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Miruna-Daniela Ivan, Joshua Lillis, Eduardo Maqui and Carlos Cañon Salazar
Funding markets are essential for wholesome and lively monetary establishments, and consequently for everybody within the financial system. The repurchase settlement (repo) market performs a key position in financial institution and non-bank monetary establishments’ (NBFIs’) every day actions by facilitating short-term financing and threat hedging. On this submit, we use novel Securities Financing Transaction Regulation (SFTR) knowledge to focus on new, and corroborate earlier, stylised repo haircut details.
What are repos? Why have they got haircuts? And why will we care?
A repo transaction is the simultaneous sale of, and ahead settlement to repurchase, securities at a particular value, at a future date (Duffie (1996)). The vendor receives money in change for the securities, whereas the client earns a return on the money lent. The agreed value of repo transactions is often decrease than the market value of the safety used as collateral, and the distinction is called a ‘haircut’. Our evaluation will present haircuts primarily reply to counterparty credit score threat, however can even mirror a variety of threat, eg market and liquidity dangers.
Repo markets assist value discovery and enhance liquidity in a wide range of markets, however they will additionally pose dangers to monetary stability. They usually contain corporations taking (or extending) leverage and might create liquidity and maturity mismatches. They are often uncovered to run-like occasions – which the position of collateral can amplify. Given the position repo markets performed throughout earlier systemic episodes, eg the worldwide monetary disaster (GFC), the 2020 ‘sprint for money’, and the 2022 liability-driven funding (LDI) disaster, central banks and regulators monitor them intently.
From earlier work we all know some stylised details about haircuts within the repo market, eg Kotidis and van Horen (2018), Julliard et al (2022), and Hüser et al (2024). Haircuts depend upon counterparty traits, eg they are usually bigger for corporations with greater (perceived) credit score threat. Haircuts additionally depend upon the traits of the underlying collateral. They’re usually bigger for longer maturity contracts, for greater Worth at Danger (VaR) collateral, and the place collateral is concentrated.
New knowledge, new insights…
Enhancing knowledge assortment has been a key a part of post-GFC regulatory initiatives to raised perceive securities financing markets. Beneath the Securities Financing Transactions Regulation (SFTR) (launched in 2019), the Financial institution of England receives transaction-level knowledge on securities financing transactions from all UK-based individuals. It goals to enhance the transparency of markets and to allow higher monitoring of dangers.
SFTR knowledge present new insights into an space that helps core secondary market exercise just like the money gilt market, together with that by non-bank market individuals. Haircut knowledge in SFTR is extra complete and of upper high quality than different present sources. Improved market protection and haircut reporting permits us to interrupt down repo haircuts by collateral kind (eg gilts), maturity, and sector. It additionally supplies new info on non-gilt government-bond repo markets, enabling us to match gilt haircuts to different core markets like US treasury securities.
Who’s available in the market for (bilateral) gilt repo?
Exercise within the bilateral gilt repo market is broadly concentrated within the dealer-to-client section of the market. Sellers embody prime brokers and different banks that usually prolong money lending to NBFI purchasers that depend on the bilateral gilt repo marketplace for their liquidity and collateral operations. As in Hüser et al (2024), we discover cash market funds (MMFs) make up the biggest share of common every day quantity (round 33%). They’re necessary (internet) lenders of money – primarily within the in a single day section of the repo market – to sellers. In flip, MMFs obtain medium (7–20 yr) and long-dated (>20 yr) gilts.
Along with earlier findings, SFTR knowledge present that hedge funds (HFs) make up the second largest share of common every day quantity (round 30%), being lively on either side of the repo market; the typical tenor of this lending is between one and two weeks. HFs have been more and more lively in authorities bond markets globally over the previous decade, with an acceleration in exercise over the past couple of years.
SFTR knowledge largely corroborate this. Chart 1 illustrates the construction of the bilateral gilt repo market throughout monetary sectors. Flows of the identical (totally different) color because the sector within the outer ring present money lending (borrowing) by (from) that sector. The width of the flows – indicated by the numbers within the outer ring – mirror the dimensions of excellent money lending and borrowing (in £ billions). We see a bigger share of excellent HF bilateral gilt repo money lending in comparison with MMFs because of the longer common tenor. Different NBFI individuals within the bilateral gilt repo market embody asset managers (AMs), insurance coverage firms and pension funds (PFs), in addition to LDI funds and different monetary establishments (OFIs).
New findings from SFTR knowledge additionally point out that non-dealer to non-dealer transactions symbolize a small fraction of whole exercise. Chart 1 reveals that almost all excellent transactions involving non-dealer counterparties are intermediated by sellers. Inter-dealer exercise is substantial, proven by the within-sector gray stream for sellers. This highlights their key position as money lenders within the gilt repo market, which may be essential during times of stress.
Chart 1: Monetary sector money lending community within the bilateral gilt repo market (inventory knowledge as of December 2023)
What do haircuts appear like?
Wanting by way of totally different collateral varieties within the bilateral repo market, haircuts usually enhance with the market threat (rate of interest and liquidity) of the underlying collateral (Chart 2). Authorities debt securities – broadly recognised because the ‘most secure’ non-cash property – have a mean haircut of near zero in bilateral transactions between seller banks and NBFIs. In keeping with Julliard et al (2022), we discover that inside the authorities bond repo market, haircuts mirror, partly, the chance of fluctuations within the collateral value (interest-rate threat). Longer-dated collateralised bonds typically contain greater haircuts largely because of being extra delicate to rate of interest modifications. In the meantime, repo backed by riskier debt securities – similar to debt issued by banks and NBFIs – attracts common haircuts of over 5%, however this stays far smaller than the 35% common haircuts on major index fairness repos.
Chart 2: Quantity-weighted common bilateral repo haircuts by collateral kind (knowledge from 15 June to 1 July 2023)
Inspecting the federal government bond repo market in additional element, SFTR knowledge present that gilt repo haircuts are typically near-zero (between 0%–2%). In the meantime, haircuts on repo transactions backed by US Treasury securities are at or under 0.5% for many of our pattern, with a notable enhance (to just about 1.5%) across the time of the Spring 2023 banking sector turmoil (Chart 3). This slight variation in haircut ranges throughout authorities bond repo supplies some additional proof that the extent of haircuts additionally displays the diploma of market liquidity within the underlying collateral securities.
Chart 3: Quantity-weighted common bilateral haircuts on authorities bond repos
Close to-zero bilateral haircuts in gilt repo are partly pushed by market construction and aggressive dynamics, past prudent threat administration concerns, as highlighted by the PRA’s 2023 thematic evaluation of main banks’ fastened revenue financing. Zero haircuts also can correspond to a set of transactions (typically known as ‘nettable packages’) whereby a seller has an almost an identical amount of money obtained/payable with the identical shopper over the identical tenor, which may be netted out (Hempel et al (2023)).
However not all bilateral gilt repo is transacted with zero haircut. In actual fact, lower than half of bilateral repo quantity (round 40%) is so. There’s excessive heterogeneity past trades with near-zero haircut pricing, which is essentially pushed by counterparty traits, similar to credit score threat concerns (Gorton and Metrick (2012); Copeland et al (2014); Krishnamurthy et al (2014); Mancini et al (2016); and Boissel et al (2017)).
SFTR knowledge corroborates earlier proof exhibiting that haircuts have a tendency to extend with counterparty credit score threat. We see this by evaluating haircut ranges throughout totally different NBFI individuals within the gilt repo market each in regular occasions and in pressured monetary market circumstances. Specializing in the LDI disaster as a case examine, Chart 4 reveals that haircuts charged on LDI funds and PFs elevated procyclically throughout this stress episode and remained elevated for a while, largely reflecting greater credit score threat. This procyclicality amplified market dysfunction by elevating the price of repo borrowing for NBFIs (see Pinter (2023)). For recognized HFs in SFTR knowledge, nevertheless, haircuts on repo gilt transactions have remained unchanged over time, and near near-zero ranges.
Chart 4: twenty fifth–seventy fifth percentile distribution of haircuts on bilateral gilt repo and reverse repo transactions throughout counterparty sectors
What implications can we draw from the evaluation?
On this submit we use novel SFTR knowledge to point out that variation in haircuts is essentially pushed by counterparty credit score threat concerns, though different elements play a component, together with the traits of the underlying collateral securities. So, nobody haircut matches all.
We discover proof of procyclical haircut fluctuations within the LDI and PF sectors throughout the 2022 LDI disaster. These have been gradual to return to pre-crisis ranges on the again of heightened credit score threat. Additional work utilizing SFTR knowledge is required to analyse the resilience of sterling markets, given the potential of haircut procyclicality to exacerbate liquidity calls for throughout stress and amplify market dysfunction.
However, the low degree of haircuts confronted by HFs could recommend that substantial leveraging could possibly be going down in a big bilateral gilt repo market section with out acceptable threat mitigation. This deserves steady monitoring given its potential monetary stability implications.
Carlos Cañon Salazar and Joshua Lillis work within the Financial institution’s Market Intelligence and Evaluation Division and Miruna-Daniela Ivan and Eduardo Maqui work within the Financial institution’s Market-Based mostly Finance Division.
If you wish to get in contact, please e-mail us at bankunderground@bankofengland.co.uk or go away a remark under.
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