Regulations aimed at reducing the risk of another financial crisis are starting to upend a key part of the bond market that expedites trading in everything from Treasuries to junk bonds.
The U.S. repurchase, or repo, market where banks and investors borrow and lend Treasuries and other fixed-income securities shrunk to $4.6 trillion daily outstanding last month, down 35 percent from a peak of $7.02 trillion in the first quarter of 2008, based on Federal Reserve data compiled from its 21 primary dealers.
From fewer repos to lower inventories of bonds, financial institutions are responding to more stringent capital standards imposed by regulators around the world. Already, the group of dealers and investors that advise the U.S. Treasury say that they see declines in liquidity in times of market stress, including wider gaps between bid and offer prices and the speed of completing trades. The potential consequences are higher borrowing costs for governments, companies, and consumers.
“During the market selloff over the past few months, those rules, a lot of which are just proposed or not yet taken effect, already impacted dealers’ willingness to take on inventory of Treasuries, investment grade corporates to emerging market debt,” Gregory Whiteley, who manages government debt investments at Los Angeles-based DoubleLine Capital LP, which oversees $57 billion, said in an Aug. 14 telephone interview. “That exacerbated the intensity of the selloff.”
Dealers are cutting back at the same time volatility is rising amid speculation an improving economy will cause the Fed to reduce the $85 billion it’s spending every month to buy bonds in an effort to boost the economy.
Bonds lost 2.9 percent over May and June, the worst two-month stretch since the $42 trillion Bank of America Merrill Lynch Global Broad Market Index began in 1997.
That was worse than even the 1.9 percent decline in the height of the financial crisis in September and October 2008, when Lehman Brothers Holdings Inc. collapsed, mortgage finance companies Fannie Mae and Freddie Mac were placed into government conservatorship, insurer American International Group Inc. agreed to a U.S. takeover to avert collapse and Merrill Lynch & Co. was compelled to sell itself to Bank of America Corp.
After a respite in July, bond losses have resumed this month. Yields on 10-year Treasury notes reached 2.9 percent today, the highest since July 2011, and were at 2.89 percent as of 2:19 p.m. New York time. The price of the benchmark 2.5 percent note due August 2023 was at 96 20/32.
Repos are part of the non-bank, or “shadow banking,” sector. Banks use repos to help finance investments in Treasuries, corporate bonds, and mortgage-backed securities. Money-market funds, such as those used by individuals to park cash and savings, are a major provider of repo financing.
“The repo markets are really the grease in many financial market systems,” Josh Galper, the managing principal of securities-finance consultant Finadium LLC in Concord, Massachusetts, said in an Aug. 14 telephone interview. “Any increased friction in fixed-income markets, such as decreased repo or increased taxation, and the outcome usually is much less liquidity in government-bond markets, higher costs to borrow, more volatility, and less security.”
In one example of a repo agreement, a money market fund may lend cash to a dealer overnight, with government securities serving as collateral for the loan.
Obtaining cash by lending securities in repos is a method dealers use to boost leverage, amplifying returns, while money funds and other lenders earn interest on the cash they provide. The average overnight repo rate for Treasuries fell as low as 0.016 percent this year, from 0.29 percent on Dec. 31, according the Depository Trust & Clearing Corp. GCF repo index.
The Fed plans to use the repo market to eventually drain reserves and guide rates higher. The central bank has conducted what’s called reverse repos with dealers and an expanded list of counterparties, including hedge and money market funds, since 2009 to test its ability to one day tighten policy.
“There will be a problem when the Fed begins their exit strategy, through using reserve draining in an attempt to put pressure and torque under the fed funds rate, if the repo market isn’t big and deep for them in Treasuries and mortgages,” Joe Abate, a money-market strategist in New York at Barclays Plc, said in a telephone interview on Aug. 8.
Even though Fed data show primary dealers trade almost $600 billion of Treasuries each day on average, making the market the deepest, most liquid in the world, prices suggest constraints on bank balance sheets are having an impact on trading.
The difference between the prices at which dealers buy and sell Treasury futures contracts is about 2/32, or 63 cents per $1,000 face amount, or double what it was in the five years before the bankruptcy of Lehman Brothers, according to data compiled by Bloomberg.
“Recent regulatory changes will cause dealers to reduce risk and to make markets less aggressively,” Bruce Tuckman, senior fellow of financial markets research at the nonprofit Center for Financial Stability and a finance professor at New York University’s Stern School of Business, said in an Aug. 14 telephone interview. “End users will lose some liquidity as dealers adjust to higher risk capital mandates, lower leverage limits, and increased margin requirements.”
The difference in yields between the newest Treasuries auctioned by the government and older bonds show investors are increasingly concerned about getting stuck with less liquid bonds, forgoing some yield in the process.
While debt markets have grown since the financial crisis, annual turnover in Treasuries as a multiple of total outstanding debt has declined to about 12 times from about 20 in 2008, according to the Treasury Borrowing Advisory Committee’s report to the Treasury last month.
Regulations from the Volcker rule ban on proprietary trading as part of the Dodd-Frank Act to risk-weighted asset requirements under Basel III guidelines and new supplementary leverage ratios have “reduced risk—but also reduced liquidity,” the TBAC wrote in its report to the Treasury published on July 31.
“Leverage ratios will leave dealers less willing to provide repo financing and to hold U.S. Treasuries,” according to the TBAC, which is made up of bond dealers and investors ranging from Goldman Sachs Group Inc. in New York to Newport Beach, California-based Pacific Investment Management Co., which manages $2 trillion, including the world’s largest bond fund.
TBAC members, including Chairman Dana Emery, who is the chief executive officer of Dodge & Cox Inc., and Vice Chairman Curtis Arledge of Bank of New York Mellon Corp., didn’t respond to telephone requests or weren’t available for comment.
Concerns that the bond market is less efficient given regulations and fewer repos are overblown, according to Vanguard Group Inc., the biggest U.S. mutual-fund firm.
“From a liquidity perspective, the depth and breadth of the market is just as deep as it has ever been,” David Glocke, who manages $65 billion of Treasuries at Vanguard in Valley Forge, Pennsylvania, said in an Aug. 14 telephone interview. “The people who are going to be impacted the most by the regulations’ effects on the marketplace are doing their very best to make regulators aware of their concerns.”
The Fed’s primary dealers had an average $2.6 trillion last month in outstanding daily repurchase agreements, central bank data shows. When that is combined with reverse repurchase agreements, where dealers take in collateral and lend cash, the total outstanding reached $4.6 trillion.
The repo market is also shrinking as the Fed scoops up Treasuries through its monthly bond purchases. The central bank owns about 17 percent of the market.
U.S. regulators proposed last month that bank holding companies have capital equal to 5 percent of their assets, and that their federally insured banking units hold capital equal to 6 percent of assets. The proposals go beyond those approved in 2010 by the 27-nation Basel Committee on Banking Supervision to prevent a replay of the 2008 financial crisis.
Global regulators also proposed an enhanced leverage ratio to measure equity to total assets, rather than formulas that let banks hold less capital for assets deemed less risky.
Barclays estimates that the repo market can shrink another 10 percent if the new regulations are implemented. Banks are already reducing repo positions at the end of each quarter to present more attractive balance sheets, with money funds seeing their balances with dealers falling about 15 percent in the final days of recent quarters, according to Barclays.
In Europe, heightened regulations are also affecting the ability of financial institutions to facilitate bond trades. The region’s biggest banks must cut 661 billion euros ($883 billion) of assets and generate 47 billion euros of capital to comply with new regulatory capital requirements, according to an analysis by Royal Bank of Scotland Group Plc.
“Before the crisis, we were able to execute clips of 20 million euros worth of corporate or covered bonds in just one or two minutes,” Stefan Kreuzkamp, the co-head of fixed income for Europe at Frankfurt-based Deutsche Asset & Wealth Management said in an Aug. 15 telephone interview. “These days, it could take a couple of hours,” said Kreuzkamp, whose firm has about 1 trillion euros in assets.
At the same time, 11 European Union states have agreed to a financial transaction tax, known as the FTT, that the European Commission estimates may raise as much as 35 billion euros a year. Stock and bond trades would be taxed at a rate of 0.1 percent and derivatives at 0.01 percent. The levy on bond transactions would include overnight transactions.
If the FTT is imposed in the current form, it will end the repo market in Europe, said Richard Comotto, a senior visiting fellow at the University of Reading’s International Capital Market Association Center in southern England who has published reports on the implications of new bank regulations. The ICMA estimates that to cover the tax, a repo market maker would have to charge a spread on an overnight repurchase agreement of 72.05 percentage points.
“While a lot of regulation is worthwhile and long overdue, it is coming too far and too much in a short space of time,” Comotto said in an interview. “Most of them are not well thought out.”