Repo traders ponder the prospect of negative rates

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Negative interest rates could become a very common sight on dealer screens in the US government bond repurchase market from next month.

Late last year, the Treasury Market Practices Group, an industry body, proposed that repo traders and investors adopt a financial penalty for so-called failed trades. This charge, which starts on May 1, is a formula of 3 per cent minus the federal funds rate. With that Federal Reserve target at near zero, repo rates could in effect trade as much as negative 3 per cent.

In a repo transaction, dealers borrow money from money market funds and other investors for short periods of time and pledge securities such as Treasuries as collateral for the loan.

A failed repo trade occurs when the borrowed security is not returned on time. Fails tend to rise when official rates are low, as the penalty for not delivering a borrowed security is very low.

After a spike following Lehman Brothers’ bankruptcy last year, the number of failed transactions has eased of late. But in the present era of low rates set by the Fed, there is a concern that the effectiveness and liquidity of the repo market is vulnerable to a renewed jump in fails.

Recently, the five-year Treasury note has been failing and trading at slightly negative rates as such trades have been cleaned up by dealers.

Negative trading in repo is rare as it means that the lender pays a fee to the borrower in order to make a loan. Since December, less than $3bn of securities have traded at negative rates, says Barclays Capital.

The question now facing dealers is just how negative could rates become, at a time when trading activity remains much lower than prior years, given the current period of deleveraging by banks and investors.

Current financing inflows of Treasuries by dealers are about $1,700bn a week, down from a peak of $3,000bn in March last year, according to Fed data. This partly reflects less lending of securities by long-term investors.

“Whether Treasuries will trade with negative repo rates depends on the amount of leverage in the markets,” said Alex Li, strategist at Credit Suisse.

He said when there is more leverage and greater demand to short Treasuries by dealers and investors, so the prospect of more repo fails emerges.

Given the mechanics of the new system, the imposition of a penalty rate may push repo rates a lot more negative, should a particular Treasury issue experience heavy demand for borrowing in repo.

“Once an issue begins failing, the repo market will use negative rate trades more actively,” said Scott Skyrm, senior vice-president at Newedge, a repo broker dealer.

A 3 per cent penalty rate means that a dealer may well elect to trade at negative rates towards that level as it is still less than the penalty rate.

“We believe that once a security is failing and it does trade negative, the rates will be much closer to -3.00 per cent than 0.0 per cent,” Mr Skyrm said.

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