Asia’s young repo market faces new OTC clearing hurdle

The risk of shifting OTC derivatives onto exchanges is that it will fragment an already small market, says JP Morgan.
Asia’s young repo market faces new OTC clearing hurdle

The repurchase market in Asia is small, which means if other regions are a guide, it should expand rapidly. However that progress could be slowed by regulatory efforts around the world to shift more trading and clearing of over-the-counter derivatives onto exchanges, or with centralised counterparties.

O’Delle Burke, product manager for collateral management at JP Morgan, speaking at AsianInvestor's third annual Southeast Asia Investment Forum in Kuala Lumpur this week, says repurchase agreements, or repos, play an important role in providing liquidity to financial institutions at a global level.

The total market for repos is $14.5 trillion, up from the $13.3 trillion recorded last December. So the amount of secure financing has risen 9% this year, providing liquidity to financial institutions and to the money-market funds industry.

Europe is the biggest market for repos, at around $8 trillion, while the US accounts for $5 trillion and Asia-Pacific $1.5 trillion. Most of the Asia-Pac activity involves Japan and Australia.

Outstanding repo transactions as a proportion of GDP is much higher in Europe and the US, ranging from 60% to 70%, while the figure is only 8.2% for Asia-Pacific, and below 2% for Asia ex-Japan and ex-Australia.

“There are a lot of opportunities to develop this market,” says Burke. “For example, if the offshore renminbi market is to grow, you need the RMB credit market to expand, and that includes securities lending and repos.” He says the region has also yet to embrace non-cash collateral in repo deals (i.e. securities-for-securities transactions).

Repos come under the definition of forward options under the International Swaps and Derivatives Association’s standards. A repo is the sale of securities together with an agreement for the seller to buy back the securities at a later date. In effect it is a secured loan, but is structured as a forward contract, with the seller (termed a borrower) using its securities as collateral, usually for a secured cash loan.

The difference in price between the repurchase price and the original sale price is the repo rate, i.e. interest. In derivatives-speak, it’s the difference between the spot price and the forward price.

Repos are used in securities-lending transactions to cover short positions or to construct complex financial arrangements; or for buyers to invest in secured loans over a customised period of time (such as money-market funds); to help traders finance long positions; and to enable central banks such as the US Federal Reserve to add or remove reserves from banking systems.

However, as OTC derivatives, they are being swept up by an initiative blessed by the G20 group of governments in 2009 to move such instruments to trade, report and clear on exchanges or other centralised counterparties (CCPs).

Most of the $600 trillion notional OTC derivatives world consists of fairly standardised interest-rate contracts, while the actual credit exposure is only $3.2 trillion. Contracts involving Asian credit amount to only 9% of that, and stripping out Australia and Japan, the size is a mere $145 billion.

So the Asian piece of this market is small, but its promise of growth is going to face new regulatory hurdles.

The move to put more OTC contracts on exchange is not, in itself, bad news. Singapore Exchange, for example, has already begun clearing OTC derivatives, and Hong Kong Exchange and Clearing is set to follow. Moreover, the G20 initiative regarding OTC derivatives had clear backing from Asian governments: China, India, Indonesia, Japan and South Korea are all G20 members.

But industry practitioners worry that, in Asia, the result will be fragmentation of an already small industry. Already three global clearing houses are active in Singapore (CME, Euronext and LCH), while governments are keen to see local CCPs develop to keep clearing onshore.

“This will require margin to be posted by the buy-side to the CCP or to a clearing broker,” Burke notes. Financial institutions will also face IT costs to develop and maintain systems for reporting and reconciliation.

He suggests the region risks facing a “collateral crunch” as trades with various CCPs proliferate.

The original purpose of CCPs was to provide operational efficiency, as one-stop hubs for trade processing and settlement. But now they are also in the risk-management game, thanks to the G20, which includes collateral management. And those collateral requirements are going to vary, with some insisting just on cash or US Treasuries, while others may accept other types of securities.

CCPs, central banks and depositories are also going to need to upgrade their ability to segregate member or client collateral. This includes making distinctions between client and proprietary, between cash and securities, and between initial and variation margining.

So while Asia has much room to grow its use of repos, such transactions are going to require more margin from investors, and better recordkeeping, reporting and segregation processes among investors, brokers and clearing houses – all of which is likely to impede progress, at least until US and European regulation is made clear and the new infrastructure is put in place.

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