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The industry initially welcomed revisions to the ratio, finalised on January 12, because it allows the netting of repos and reverse repos with the same counterpartyunder certain circumstances – something that was not permitted when the revisions were proposed in July last year. A closer reading has left some institutions worried bilateral repos may be excluded - that is around 50 per cent of the market, according to some estimates. Without the ability to net, each new trade would add to a bank's leverage exposure, forcing it to hold more capital.
"Where the market could be most impacted is government bond repos – larger markets like Germany, France and the UK especially. These markets are very liquid and they don't have large spreads as a result, meaning they look worse from a return-on-capital point of view", says a senior financing specialist at a US bank in London.
The January text sets out criteria for the netting of repos and reverse repos, the first two of which are relatively straightforward: the transactions need to have the same final settlement date, and the legal right of set-off needs to exist. However the third criterion – set out in paragraph 33(i)(c) – is being interpreted differently from one bank to another, with some arguing it closes the door on netting altogether for bilateral repos. To obtain netting, it says counterparties must "intend to settle net, settle simultaneously, or the transactions are subject to a settlement mechanism that results in the functional equivalent of net settlement". It adds that the transactions to be netted must go through the same settlement system and be supported by liquidity arrangements that ensure they will both settle by the end of the day.
Around 10 per cent of bilateral repo trades fail to settle on time due to operational issues, according to one banker's estimate, which might mean only repo transactions that are handled by a central counterparty (CCP) could be seen as satisfying the intent criterion – because it's the only way to be sure a trade will settle net.The problem is that only around 30 per cent of repo transactions are cleared, according to the International Capital Market Association, and CCPs currently only handle interdealer trades – meaning client-to-dealer repo transactions would remain bilateral, and may not qualify for netting.
This would have a number of effects, in particular on government bonds, which make up around 85 per cent of the repo market, claims the financing source. First, he says banks may have to reduce their involvement in the government bond repo market because the small spreads and increased leverage costs mean it is no longer profitable. Second, repo trades between clients and dealers would be a leverage burden for the latter, meaning customers would face higher transaction costs.
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