Fitch: Haircut Minimums May Push More Repo to Central Clearing

The Financial Stability Board's (FSB) proposed global minimums for collateral haircuts affecting noncentrally cleared repurchase agreement (repo) transactions could gradually increase central clearing for nonbank repos backed by riskier collateral types, according to Fitch Ratings. Minimum haircuts on repo collateral when clearing through central clearing parties (CCPs) will likely be less punitive than the proposed guidance, Fitch believes.

The FSB's minimum haircut levels distinguish collateral risks by maturity bucket and by credit type (i.e. corporate versus structured credit). Structured finance collateral with less than 10 years to maturity, for example, would face at least two times the haircut minimums of corporate credit risks.

Fitch believes that the proposed haircut minimums are near or below the lowest decile of haircuts currently available in the market, based on data from the U.S. tri-party repo market and disclosed by the New York Fed. So while a dramatic resetting of haircuts would not be expected, some of the lowest, (or more preferred) haircuts in the market would likely need to be reset.

Looking ahead, as the proposed minimums are adopted into regulation, they could serve as a barrier to softening repo collateral requirements in more benign market environments.

The suggested minimum haircuts may over time help regulators achieve the goal of moving more bilateral and tri-party repo transactions toward central clearing, which should help manage systemic risk and improve market transparency. Longer term, better efficiency and capital relief provided by central clearing may make this a preferred avenue for the major broker-dealers.

The proposed guidance, which was announced on Oct. 14, is a positive step toward protecting large banks and their clients operating in the repo market. Repo is expected to remain an important form of wholesale funding for a number of buy side participants including hedge funds, money market funds, REITs and traditional asset managers (on behalf of their funds).

If more volume shifts to CCPs, large broker-dealers may gain flexibility to preserve their existing buy side relationships because centrally cleared transactions tend to carry lower regulatory capital charges. Longer term, however, the increase in transparency provided by CCPs may facilitate direct transactions among buy-side institutions. This may in turn lead to disintermediation of the broker-dealers, which have already reduced their footprint in the repo market due to regulatory constraints, such as heightened leverage ratio requirements for those that are part of banking groups.

The same week as the FSB's proposed guidance was announced, the Depository Trust and Clearing Corporation's (DTCC) subsidiary, Fixed Income Clearing Corporation, announced that it is seeking regulatory approval to provide central clearing for the tri-party repo market. The move would expand the DTCC's already established services for centrally clearing repo for its qualified members under its Government Securities Division, which comprises major broker-dealers and other institutions.

While sovereign- and government-backed securities comprise the bulk of the repo market's overall collateral, the new haircut guidance applies to equities and nongovernment fixed-income repo collateral, the forms of collateral that contributed to the funding pressures experienced financial institutions during the financial crisis.

The final impact of implementing the proposals will be dependent on the counterparties, products, geographies, banks and various regional forms of implementation. Repo haircuts applied by banks tend to be tailored to specific counterparties and collateral types, and unlike the FSB's guidelines, make clear distinctions based on the collateral's credit strength.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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