponsors. It’s true that right now there are just over a handful of sponsors and that more will come soon. However, new sponsors may or may not bring added value in the form of new clients that add two-sided liquidity. Rated money funds have a 25% limit to any one counterparty and that includes FICC. More sponsors won’t necessary bring more cash providers, but they will likely bring more hedge funds looking to finance collateral. We think the causality of more sponsors entering the market, meaning that somehow there will be more liquidity, is unproven. The Risk article on plumbing notes that “as it expands, the service could make repo more robust…” Well, it depends.

Honestly, who really cares about two vs. 20 sponsors if cash is leaving the market for underlying reasons.

To the point of what happened the week of September 16, did sponsored repo contribute to heightened instability? We heard that volumes were down around 15% on sponsored repo, but with corporate tax payments, UST settlement and Saudi Arabia rumored to have pulled out $30-$40 billion following the attack on their oil facilities, this could be equally argued as a pro rata reduction as much as systemic. We also heard that a reduction in sponsored repo translated into less funding for smaller dealers that needed it, which in turn led to rate spikes.

Rather than be worried about sponsored repo concentration, we’re more concerned about general repo market concentration. Big dealers enjoy a regulatory moat that defends their market position. This isn’t sponsored repo’s fault, but rather the way that balance sheet regulations are set up. We’d like to see less concentration risk among dealers across all parts of the repo market as a top priority.
As the Federal Reserve’s Liberty Street Economics reported in April 2019:

New participants remain a small part of the overall market. In GCF Repo, these participants make up about 6 percent of total gross activity in the last quarter of 2018. Similarly, in FICC DvP, new repo participants are 3 percent of total gross activity for the same time period. As a point of reference, the average amount of GCF Repo and FICC DvP activity for a top-ten dealer is larger than the sum of the repo activity for all new participants.

It is fair to say that sponsored repo is a new way for the repo markets to function and that potential impacts should be evaluated. But as a panelist at our Rates & Repo 2019 conference noted, the repo market is much bigger than FICC rules or structure. We think that Risk and Bloomberg, and the pundits that will follow them, are wrong to raise alarms about the stability of the system due to sponsored repo without looking at the bigger picture.

Now that repo is better understood by the general public, everyone has an opinion. But as we told the AV guy at our Rates & Repo 2019 conference last week, if you’re looking for the source of the next crisis, it’s not likely to be found in repo so long as the Fed is around.

This article originally appeared on Securities Finance Monitor.