Mark Pelham discusses the potential rivalry between overnight swaps and repurchase agreements at the short end of the euro yield curve.The euro-denominated interest rate swap market is the largest over-the-counter derivatives market, with a total estimated notional outstanding worth of $31,500bn, according to the latest figures from the Bank for International Settlements (BIS). As befits such status, the euro swap curve has emerged as the pre-eminent benchmark yield curve in euro financial markets, against which even government bonds are now often referenced.
After the watershed of European Monetary Union, swaps have quickly displaced most of the legacy currency benchmarks as the locus for interest rate price discovery. However, there is a school of thought that swap contracts at the very short end of the yield curve could one day face competition.
Overnight index swaps (OISs) have become especially popular hedging and positioning vehicles in euro financial markets. An OIS is a fixed-for-floating interest rate swap, with a floating rate leg tied to an index of daily interbank rates. Unlike plain vanilla interest rate swaps, the floating rate leg of an OIS is determined and paid only at maturity, as opposed to having the floating rate determined at one settlement date and paid at the next.
In the euro market, OISs are almost always referenced to the euro overnight index average (EONIA) rate – a weighted average of interest rates contracted on unsecured overnight loans in the interbank market. In a recent report on the euro interest rate swap market, the BIS noted that trading in EONIA swaps is highly concentrated in maturities of three months or less, and EONIA swap rates are widely considered to be the pre-eminent benchmark at the short end of the euro yield curve.
While OISs are also traded in US dollars and other major currencies, they have not gained benchmark status outside of Europe.
Such status inevitably invites closer regulatory scrutiny. The nature of the whole euro swaps market raises widely-held regulatory concerns over counterparty credit risk exposure. Swap dealers argue that the market is addressing this with increasing use and improvement of collateral management, netting agreements and initiatives that include the clearing of trades through London Clearing House’s Swapclear.
However, there are additional issues in connection with EONIA swaps. Thanks to its short-term nature, regulators find the market difficult to grasp; the practice of gathering outstanding notional figures at the end of each quarter, for example, fails to capture most EONIA swap trades. In addition, the market currently operates without an officially accepted ‘fix’ (fix rates for euro swaps over one year are published twice daily under the aegis of the International Swaps and Derivatives Association), although the AIC (the Financial Markets Association) is understood to be investigating the possibility of doing so.
Repo growth
Perhaps with those concerns in mind, the BIS report argues that repos (repurchase agreements) could eventually compete with EONIA swaps for benchmark status at the short end of the euro yield curve. “European repo markets are growing rapidly and steadily becoming more integrated, boosted in large part by market participants’ efforts to limit counterparty credit exposures,” the report says.
Although initiatives such as the increasing use of tri-party repo and the daily publication, since March last year, of the Eurepo benchmark have undoubtedly improved the repo markets in Europe, they still face significant challenges. Not least of these is the country-by-country variations in fiscal treatments, delivery mechanisms, legal frameworks and clearing and settlement methods – the latter being the area of most concern to repo dealers.
“Differing legislation is undoubtedly a problem,” says Godfried De Vidts, global funding co-ordinator at Fortis Bank and chairman of the European Repo Council. “However, the Giovannini report [which calls for the removal of all European clearing and settlement barriers within three years] is finally telling politicians that clearing and settlement is important, and that if the current situation doesn’t change, a truly unified European market will never develop. From what I hear, I think that this message has got through and it’s finally going to be done. Off the back of this, the present legal and fiscal discord will also be resolved.”
Mr de Vidts concedes that EONIA swaps do not face the same challenges because they are derivatives contracts, but says that while firms might do as much EONIA as they want, they still have to move the associated cash. “The depo [deposit] money market used to be the market in which to move cash around, and the repo market has already taken this over and will continue to grow, especially with the expansion of the European corporate bond and commercial paper markets.”
EONIA strength
How much the repo market has to grow to catch up with the EONIA swaps market is not clear; official statistics on the size of the latter are not readily available. However, the suggestion is that the EONIA swaps market is much bigger than the repo market.
The BIS report, for example, says that banks, pension funds, insurance companies, money market mutual funds and hedge funds all make extensive use of EONIA swaps to hedge and speculate on short-term interest rate movements. EONIA swaps are the most liquid segment of the euro money market, with swaps of E2bn ($2.3bn) regularly traded in the inter-dealer market for maturities up to three months, and significantly larger trades are not uncommon. Bid-ask spreads are typically one basis point.
Recent trading figures support the notion of the larger EONIA market, with reports of unprecedented flows of EONIA swaps from early to late May. Single trades as large as E25bn were executed without much fuss, as firms placed massive bets that the European Central Bank would cut rates on June 5 by more than 25 basis points.
Liquidity limits
Meyrick Chapman, head of derivatives strategy at UBS Warburg in London, believes that depth of market is the key to the continuing status of EONIA swaps as the short end benchmark. “You can write massively bigger tickets in EONIA swaps than you can in repo,” he says, “and that’s unlikely to change because repo is generally attached to an asset. Given that there are liquidity constraints on the underlying asset, it’s unlikely that it will develop as much liquidity as EONIA has.”
Mr Chapman argues that a further disadvantage for repo is that there are issues of ‘specialness’ still attached to a large number of bonds, which occasionally makes repo difficult to forecast. “As a result, unless the market starts trading repo independent of collateral, repo hasn’t got much of a chance of attaining benchmark status, and even then it would be unlikely,” he says.
It takes two
However, there is another possible outcome. Mark Painting, executive director and head of European money market trading at Goldman Sachs, argues that EONIA and Eurepo complement each other. “EONIA is really a benchmark for overnight unsecured cash trading, whereas if you want a secured benchmark, you should be using Eurepo,” he says.
Mr Painting believes that both benchmarks have a relevance in their own space and says that it is important for people to understand which is the right benchmark for them and then to choose it. “As a consequence of that, if more and more short-term money market trading drifts from the unsecured area into the secured area, then it is natural that the Eurepo benchmark would become more powerful than the EONIA benchmark.”
