INTERVIEW | Regulatory incentives have nudged both buy- and sell-side market participants towards more central clearing – resulting in more repo transactions and other liquidity management efforts to manage margin than were needed back in “the bilateral world”. Now, these repo contracts themselves call for more central clearing but the operational threshold is high. ABN Amro Clearing’s Alexander Jacobs is planning the launch of a new access service.
“Let’s call it ‘The Standard … Simple … ‘, no, I’ll have to think about it,” laughs Alexander Jacobs, ABN Amro Clearing’s global head of OTC clearing.
The service is underway – in collaboration with Eurex and Clearstream, the CCP and CSD in the Deutsche Börse Group – but per PostTrade 360°’s meeting with Alexander Jacobs at the Global Funding and Financing Summit in Luxembourg in late January, the name of the service is yet to be determined.
Leaning on ICMA estimates of Europe’s repo market at €11 trillion outstanding, with only about 30% of this being centrally cleared, ABN Amro Clearing expects that more actors would use central clearing if the operational hassle could be reduced. Seeing total European populations of about 3,000 banks and 4,000 buy-side institutions, the potential demand should be high. (Though, even for the new service, a lower threshold will remain. As a rule of thumb, institutions with less than 200 million euro in average repo exposures will be better off without centrally cleared repos but should rather look for “something bilateral” such as a credit facility or borrowing-lending agreement, Alexander Jacobs foresees.)
Sellers and buyers both see their reasons
Pushed by different regulations, both sell-side and investor-side institutions have come to manage their daily liquidity ever-tighter over the last decades. The growth of central clearing (generally, not specifically of repo transactions) is one of the key drivers, as the user of the clearing services needs to be prepared for calls from the CCP to prop up the variation margin with cash when open positions have lost value.
“A pension fund, for example, will face a strategic decision over how much cash to set aside to cover for possible variation margin calls – and each euro it sets aside is one that it cannot invest for a return. That is where liquidity management comes into play – in a way that wasn’t there in the bilateral world,” says Alexander Jacobs.
The repo market offers chances to balance temporary cash surpluses and deficits between market participants – exchanging securities and cash with each other in a low-risk way that allows low interest costs for the borrower.
Historically, this repo market has developed through fully bilateral relations between large banks and asset managers, but central clearing is now expanding also here. Position-netting possibilities can be one attraction at the CCP when compared to multiple lines with separate counterparties in a bilateral environment. However, for Europe’s smaller banks and asset managers, the threshold to be a member with CCPs and CSDs can be high – in terms of costs, project staff, operational requirements, and onboarding lead time. It is against this that ABN Amro Clearing, one of the world’s leading brokers of clearing services, is now onboarding clients to its new service. The idea is to aggregate the volumes of many market participants, who each by itself doesn’t have the scale to motivate becoming a clearinghouse member.
“We thought, why couldn’t we create a model where we are the single clearing member, and they use us while we organise everything. And instead of needing a year for onboarding, it is done in three months,” says Alexander Jacobs.
Repos could go into new arbitrage strategies
The basic logic of the new service is rather simple, essentially adding the repo product to a line of services already existing for others.
“Each clearing member is responsible for depositing initial margin for their respective portfolio, for each product, so why would it be different between product one and product two? Repo is simply one of the products, and among all the cleared products – for example interest rate swaps, equity derivatives, or futures – there is no less risky thing than repo, where the cash borrowing is covered by treasury bonds.”
In the innovative trading industry, Alexander Jacobs imagines that the possibility to clear repos could also underpin new trading strategies by for example hedge funds. The key to this lies in the interest-rate component which is central to the repo deal – but which should at any time correlate with the interest rates that are implied in the valuations of other bonds and derivatives, such as interest-rate or currency swaps and futures. Sometimes the prices of different instruments will not all adapt immediately in a consistent way, which can allow traders to combine a long and a short position into a certain profit at no risk – an arbitrage.
In purely bilateral trading, it is hard for small market participants to become a trusted counterparty that is allowed to trade on the basis of such strategies. For these, central clearing can open new doors and enable new trading models, Alexander Jacobs speculates.
“You can imagine smart people will be coming to think of ways to apply it.”
Long line of regulations
Both asset managers, such as the pension fund, and the banks who broker and deal in securities, have come to manage their liquidity more closely over the past decade or so – for different reasons.
The fund can be described as “collateral-rich” but “cash-poor” as it seeks to be fully invested. As its engagement with CCPs grows, the pension fund can cover for the “initial margin” to the CCP by posting collateral – that is, securities from its inventory. However, the daily “variation margin” to cover for value swings over time should typically be posted in cash. So, what level of reserve liquidity is the sweet spot that offers both resilience and investment returns in optimised combination?
So far the investor side. For Europe’s thousands of banks, a number of requirements have added costs to the keeping of bilateral exposures, including the banking sector’s Basel III framework, with its rules on a “net stable funding ratio” (NSFR), and the EU’s so-called uncleared-margin rules (UMR) that force influencial derivatives-market participant to apply more rigourous margin management when not clearing centrally. The result is that these institutions, too, have developed a growing daily need to look hard at their liquidity situation, starting from whether they face an excess or deficit of cash per the day.
