Cassandra Jones, managing director and EMEA head of securities finance client management at State Street Global Markets, assesses the peer-to-peer construct and its potential to empower the buy side
A changing market environment has produced a refreshed urgency to establish the right tools for liquidity and diversification. Uncertainty is prevalent as global markets are debating a near term recession, while a recent, albeit contained, banking crisis is top of mind for investors. On one hand, volatility and credit concerns highlight the importance of having risk-efficient options for cash investment and cash borrowing. On the other hand, there is now a significant opportunity cost of cash with interest rates well into positive, restrictive territory in many locations around the globe.
There are many opportunities to obtain a decent return on invested cash. The interplay of these considerations builds the case for alternative repo solutions. Many investors are turning to the secured markets as a way to place their cash, which provides the safety of collateralisation rather than remaining unsecured. Market practitioners need to have many tools in the toolbox to deal with funding, cash investment and liquidity needs in this rapidly evolving environment. When considering bilateral, cleared and new peer-to-peer repo structures, it makes sense to have a complete set of diversified solutions which act differently in times of crisis.
Following the global financial crisis, additional regulatory considerations such as risk-weighted assets under Basel capital requirements have driven down the appetite for traditional on-balance sheet lending that banks previously offered in abundance. In lockstep with the buy-side’s evolving needs, a mainstay of cleared transactions re-emerged — the Fixed Income Clearing Corporation’s (FICC’s) Sponsored Member Repo programme.
This programme has surged, in a flight to safety, to a peak of over US$600 billion in daily volume in March 2023. In addition to FICC’s credit rating, the cleared structure mitigated capacity constraints over month, quarter and year-ends. Due to its success in meeting market needs, the FICC Sponsored Repo programme continues to be a significant repo and reverse repo counterpart to money market funds, asset managers, pension funds and hedge funds.
Both the Federal Reserve System and European Central Bank (ECB) continue to reduce their balance sheets and rising rates could revive repo market volatility. Over the years, and particularly when the Fed has proceeded with quantitative tightening, we have seen funding strains in the bilateral repo markets. Market participants can recall the pressures that have emerged in past years with quantitative tightening, with repo rates hitting an overnight high of around 10 per cent in September 2019.
With inflation running at around double-digit levels in the UK, Eurozone and US, we can expect near term central bank tightening to continue and the potential for other liquidity concerns to remain. These market dynamics set the stage for peer-to-peer repo offerings to fit a market need. Both lenders and borrowers were eager for new sources of liquidity, counterparty diversification and the capacity a peer marketplace can offer.
The concept isn’t new, but the execution of the model is new and improved. Peer-to-peer repo puts the power in the hands of the buy side. Buy-side counterparts are able to trade directly with one another, while a bank like State Street, provides an indemnification to supply credit intermediation. This eliminates the traditional spread taken by dealers to offer potentially improved rates and it unlocks new sources of liquidity.
The case for peer-to-peer constructs holds across regions. Arguably, in EMEA, there is an even stronger case for a peer-to-peer marketplace to unlock liquidity across bifurcated jurisdictions. In EMEA, more countries and markets produce significant specials activity. There is also significant untapped liquidity across borders and currencies.
The European Sponsored Repo programmes are not as prevalent as in the US, so the market is currently searching for alternative ways of accessing liquidity. Market forces have driven this need. As in the US, there has been unprecedented action taken by central banks in the wake of the pandemic. The ECB’s pandemic emergency purchase programme (PEPP) introduced a vast amount of liquidity into the market through bond buying, with excess reserves increasing from €1.7 trillion at the end of 2019 to €3.2 trillion by the end of October 2020, according to the ICMA European Repo Market Paper.
We witnessed collateral scarcities in the European markets as a result — for example, at year-end 2016 when collateral scarcity caused repo rates to plunge for high quality liquid assets. Weighted average prints reached around -8 per cent for French and German general collateral (GC). Although the ECB has started to wind down its balance sheet, these cases highlight the potential for peer-to-peer adoption driven by the need for collateral.
Peer-to-peer creates an additional opportunity for market participants to access balance sheets and assets that were traditionally off limits. For example, a hedge fund may be able to source specials from a large asset owner, sovereign wealth fund or insurer directly, and those asset owners feel comfortable trading with that hedge fund when there is indemnification provided by the peer-to-peer programme provider. On the cash investment side in EMEA, there is differential access to cash investment outlets for US and non-US money market funds.
US funds are able to park cash at the Federal Reserve’s Reverse Repo facility (Fed RRP) at stable rates. The Fed RRP still stands above US$2 trillion. UCITS funds do not have access to the same Fed facilities. Peer-to-peer repo could offer additional outlets for cash investment which deliver more competitive rates against this backdrop of continued cash abundance.
Regulatory and compliance considerations also present changing demands on market participants. Some regulations will require additional reporting (the Securities Financing Transactions Regulation, or SFTR, for example) or even bifurcated liquidity (via multilateral trading facilities). However, there can also be opportunities for streamlined regulatory compliance through peer-to-peer repo.
For example, UCITS concentration limits are a factor. For reverse repos, the concentration limits look through to the underlying securities being provided as collateral. Peer-to-peer repo solutions can provide an effective outlet for cash investment to help firms to manage within concentration limits.
The success of peer-to-peer in the European markets will stem liquidity that can be brought to the programme. The launch of a centralised platform to pool this liquidity will help with price discovery and centralisation, while allowing for increased scale.
With State Street’s solution, the firm has found the following client benefits:
Indemnification: State Street provides an indemnification to the cash lender, guaranteeing the cash borrower’s payment obligations. S&P has reviewed the terms of the guaranty, affirming that the guaranty meets S&P’s principles for credit substitution of an unrated counterparty.
Streamlined documentation: rather than signing bespoke documentation on a per counterparty basis, State Street has created a streamlined set of documentation. Once executed, the documentation facilitates counterparties to trade freely between participants.
Competitive economics: in a rising and competitive rate environment, the peer-to-peer structure may facilitate yield enhancement for cash investors and provide favourable financing for cash borrowers. In avoiding bank’s balance sheets, State Street anticipates lenders will receive a premium compared to dealer-offered repo rates.
Workflow automation: in an effort to bring liquidity sources together, generate critical mass, and automate the trade workflow, State Street has partnered with FinOptSys to create an electronic peer-to-peer marketplace — Venturi SM. This platform allows counterparties to access and automate the full trade lifecycle. Further, State Street serves an administrative function, providing daily margin requirements and reporting on outstanding guaranteed transactions.
Although peer constructs have continued to grow in fits and starts across EMEA, State Street has worked to build a solution that addresses previous viability concerns. The collation of indemnification, a centralised trade negotiation platform, triparty collateral management and streamlined documentation may allow European market participants access to their buy-side counterparts directly. The aim is to disrupt the traditional methods of repo trading and empower the buy side.
