Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
BrackenMarch 26 2012

The repo market is vital, not villainous

The misuse of the repo market by Lehman Brothers and MF Global should not prompt hasty regulation proposals, because the vast majority of repo activity is entirely transparent and straightforward.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

In the January 2012 edition of The Banker, Sharon Bowles, chair of the European Parliament’s Economics and Monetary Affairs Committee, questioned whether enough was being done to prevent a repetition of the financial crisis. She was particularly concerned about the role that repo might have played, and whether it was accounted for in bank balance sheet reporting in a way that transparently revealed its true impact. She raised the possibility of a trade repository as a means of improving transparency.

Editor's choice 

Unfortunately, the arguments appear to be based on a misunderstanding of current accounting practice. There is no room for error here. The repo market is too important to the efficiency and stability of the financial system to risk making regulatory mistakes. It is an irreplaceable safe haven for the investment of liquid reserves, the source of the funding and bond borrowing that underpins liquidity and smooth settlement in the primary and secondary securities markets, the channel through which central banks implement monetary policy and inject emergency assistance, and the venue where collateral is traded, which means it will be key to the increased collateralisation and use of central clearing counterparties being demanded by regulators.

‘Window dressing’ the balance sheet?

The pivotal misunderstanding is the idea that repo removes assets from the balance sheets of sellers (the ‘cash borrowers’). Under International Financial Reporting Standards and most (if not all) existing European accounting regimes, this is categorically untrue. Because the seller of collateral in a repo commits to buy back that collateral at a fixed price in the future, the risk on the collateral remains with the seller, which means that the collateral remains on the seller’s balance sheet. And because the cash borrowed through the repo creates a new asset and liability, the net result is that the seller’s balance sheet will expand, thereby transparently demonstrating that he has borrowed. So, although repo legally is a sale and repurchase of securities, it is accounted for in exactly the same way as a secured loan.

Proper accounting practice is sometimes circumvented. But such cases are exceptional and have usually represented the exploitation of weak spots in the accounting regime by firms already in trouble. We are talking here about Lehman’s Repo 105 and MF Global’s use of repo to maturity. Both institutions were able to slip part of their repo activity through loopholes in US Generally Accepted Accounting Principles that do not exist in Europe.

A complex financial derivative?

The misunderstanding about accounting for repo may have prompted the suggestion that the commitment by the seller to repurchase the collateral in the future makes repo “a complex financial derivative”, to quote Ms Bowles, by replacing the collateral with “a hard-to-price forward contract which falls into the ‘dangerous’ category during times of stress”.

But there is an implicit assumption here that all collateral is illiquid and a suggestion that repo is designed to work with illiquid assets (indeed, in Ms Bowles' article, repo was called “that friend of illiquid assets”). In fact, illiquid collateral is a repo dealer’s nightmare. They need to be able to value collateral every day and are always conscious of the risk that it would have to be liquidated in the event of a default. This is why some 80% of collateral in European repo is government bonds, chosen because they have traditionally been the most liquid (and creditworthy) assets. The remainder of the market is largely high-quality alternatives, including covered bonds, mortgage-backed securities and equity. As the semi-annual market survey published by the International Capital Markets Association’s European Repo Council shows, exotic collateral is rare.

Greater transparency

Another concern was that repo is used as a 'magic wand' to transform the credit quality of low-rated assets ('sweepo-repo'). This is a reference to liquidity swaps, under which illiquid assets are swapped for liquid assets from an institution with less need for liquidity, such as an insurance company or pension fund. The liquid assets can then potentially be repo-ed out for cash.

But why is repo the villain of the piece? It is entirely desirable that repo collateral should be liquid. Where it comes from is another matter. The real concern  with liquidity swaps is not the swap itself, but whether liquidity is being accurately priced.

There is usually room to improve transparency, and repo is no exception. But we need to appreciate the degree of transparency that already exists and build on it. Whether a trade repository would be a cost-effective improvement is unclear. Repo is a high-volume market similar to foreign exchange, but carries far more data. The cost will be high, and the case for imposing this cost has yet to be made.

Richard Comotto is a senior visiting fellow of the ICMA Centre at the University of Reading.

Was this article helpful?

Thank you for your feedback!