Modernising the repo market: Navigating regulatory changes and embracing innovation
11 June 2024
To align with the rapid pace of modernisation, firms must prioritise investment in technology that meets both client demands and regulatory requirements, according to Clear Street鈥檚 Joseph DiMartino, managing director of repo trading
Image: stock.adobe/melhak
An industry reliant on phone calls, chats and emails 鈥� the repo market has been hesitant to adopt new technologies and modern ways of working. Despite the crucial role that repo plays in funding the financial industry, the more than US$3 trillion US repo market still runs on outdated practices, including spreadsheets and paper confirmations.
However, changing market demands and new US central clearing rules are bringing repo into the 21st Century. In the most significant change for the Treasury market structure in decades, the US 色花堂and Exchange Commission (SEC) adopted a rule in December 2023, aimed at reducing risk and increasing transparency in the US repo market.
In practice, this rule will reassemble how the Treasury market functions by requiring market participants to clear all repo and interdealer cash trades. A 2021 report by the Treasury Market Practices Group estimated that 13 per cent of cash transactions are centrally cleared, 68 per cent are bilaterally cleared, and 19 per cent involve hybrid clearing.
After a relatively calm four years, a policy of quantitative tightening has reawakened volatility during banks鈥� critical funding periods, making the activity in the repo market more significant than ever. As broker-dealers, funds, and other market participants adjust to changing regulations and client needs, those who invest in cutting-edge technology will take the lead.
Legislation driving modernisation
The SEC鈥檚 December 2023 landmark regulations include specific requirements for repo and reverse repo collateralised by US Treasury securities to be cleared centrally. The new rules for clearing houses will take effect in March 2025. Firms will have to meet heightened standards for risk management, access to settlement services, and protection of customer assets. The rules for clearing house members to clear cash transactions will take effect in December 2025, and repo transactions will go into practice in June 2026.
Central clearing is set to increase transparency in the repo market and may reduce gross exposures and flows, lessening the amplification of small shocks and lowering stress in the Treasury and other markets. However, the associated rise in transactional fees could cause some market participants to shrink their balance sheets.
Smaller players will have to pass on the additional cost, and may lose clients who cannot accept a higher barrier to entry, leading to potential concentration risk. However, granting increased exposure to the Fed and its operations, either outright or through primary dealerships, could alleviate some of these concerns. Additionally, there is a possibility of unintended consequences, including less liquidity and possible disruptions in US Treasury auctions.
In tandem, debt-fueled bets by prop traders and hedge funds, also known as basis trades, have drawn scrutiny from regulators, who are concerned that an abrupt unwind of leveraged positions could strain markets. Visibility of Treasury cash-futures basis trades are historically limited, and the Federal Reserve is seeking to better understand hedge funds鈥� Treasury holdings and repo activity.
Enhancing efficiency in post-trade
鈥淢ajor industry transformations happen every 15 to 20 years, and while there have been steady incremental improvements over recent years, I think we鈥檙e set for a period of significant reform,鈥� said Magnus Haglind, head of products, marketplace technology, for Nasdaq. 鈥淔or example, we鈥檙e now in the second full decade of cloud adoption in many parts of the global economy, but its potential has yet to be realised in financial markets.鈥�
Haglind was referring to the slow adoption of new technologies in financial services compared to other industries. Fundamental change across the financial services industry will require a change in mindset, and firms must ensure they have the right people and training to support agile, client-centric development.
Innovation also requires a shift around cost dynamics. For many firms, back office processes are out of sight and mind until something goes wrong. The cost of trade failure is substantial when factoring in borrowed securities, interest costs, balance sheet impact, and penalties.
Simplifying the technology behind trading and post-trade functions can transform it from a cost centre to a competitive advantage. But for many firms, upgrading would require rewriting numerous systems with significant technical debt, massive resourcing, and high planning costs 鈥� a daunting project.
Modernisation ultimately results in enhanced transparency, reduced counterparty risk, and cost efficiency. Firms already using new technology will be better equipped to adopt standardisation models, increase cost efficiency, and reduce counterparty risks.
The repo market is historically relationship-driven, but the importance of relationships should not undermine or stifle technological innovation. While differences in collateral and dates can complicate standardising repo operations, when the balance sheet gets scarce, it becomes more difficult to trade on a platform, particularly repo.
To streamline processes, firms should reduce manual actions, automate functions like affirmation and confirmation processes, and move away from overnight batch processing.
A modern brokerage ecosystem
The shrinking prime brokerage industry, coupled with the regional banking crisis, the meme stock saga, and the collapse of Archegos Capital, has challenged hedge funds in formulating their prime brokerage strategies. A counterparty鈥檚 stability in volatile markets can be a key differentiator, together with their product offering, securities lending supply, and financing capabilities. For example, as Common Equity Tier 1 (CET1) ratios face pressure under Basel III regulations, banks may need to scale down their balance sheets, potentially reducing hedge fund lending.
The solution lies in a centralised platform that breaks down silos of critical inputs, and harnesses advanced analytics and machine learning to optimise inventory, collateral, and margin, in response to customer demand. Advancements in pre and post-trade processes such as onboarding, trade settlement, and loan allocation, promise to increase efficiencies. The ultimate aim is to enhance liquidity, improve economics, and mitigate systemic risk.
As the repo market faces increased demand for transparency, automation, and time and cost efficiency, the future is a modern, scalable prime brokerage model. A technology-first approach 鈥� driven by engineers and securities finance veterans 鈥� can improve speed to market and expansion into new products and services. Downstream, these efficiencies translate into personalised, white-glove client service with increased visibility and lower costs.
The repo market is ripe for disruption. There is an opportunity for independent prime brokers with the autonomy to prioritise client interests without the constraints of standardised capital requirements or conflicting business agendas.
This new generation of firms have greater flexibility and discretion in pricing, and can deliver products faster, with enhanced customisation and improved alignment on risk and margin policies.
To align with the rapid pace of modernisation, firms must prioritise investment in technology that meets both client demands and regulatory requirements. Those who embrace this shift will play a crucial role in shaping the modern and scalable landscape of capital markets, ultimately enhancing access, speed, and service for all stakeholders.
However, changing market demands and new US central clearing rules are bringing repo into the 21st Century. In the most significant change for the Treasury market structure in decades, the US 色花堂and Exchange Commission (SEC) adopted a rule in December 2023, aimed at reducing risk and increasing transparency in the US repo market.
In practice, this rule will reassemble how the Treasury market functions by requiring market participants to clear all repo and interdealer cash trades. A 2021 report by the Treasury Market Practices Group estimated that 13 per cent of cash transactions are centrally cleared, 68 per cent are bilaterally cleared, and 19 per cent involve hybrid clearing.
After a relatively calm four years, a policy of quantitative tightening has reawakened volatility during banks鈥� critical funding periods, making the activity in the repo market more significant than ever. As broker-dealers, funds, and other market participants adjust to changing regulations and client needs, those who invest in cutting-edge technology will take the lead.
Legislation driving modernisation
The SEC鈥檚 December 2023 landmark regulations include specific requirements for repo and reverse repo collateralised by US Treasury securities to be cleared centrally. The new rules for clearing houses will take effect in March 2025. Firms will have to meet heightened standards for risk management, access to settlement services, and protection of customer assets. The rules for clearing house members to clear cash transactions will take effect in December 2025, and repo transactions will go into practice in June 2026.
Central clearing is set to increase transparency in the repo market and may reduce gross exposures and flows, lessening the amplification of small shocks and lowering stress in the Treasury and other markets. However, the associated rise in transactional fees could cause some market participants to shrink their balance sheets.
Smaller players will have to pass on the additional cost, and may lose clients who cannot accept a higher barrier to entry, leading to potential concentration risk. However, granting increased exposure to the Fed and its operations, either outright or through primary dealerships, could alleviate some of these concerns. Additionally, there is a possibility of unintended consequences, including less liquidity and possible disruptions in US Treasury auctions.
In tandem, debt-fueled bets by prop traders and hedge funds, also known as basis trades, have drawn scrutiny from regulators, who are concerned that an abrupt unwind of leveraged positions could strain markets. Visibility of Treasury cash-futures basis trades are historically limited, and the Federal Reserve is seeking to better understand hedge funds鈥� Treasury holdings and repo activity.
Enhancing efficiency in post-trade
鈥淢ajor industry transformations happen every 15 to 20 years, and while there have been steady incremental improvements over recent years, I think we鈥檙e set for a period of significant reform,鈥� said Magnus Haglind, head of products, marketplace technology, for Nasdaq. 鈥淔or example, we鈥檙e now in the second full decade of cloud adoption in many parts of the global economy, but its potential has yet to be realised in financial markets.鈥�
Haglind was referring to the slow adoption of new technologies in financial services compared to other industries. Fundamental change across the financial services industry will require a change in mindset, and firms must ensure they have the right people and training to support agile, client-centric development.
Innovation also requires a shift around cost dynamics. For many firms, back office processes are out of sight and mind until something goes wrong. The cost of trade failure is substantial when factoring in borrowed securities, interest costs, balance sheet impact, and penalties.
Simplifying the technology behind trading and post-trade functions can transform it from a cost centre to a competitive advantage. But for many firms, upgrading would require rewriting numerous systems with significant technical debt, massive resourcing, and high planning costs 鈥� a daunting project.
Modernisation ultimately results in enhanced transparency, reduced counterparty risk, and cost efficiency. Firms already using new technology will be better equipped to adopt standardisation models, increase cost efficiency, and reduce counterparty risks.
The repo market is historically relationship-driven, but the importance of relationships should not undermine or stifle technological innovation. While differences in collateral and dates can complicate standardising repo operations, when the balance sheet gets scarce, it becomes more difficult to trade on a platform, particularly repo.
To streamline processes, firms should reduce manual actions, automate functions like affirmation and confirmation processes, and move away from overnight batch processing.
A modern brokerage ecosystem
The shrinking prime brokerage industry, coupled with the regional banking crisis, the meme stock saga, and the collapse of Archegos Capital, has challenged hedge funds in formulating their prime brokerage strategies. A counterparty鈥檚 stability in volatile markets can be a key differentiator, together with their product offering, securities lending supply, and financing capabilities. For example, as Common Equity Tier 1 (CET1) ratios face pressure under Basel III regulations, banks may need to scale down their balance sheets, potentially reducing hedge fund lending.
The solution lies in a centralised platform that breaks down silos of critical inputs, and harnesses advanced analytics and machine learning to optimise inventory, collateral, and margin, in response to customer demand. Advancements in pre and post-trade processes such as onboarding, trade settlement, and loan allocation, promise to increase efficiencies. The ultimate aim is to enhance liquidity, improve economics, and mitigate systemic risk.
As the repo market faces increased demand for transparency, automation, and time and cost efficiency, the future is a modern, scalable prime brokerage model. A technology-first approach 鈥� driven by engineers and securities finance veterans 鈥� can improve speed to market and expansion into new products and services. Downstream, these efficiencies translate into personalised, white-glove client service with increased visibility and lower costs.
The repo market is ripe for disruption. There is an opportunity for independent prime brokers with the autonomy to prioritise client interests without the constraints of standardised capital requirements or conflicting business agendas.
This new generation of firms have greater flexibility and discretion in pricing, and can deliver products faster, with enhanced customisation and improved alignment on risk and margin policies.
To align with the rapid pace of modernisation, firms must prioritise investment in technology that meets both client demands and regulatory requirements. Those who embrace this shift will play a crucial role in shaping the modern and scalable landscape of capital markets, ultimately enhancing access, speed, and service for all stakeholders.
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