Regulations aimed at reducing the risk of another financialcrisis are starting to upend a key part of the bond market thatexpedites trading in everything from Treasuries to junk bonds.

The U.S. repurchase, or repo, market where banks and investorsborrow and lend Treasuries and other fixed-income securities shrunkto $4.6 trillion daily outstanding last month, down 35 percent froma peak of $7.02 trillion in the first quarter of 2008, based onFederal Reserve data compiled from its 21 primary dealers.

From fewer repos to lower inventories of bonds, financialinstitutions 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 marketstress, including wider gaps between bid and offer prices and thespeed of completing trades. The potential consequences are higherborrowing costs for governments, companies, and consumers.

“During the market selloff over the past few months, thoserules, a lot of which are just proposed or not yet taken effect,already impacted dealers' willingness to take on inventory ofTreasuries, investment grade corporates to emerging market debt,”Gregory Whiteley, who manages government debt investments at LosAngeles-based DoubleLine Capital LP, which oversees $57 billion,said in an Aug. 14 telephone interview. “That exacerbated theintensity of the selloff.”

Dealers are cutting back at the same time volatility is risingamid speculation an improving economy will cause the Fed to reducethe $85 billion it's spending every month to buy bonds in an effortto boost the economy.

Bonds lost 2.9 percent over May and June, the worst two-monthstretch since the $42 trillion Bank of America Merrill Lynch GlobalBroad Market Index began in 1997.

That was worse than even the 1.9 percent decline in the heightof the financial crisis in September and October 2008, when LehmanBrothers Holdings Inc. collapsed, mortgage finance companies FannieMae and Freddie Mac were placed into government conservatorship,insurer American International Group Inc. agreed to a U.S. takeoverto avert collapse and Merrill Lynch & Co. was compelled to sellitself to Bank of America Corp.

Losses Resume

After a respite in July, bond losses have resumed this month.Yields on 10-year Treasury notes reached 2.9 percent today, thehighest 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 dueAugust 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-marketfunds, 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 marketsystems,” Josh Galper, the managing principal of securities-financeconsultant Finadium LLC in Concord, Massachusetts, said in an Aug.14 telephone interview. “Any increased friction in fixed-incomemarkets, such as decreased repo or increased taxation, and theoutcome usually is much less liquidity in government-bond markets,higher costs to borrow, more volatility, and less security.”

Fed Plan

In one example of a repo agreement, a money market fund may lendcash to a dealer overnight, with government securities serving ascollateral for the loan.

Obtaining cash by lending securities in repos is a methoddealers use to boost leverage, amplifying returns, while moneyfunds and other lenders earn interest on the cash they provide. Theaverage overnight repo rate for Treasuries fell as low as 0.016percent this year, from 0.29 percent on Dec. 31, according theDepository Trust & Clearing Corp. GCF repo index.

The Fed plans to use the repo market to eventually drainreserves and guide rates higher. The central bank has conductedwhat's called reverse repos with dealers and an expanded list ofcounterparties, including hedge and money market funds, since 2009to test its ability to one day tighten policy.

“There will be a problem when the Fed begins their exitstrategy, through using reserve draining in an attempt to putpressure and torque under the fed funds rate, if the repo marketisn't big and deep for them in Treasuries and mortgages,” JoeAbate, a money-market strategist in New York at Barclays Plc, saidin a telephone interview on Aug. 8.

Even though Fed data show primary dealers trade almost $600billion of Treasuries each day on average, making the market thedeepest, most liquid in the world, prices suggest constraints onbank balance sheets are having an impact on trading.

The difference between the prices at which dealers buy and sellTreasury futures contracts is about 2/32, or 63 cents per $1,000face amount, or double what it was in the five years before thebankruptcy of Lehman Brothers, according to data compiled byBloomberg.

“Recent regulatory changes will cause dealers to reduce risk andto make markets less aggressively,” Bruce Tuckman, senior fellow offinancial markets research at the nonprofit Center for FinancialStability and a finance professor at New York University's SternSchool of Business, said in an Aug. 14 telephone interview. “Endusers will lose some liquidity as dealers adjust to higher riskcapital mandates, lower leverage limits, and increased marginrequirements.”

Yield Discrepancies

The difference in yields between the newest Treasuries auctionedby the government and older bonds show investors are increasinglyconcerned about getting stuck with less liquid bonds, forgoing someyield in the process.

While debt markets have grown since the financial crisis, annualturnover in Treasuries as a multiple of total outstanding debt hasdeclined to about 12 times from about 20 in 2008, according to theTreasury Borrowing Advisory Committee's report to the Treasury lastmonth.

Regulations from the Volcker rule ban on proprietary trading aspart of the Dodd-Frank Act to risk-weighted asset requirementsunder Basel III guidelines and new supplementary leverage ratioshave “reduced risk—but also reduced liquidity,” the TBAC wrote inits report to the Treasury published on July 31.

“Leverage ratios will leave dealers less willing to provide repofinancing and to hold U.S. Treasuries,” according to the TBAC,which is made up of bond dealers and investors ranging from GoldmanSachs Group Inc. in New York to Newport Beach, California-basedPacific Investment Management Co., which manages $2 trillion,including the world's largest bond fund.

Still 'Deep'

TBAC members, including Chairman Dana Emery, who is the chiefexecutive officer of Dodge & Cox Inc., and Vice Chairman CurtisArledge of Bank of New York Mellon Corp., didn't respond totelephone requests or weren't available for comment.

Concerns that the bond market is less efficient givenregulations and fewer repos are overblown, according to VanguardGroup Inc., the biggest U.S. mutual-fund firm.

“From a liquidity perspective, the depth and breadth of themarket is just as deep as it has ever been,” David Glocke, whomanages $65 billion of Treasuries at Vanguard in Valley Forge,Pennsylvania, said in an Aug. 14 telephone interview. “The peoplewho are going to be impacted the most by the regulations' effectson the marketplace are doing their very best to make regulatorsaware of their concerns.”

The Fed's primary dealers had an average $2.6 trillion lastmonth in outstanding daily repurchase agreements, central bank datashows. When that is combined with reverse repurchase agreements,where dealers take in collateral and lend cash, the totaloutstanding reached $4.6 trillion.

The repo market is also shrinking as the Fed scoops upTreasuries through its monthly bond purchases. The central bankowns about 17 percent of the market.

U.S. regulators proposed last month that bank holding companieshave capital equal to 5 percent of their assets, and thattheir federally insured banking units hold capital equal to6 percent of assets. The proposals go beyond those approved in2010 by the 27-nation Basel Committee on Banking Supervision toprevent a replay of the 2008 financial crisis.

Global regulators also proposed an enhanced leverage ratio tomeasure equity to total assets, rather than formulas that let bankshold less capital for assets deemed less risky.

Barclays estimates that the repo market can shrink another 10percent if the new regulations are implemented. Banks are alreadyreducing repo positions at the end of each quarter to present moreattractive balance sheets, with money funds seeing their balanceswith dealers falling about 15 percent in the final days of recentquarters, according to Barclays.

Europe's Pain

In Europe, heightened regulations are also affecting the abilityof financial institutions to facilitate bond trades. The region'sbiggest banks must cut 661 billion euros ($883 billion) of assetsand generate 47 billion euros of capital to comply with newregulatory capital requirements, according to an analysis by RoyalBank of Scotland Group Plc.

“Before the crisis, we were able to execute clips of 20 millioneuros worth of corporate or covered bonds in just one or twominutes,” Stefan Kreuzkamp, the co-head of fixed income for Europeat Frankfurt-based Deutsche Asset & Wealth Management said inan Aug. 15 telephone interview. “These days, it could take a coupleof hours,” said Kreuzkamp, whose firm has about 1 trillion euros inassets.

At the same time, 11 European Union states have agreed to afinancial transaction tax, known as the FTT, that the EuropeanCommission 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 andderivatives at 0.01 percent. The levy on bond transactions wouldinclude overnight transactions.

If the FTT is imposed in the current form, it will end the repomarket in Europe, said Richard Comotto, a senior visiting fellow atthe University of Reading's International Capital MarketAssociation Center in southern England who has published reports onthe implications of new bank regulations. The ICMA estimates thatto cover the tax, a repo market maker would have to charge a spreadon an overnight repurchase agreement of 72.05 percentagepoints.

“While a lot of regulation is worthwhile and long overdue, it iscoming too far and too much in a short space of time,” Comotto saidin an interview. “Most of them are not well thought out.”

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