In a detailed report, the J.P. Morgan Global Research team unpacks sponsored repo, a growing market that takes a significant step in alleviating the regulatory costs of fixed-income financing in a post-crisis world.
“We believe sponsored repo cannibalizes less efficient forms of repo, ultimately freeing up capital and creating more capacity for banks to provide liquidity to the fixed-income markets,” wrote J.P. Morgan analysts Teresa Ho, Joshua Younger, Alex Roever and Ryan Lessing.
Fixed-income financing, also known as repo, is a type of short-term borrowing in which counterparties obtain cash by posting collateral. Cash borrowers, such as hedge funds, often use repos to fund security purchases. Meanwhile, cash rich lenders such as money market funds (MMFs) take the other side of the deal seeking a profit. In most cases, a dealer—often a large bank—acts as an intermediary between the parties to facilitate the transaction.
The first signs of the financial crisis bubbled up in this corner of the market, also dubbed the lifeblood of Wall Street by the press, when dealers could no longer roll their significant repo exposures as liquidity rapidly dried up.
After Lehman Brothers failed, banks and regulators recognized the risks associated with short-term funding, both unsecured and secured, and ushered in a new series of rules. Bank capital requirements, such as Basel’s Leverage Ratio and the Global Systemically Important Bank (G-SIB) capital surcharge, require banks to hold capital against exposures associated with secured lending. In response, dealer transactions in the repo market have declined and the way banks fund themselves has fundamentally been altered.
As Roever points out, the gross size of the repo market now stands at approximately $5.1 trillion, according to the Fed’s most recent primary dealer financing data. Of this, reverse repo—which is when a dealer lends money in exchange for bonds—accounts for $2.3 trillion.
“These balances are a far cry from where they were pre-crisis in 2008 as post-crisis regulations have limited the amount of repos dealers can do with clients by significantly increasing the cost of bank balance sheets,” said Ho.
The amount of Treasury repos, for example, supporting the overall Treasury market has declined from a high of approximately 60% to now as low as 10%.
Sponsored repo is a transaction in which a dealer sponsors non-dealer counterparties onto Fixed Income Clearing Corporation’s (FICC) cleared repo platform—a system that matches and nets repo trades in U.S. government debt.
In a typical matched-book repo trade, a dealer would borrow $100 from a cash rich lender (e.g., a money market fund) and then on-lend the proceeds to a cash borrower (e.g., a hedge fund) in exchange for collateral. As part of this, the dealer would have to put up its own capital against $100 of repo exposure.
In sponsored repo, FICC intermediates both sides of the trade, thereby allowing dealers to net the transactions off against each other. This means the amount of capital banks have to hold is greatly decreased, allowing dealers to provide more balance sheet to clients or deploy capital towards other operations.
But this netting benefit comes at a cost, points out Younger. Dealers have to provide a guarantee to FICC with respect to all obligations of its sponsored members and post additional capital into FICC’s clearing fund. They may also have to post additional liquidity at FICC's Capped Contingent Liquidity Facility, which is a liquidity buffer that each netting member needs to maintain institutionally to support a potential liquidity crisis of the clearinghouse.
In sum: sponsored repo is largely a form of repo substitution, with dealers moving away from balance sheet intensive repo trades to something that's efficient, allowing the capital gained in the process to be redeployed towards other uses.
MMFs reported holding $138 billion of sponsored repos as of December 2018. While this is only a fraction of the $5.1 trillion gross repo market, sponsored repo has come a long way since mid-2017 when MMFs began participating in the product.
In the near-term, FICC is expected to receive approval from the Securities Exchange Commission (SEC) to expand its cleared repo platform to other counterparties.
But the upside is limited, with FICC capping how much non-bank members can engage in sponsored repo to account for the somewhat riskier nature of these members relative to “well-capitalized” Bank Netting Members such as U.S. G-SIBs.
We would not be surprised if the market grows materially in size in the coming year, particularly as FICC is expected to expand its sponsoring and sponsored eligibility requirements to include more counterparties.
Sponsored repo gives MMFs the ability to access collateral on days when it may not be otherwise available, such as during quarter-end when banks restrict balance sheet use. For hedge funds, who lend collateral versus cash, its benefit is mostly in financing availability.
There are some legal agreements clients need to have in place with the sponsoring member and FICC, which can take anywhere from a couple days to a few weeks before a client may engage in sponsored repo.
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