An industry-led proposal to alleviate problems in the US government repurchase or repo market has brought a mixed response from analysts and brokers.
The repo market underpins trading activity in the US Treasury bond market. In a repo, a security is borrowed in return for a short term cash loan and such activity allows traders to sell Treasuries short without owning them. It also provides owners of Treasuries with funding when they lend them.
Since the collapse of Lehman Brothers in September, the repo market has been hit by a rise in so-called repo fails. A fail occurs when a security borrowed in exchange for a short-term cash loan is not returned on time. Failure to deliver borrowed securities reached a record $2,700bn last month, and the total remains at a still high level of $1,340bn.
The turmoil in repo has been compounded by the Federal funds rate effectively trading well below its target rate of 1 per cent in recent weeks. When rates are low, repo fails persist as the penalty for a fail is minimal.
This week, the Treasury Market Practices Group, which comprises senior members of securities dealers, banks and investment groups and is sponsored by the Federal Reserve Bank of New York, set out a number of proposals, led by a call for implementing a greater penalty for repo fails. The TMPG wants the market to adopt a financial penalty for fails, calculated by a formula of 3 per cent minus the Fed funds target rate. Such a penalty would be 2 per cent at this time and the group wants the market to start moving by early January.
The TMPG also wants the market to adopt greater use of netting out various repo positions between banks and investors, a move designed to reduce the chain of prolonged fails that can be triggered across the market. That proposal, along with institutions providing greater margin when a security starts failing in repo won plaudits from the market.
Scott Skyrm, senior vice-president at Newedge, a repo broker-dealer said the TMPG’s proposals were a mix of the good, the bad and the the ugly, with the best aspect being that they were preliminary recommendations and the market had until January to lodge objections.
Mr Skyrm said one concern was that the proposal created an incentive for dealers to benefit should a customer not deliver a borrowed security in time. “If my client fails to me, I make 200 basis points. Customers do not have access to the broker’s screens and dealers will mark up rates considerably to write a negative rate trade and settle a guaranteed settlement,” he said.
Michael Cloherty, strategist at Banc of America Securities, said rolling out the penalty fee for fails initially for dealers and not customers as well early next year “would be extremely damaging”.
He warned that could create a chain of fails between investors across the market as “non-dealers get paid 200bps” from the penalty, a scenario which would make it difficult to reduce fails.
However, other proposals from the TMPG’s won plaudits.
“Multilateral netting is extremely helpful in reducing fails, because it nets out a daisy chain of institutions involved in a fail, and leaves just the original fail and the ultimate buyer,” Mr Cloherty said.
Mr Skyrm said: “Margining of fails is a good thing. There are significant counter party credit risks which arise from fails.”
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