Addressing the transformation of secured funding markets
01 October 2024
Shiv Rao, chairman at Sunthay, explores how all-to-all trading that incorporates standardised documentation, electronic trading, and integrated post-trade collateral management services can change the status quo
Image: stock.adobe.com/1st footage
Secured funding markets are on the cusp of the greatest changes and challenges in decades. Impending regulatory changes that will increase capital requirements and operational risks and costs for banks will force market participants to either deal with substantially higher costs or adopt alternative trading models that can preserve efficiency. Either way, significant changes are inevitable.
For firms willing to change the status quo, there is a solution that results in greater efficiency than any other secured funding model 鈥� Guaranteed Repo. Guaranteed Repo is also easy to implement as it uses existing market plumbing and trading conventions.
What is Guaranteed Repo?
Guaranteed Repo 鈥� developed by Sunthay Holdings 鈥� allows banks to perform their vital credit intermediary role in repo markets without using their balance sheets. Banks facilitate repo trades among end users and end providers that do not normally trade directly with one another (eg hedge funds and money market funds) by guaranteeing the performance of the low-credit quality counterparty.
Sunthay鈥檚 Guaranteed Repo solution is a form of all-to-all trading that incorporates standardised documentation, electronic trading, and integrated post-trade collateral management services. These services are provided by firms with deep expertise and experience in secured funding markets. The solution is available globally as the structure complies with global regulations and accounting and legal requirements.
The capital and cost efficiency
A host of regulatory changes that will affect the economics of secured funding transactions are scheduled to be implemented by early to mid-2026. Among the important ones are the Basel III Endgame, the Global Systemically Important Bank (G-SIB) Surcharge, and the US clearing requirement for US Treasury-backed repo transactions. Other existing regulations such as the supplementary leverage ratio (SLR), the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) also impose significant costs on secured funding transactions.
Guaranteed Repo transactions are not included in the SLR calculation, generate risk-weighted assets (RWAs) that are 40 per cent to 100 per cent lower than principal transactions (including cleared transactions), are excluded from most of the components of the G-SIB Surcharge calculation, and have lower operational costs and risks than any other secured funding model. They are also excluded from the LCR and the NSFR.
Guaranteed Repo transactions are expected to be between firms that are not clearing house direct members and are therefore exempt from the US clearing requirement, which only applies to transactions in which at least one counterparty is a clearing house direct member. While guarantors are likely to be direct members of clearing houses, they are not counterparties to transactions.
Guaranteed Repo is a 鈥榦ne-step鈥� model, in that cash and collateral are exchanged directly between end users and end providers 鈥� settlement is delivery-versus-payment (DVP). In contrast, the dominant existing principal secured funding model is a 鈥榯wo-step鈥� structure, wherein cash and collateral are exchanged twice: first, between end users and intermediary banks (primarily DVP settlement), and second, between intermediary banks and end providers (primarily triparty settlement). One-step models result in substantially lower operational costs (six or more basis points lower) than two-step models.
The tremendous capital and cost efficiency of Guaranteed Repo can make client financing one of the most profitable businesses for banks that adopt it, with return on equity well in excess of the cost of capital and stellar return on assets.
Promoting systemic resilience
Guaranteed Repo addresses the concerns voiced by regulators and market observers relating to systemic resilience. It helps preserve and enhance secured funding markets鈥� liquidity by making credit intermediation by banks economically attractive, while ensuring transparency and adequate capitalisation of risk. As secured funding markets grow in coming years, it is likely to play an increasingly important role in supporting market functioning.
A note on capital efficiency
The impending finalisation of Basel III Endgame and the G-SIB Surcharge rules will increase banks鈥� capital requirements for secured funding transactions. Basel III Endgame sharply limits banks鈥� ability to use internal assessments of counterparty risk weights, instead applying standardised risk weights when calculating RWAs.
This change can result in substantially higher risk weights for many counterparties, particularly low-risk entities such as money market funds (MMFs) or certain beneficial owners. In some cases, the standardised risk weights for these counterparties can be more than 10 times greater than internally modelled ones.
Counterintuitively, RWAs for secured funding transactions under Basel III Endgame are likely to be higher for banks on their liability-leg exposures (eg repo leg) when facing low-risk end providers such as MMFs, than on their asset-leg exposures (eg reverse-repo leg) to high-risk end users such as hedge funds. This quirk results from: (1) the operation of the RWA formula, and (2) the standardised (high) risk weights.
RWAs are determined by what appears to be a straightforward formula 鈥� exposure X risk weight. The exposure calculation is symmetrical for transactions with zero haircuts, ie such transactions result in identical exposures for asset and liability legs. However, once haircuts are taken into account, exposures become asymmetrical. Essentially, asset-side transactions can result in zero exposure (if haircuts are sufficiently high), while exposures on liability-side transactions can never be zero. These results hold for centrally cleared transactions as well as bilateral transactions.
When risk weights could be internally determined, the RWA for liability-leg exposures could remain low. The application of high standardised risk weights makes the liability-leg exposure much more significant.
In Guaranteed Repo transactions, guarantors only guarantee the performance of end users, not end providers. The guarantee generates RWAs equivalent to the asset-leg RWAs in two-step structures. Because the guarantor has no exposure to end providers, the liability-leg RWAs of two-step principal structures are eliminated.
Because asset-leg RWAs can be reduced to zero if end users post sufficiently high haircuts, guarantors have the ability to eliminate RWAs entirely for Guaranteed Repo transactions (as liability-leg exposures are always zero), thereby transforming segments of their financing activities into a capital-light, fee-based business.
Another source of substantial capital efficiency for larger banks is under the G-SIB Surcharge calculation. Most elements of the G-SIB Surcharge apply only to on-balance sheet items. Guaranteed Repo transactions do not appear on banks鈥� balance sheets. The efficiency is greatest for US banks, which are subject to an alternative 鈥榞old plating鈥� standard which penalises reliance on short-term wholesale funding, primarily secured funding transactions.
Guaranteed Repo transactions are also excluded from the LCR and NSFR calculations, further enhancing capital efficiency.
A timely solution for secured funding markets
Guaranteed Repo squarely addresses the challenges facing market participants. It is a fully developed solution that can be implemented with minimal effort.
Now is the time for all repo participants, whether end users, intermediary banks or end providers, to evaluate the benefits of Guaranteed Repo, alongside the analysis of current structures and other solutions such as total return swaps and central clearing. Guaranteed Repo offers scalability and global applicability that eludes these other options.
Guaranteed Repo is a financing structure that is fully compliant with existing regulations and market conventions. No other existing or proposed solution incorporates these elements.
For these reasons, it is a highly efficient solution to address the coming transformation of secured funding markets, will compare extremely favourably with other solutions, and will become an important and vital component to address the coming transformation of secured funding strategies.
Guaranteed Repo is expected to be launched in Q4 2024.
For firms willing to change the status quo, there is a solution that results in greater efficiency than any other secured funding model 鈥� Guaranteed Repo. Guaranteed Repo is also easy to implement as it uses existing market plumbing and trading conventions.
What is Guaranteed Repo?
Guaranteed Repo 鈥� developed by Sunthay Holdings 鈥� allows banks to perform their vital credit intermediary role in repo markets without using their balance sheets. Banks facilitate repo trades among end users and end providers that do not normally trade directly with one another (eg hedge funds and money market funds) by guaranteeing the performance of the low-credit quality counterparty.
Sunthay鈥檚 Guaranteed Repo solution is a form of all-to-all trading that incorporates standardised documentation, electronic trading, and integrated post-trade collateral management services. These services are provided by firms with deep expertise and experience in secured funding markets. The solution is available globally as the structure complies with global regulations and accounting and legal requirements.
The capital and cost efficiency
A host of regulatory changes that will affect the economics of secured funding transactions are scheduled to be implemented by early to mid-2026. Among the important ones are the Basel III Endgame, the Global Systemically Important Bank (G-SIB) Surcharge, and the US clearing requirement for US Treasury-backed repo transactions. Other existing regulations such as the supplementary leverage ratio (SLR), the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) also impose significant costs on secured funding transactions.
Guaranteed Repo transactions are not included in the SLR calculation, generate risk-weighted assets (RWAs) that are 40 per cent to 100 per cent lower than principal transactions (including cleared transactions), are excluded from most of the components of the G-SIB Surcharge calculation, and have lower operational costs and risks than any other secured funding model. They are also excluded from the LCR and the NSFR.
Guaranteed Repo transactions are expected to be between firms that are not clearing house direct members and are therefore exempt from the US clearing requirement, which only applies to transactions in which at least one counterparty is a clearing house direct member. While guarantors are likely to be direct members of clearing houses, they are not counterparties to transactions.
Guaranteed Repo is a 鈥榦ne-step鈥� model, in that cash and collateral are exchanged directly between end users and end providers 鈥� settlement is delivery-versus-payment (DVP). In contrast, the dominant existing principal secured funding model is a 鈥榯wo-step鈥� structure, wherein cash and collateral are exchanged twice: first, between end users and intermediary banks (primarily DVP settlement), and second, between intermediary banks and end providers (primarily triparty settlement). One-step models result in substantially lower operational costs (six or more basis points lower) than two-step models.
The tremendous capital and cost efficiency of Guaranteed Repo can make client financing one of the most profitable businesses for banks that adopt it, with return on equity well in excess of the cost of capital and stellar return on assets.
Promoting systemic resilience
Guaranteed Repo addresses the concerns voiced by regulators and market observers relating to systemic resilience. It helps preserve and enhance secured funding markets鈥� liquidity by making credit intermediation by banks economically attractive, while ensuring transparency and adequate capitalisation of risk. As secured funding markets grow in coming years, it is likely to play an increasingly important role in supporting market functioning.
A note on capital efficiency
The impending finalisation of Basel III Endgame and the G-SIB Surcharge rules will increase banks鈥� capital requirements for secured funding transactions. Basel III Endgame sharply limits banks鈥� ability to use internal assessments of counterparty risk weights, instead applying standardised risk weights when calculating RWAs.
This change can result in substantially higher risk weights for many counterparties, particularly low-risk entities such as money market funds (MMFs) or certain beneficial owners. In some cases, the standardised risk weights for these counterparties can be more than 10 times greater than internally modelled ones.
Counterintuitively, RWAs for secured funding transactions under Basel III Endgame are likely to be higher for banks on their liability-leg exposures (eg repo leg) when facing low-risk end providers such as MMFs, than on their asset-leg exposures (eg reverse-repo leg) to high-risk end users such as hedge funds. This quirk results from: (1) the operation of the RWA formula, and (2) the standardised (high) risk weights.
RWAs are determined by what appears to be a straightforward formula 鈥� exposure X risk weight. The exposure calculation is symmetrical for transactions with zero haircuts, ie such transactions result in identical exposures for asset and liability legs. However, once haircuts are taken into account, exposures become asymmetrical. Essentially, asset-side transactions can result in zero exposure (if haircuts are sufficiently high), while exposures on liability-side transactions can never be zero. These results hold for centrally cleared transactions as well as bilateral transactions.
When risk weights could be internally determined, the RWA for liability-leg exposures could remain low. The application of high standardised risk weights makes the liability-leg exposure much more significant.
In Guaranteed Repo transactions, guarantors only guarantee the performance of end users, not end providers. The guarantee generates RWAs equivalent to the asset-leg RWAs in two-step structures. Because the guarantor has no exposure to end providers, the liability-leg RWAs of two-step principal structures are eliminated.
Because asset-leg RWAs can be reduced to zero if end users post sufficiently high haircuts, guarantors have the ability to eliminate RWAs entirely for Guaranteed Repo transactions (as liability-leg exposures are always zero), thereby transforming segments of their financing activities into a capital-light, fee-based business.
Another source of substantial capital efficiency for larger banks is under the G-SIB Surcharge calculation. Most elements of the G-SIB Surcharge apply only to on-balance sheet items. Guaranteed Repo transactions do not appear on banks鈥� balance sheets. The efficiency is greatest for US banks, which are subject to an alternative 鈥榞old plating鈥� standard which penalises reliance on short-term wholesale funding, primarily secured funding transactions.
Guaranteed Repo transactions are also excluded from the LCR and NSFR calculations, further enhancing capital efficiency.
A timely solution for secured funding markets
Guaranteed Repo squarely addresses the challenges facing market participants. It is a fully developed solution that can be implemented with minimal effort.
Now is the time for all repo participants, whether end users, intermediary banks or end providers, to evaluate the benefits of Guaranteed Repo, alongside the analysis of current structures and other solutions such as total return swaps and central clearing. Guaranteed Repo offers scalability and global applicability that eludes these other options.
Guaranteed Repo is a financing structure that is fully compliant with existing regulations and market conventions. No other existing or proposed solution incorporates these elements.
For these reasons, it is a highly efficient solution to address the coming transformation of secured funding markets, will compare extremely favourably with other solutions, and will become an important and vital component to address the coming transformation of secured funding strategies.
Guaranteed Repo is expected to be launched in Q4 2024.
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