Extreme repo volatility could become 'new normal' warns industry group

The bout of extreme volatility that hit European repo markets over year-end could become the "new normal," according to an industry report that warns further turbulence could have systemic consequences for financial markets.

Repos, or repurchase agreements, are critical to the smooth running of Europe's financial markets, so their disruption is a potential cause for alarm. This happened at the end of 2016 when repo rates — or the cost of borrowing cash against various types of bonds — fell sharply, taking the rate against German collateral to -4.9% on Dec. 30, 2016. It has since recovered and now trades at around -0.64%.

The scale of this volatility was "unprecedented in [its] severity" according to a post-mortem report from the International Capital Market Association written by Andy Hill on behalf of the trade group's European Repo and Collateral Council, or the ERCC.

The report says this level of market dislocation is simply unknown in the post-euro era and exceeded that seen even during the collapse of Lehman Brothers. It further raises questions as to whether it was a one-off or an omen that the market may struggle to function efficiently under stressed circumstances.

"If the extreme volatility and dislocations witnessed at the end of December are an indication of future market resilience, we should be concerned," Godfried De Vidts, Chairman of the ERCC, said in a statement that noted the market had previously functioned relatively effectively during the Lehman default and eurozone sovereign bond crisis.

The ICMA said the dislocations were due to "a perfect storm" brought on by strong demand for high-quality liquid assets just as the ECB's quantitative easing program and regulatory pressure on banks' balance sheets reduced supply of these assets.

Yves Mersch, a member of the executive board of the ECB, admitted the pressures caused by the central bank's actions in a speech in Luxembourg in January, although he said it was only one of many factors at play. "The situation in the repo market today in fact reflects a confluence of longer-term trends that have affected both the supply and demand for good collateral", he said.

Patrick Jacq, Europe strategist at BNP Paribas, pointed out that it is typical to see illiquid conditions at year-end but that participants were not prepared for the scale of the collapse.

"We could have similar conditions at the end of this year but markets are better prepared and would probably manage better," he said.

Indeed, a year-end outage — even one as severe as 2016 — has only limited impact, noted observers. While analysts agreed it is worrying to see repo-rates collapse, there is little "blood" in the market at that time, which means it is unlikely that any transactions were affected.

"This type of illiquidity is happening to a lesser extent at the end of each quarter," said Jacq.

The ICMA further noted that forward pressure for the March quarter-end suggests this type of disruption could become a "new normal" for the market. This, in turn, could heighten risks related to banks' and firms' ability to meet margin calls, with potential systemic consequences. Any single solution, whether regulatory or monetary, would not be enough to provide a quick fix, but "careful fine-tuning of some of the technical measures put in place by regulatory reforms, already being considered by the authorities, is fully justified," according to De Vidts.