Central Clearing of Repos in Australia: A Consultation Paper March 2015 2. The Australian Repo Market

This section provides an overview of the Australian repo market, describing the nature and scale of current activity in the market and prevailing operational and risk management practices. The section closes with a short review of the Bond and Repo Clearing (BRC) service that operated in the Australian fixed income market in the early 2000s.

2.1 Activity

Gross outstanding positions in the Australian repo market total more than $110 billion (Graph 1). The size of the Australian repo market has increased by more than 40 per cent since early 2013, primarily due to larger positions held by the Bank and by foreign institutions acting as cash providers in the Australian market. Most repos are contracted for terms under 14 days.

In Australia, around 85 per cent of repos are contracted against what is termed ‘General Collateral 1’ (GC1). GC1 includes only CGS and securities issued by the states and territories (semi-government securities, or ‘semis’). Most of the remaining repos in the Australian market are generally against ‘General Collateral 2’ (GC2), which includes debt issued by authorised deposit-taking institutions, asset-backed securities and supranational, foreign agency and government-guaranteed debt, as well as other AAA securities such as covered bonds.

Active participants in the domestic repo market include banks, securities dealers – typically large domestic and international banks that are market makers in domestic government securities – as well as some smaller institutional non-dealer participants and the Bank.^[2] As at November 2014, repos with the Bank accounted for around 35 per cent of outstanding repo market positions (Table 1).

The two most significant areas of repo market activity in Australia are related to market making in government securities and the Bank's open market operations.^[3]

• Market making. Dealers make a market in domestic government securities by matching buyers and sellers of the same security, or – when timing mismatches arise – buying and selling for their own account. Dealers are able to fund their inventory of securities by selling them under repo. Selling securities under repo allows dealers to raise funding while maintaining their exposure to the securities. Dealers may also use repos to obtain securities they have agreed to sell to their customers.
• The Bank's open market operations. Repos offer a flexible instrument for the Bank to manage the total amount of outstanding Exchange Settlement Account (ESA) balances in the banking system so as to keep the cash rate as close as possible to the target set by the Reserve Bank Board. By executing repos with its counterparties in its open market operations, principally as a cash provider, the Bank manages the aggregate of institutions' ESA balances. Consequently, the Bank is a major source of funding for the domestic repo market.

Investment funds and other non-dealer institutions are also providers of high-quality assets to dealers. These institutions typically use repos to manage their short-term funding while maintaining their exposure to these assets, and in some cases to enhance portfolio returns.

2.2 Counterparty Credit Risk

Repo transactions are generally agreed under industry standard documentation, typically the Global Master Repurchase Agreement (GMRA). The GMRA governs the transaction, establishing the rights and obligations of the contracting parties. In a repo transaction, legal title to the collateral passes to the cash provider for the duration of the repo agreement, while the economic benefits (e.g. coupon payments) are retained by the securities provider. Since legal ownership of the security is transferred, the cash provider has an automatic right to re-use the securities.

Among the matters dealt with in the GMRA are the mechanisms by which counterparties to the trade manage their counterparty credit risk to each other.

2.2.1 Collateralisation

Repos can be executed against a specific security or against a class of general collateral (e.g. GC 1). If a repo is against a class of general collateral, the securities provider may have the right to substitute collateral under certain circumstances.

The collateral provided is generally subject to a haircut. That is, the market value of collateral is reduced by a given percentage, the haircut, to reflect the potential change in value should the collateral need to be liquidated. The purpose of the haircut is therefore similar to that of initial margin in a centrally cleared transaction (see Section 3.1.1). The size of the haircut is negotiated bilaterally between the parties to the transaction. In the case of transactions with the Bank, haircuts are imposed on all securities purchased under repo. The Bank's schedule of haircuts is publicly disclosed and changes from time to time.^[4]

Over the life of a repo, if the value of collateral changes significantly, additional collateral may be called or excess collateral returned; this is the equivalent of variation margin for centrally cleared transactions (described in Section 3.1.1). As part of this process, the value of the cash leg is typically adjusted to include the repo interest that has accrued to the cash provider. The daily settlement of net gains and losses may be subject to the change in value exceeding an agreed minimum transfer amount. Such thresholds are generally negotiated between parties upon establishing their GMRAs. This daily settlement process can be automated through a centralised collateral management service such as ASX Collateral (see ‘Box A: ASX Collateral’).

The GMRA provides for close-out netting in the event one of the counterparties defaults. Close-out netting allows an institution to terminate and settle the net value of all contracts with a particular counterparty immediately upon the occurrence of one of a list of defined events, such as the appointment of a liquidator to that counterparty. While this accelerates the realisation of the loss or gain on the outstanding position, the surviving counterparty will typically seek to re-establish the position with another counterparty. If prices have moved adversely, this will come at a cost (i.e. replacement cost). For the cash provider, this replacement cost risk is mitigated by the haircut on the collateral that it has received.

2.2.2 Capital requirements and counterparty limits

To ensure that a prudentially regulated institution could withstand the default of a counterparty, the Australian Prudential Regulation Authority (APRA) requires that capital be held against counterparty exposures – including repo positions. Since APRA's requirements are based on the international standards developed by the Basel Committee on Banking Supervision (BCBS), it is expected that overseas participants in the Australian market are subject to similar capital requirements for repo exposures.

As an additional safeguard, the BCBS has developed a large exposure framework.^[5] Under this framework, the sum of all the exposure values of a bank to a single counterparty or to a group of connected counterparties must not be higher than 25 per cent of the bank's available eligible capital base at all times. On a broader level, the BCBS leverage ratio framework also requires banks to hold capital against total exposures, which includes repo exposures.^[6]

In addition to regulatory constraints on counterparty exposures, institutions' internal risk management frameworks generally incorporate counterparty limits. These limits often vary with the perceived creditworthiness of a counterparty, and can therefore create funding pressures if the risk appetite of an institution declines or there are perceived issues with a particular counterparty.

2.3 Operational Efficiencies

Repo markets vary in the degree of automation in trading, clearing and settlement processes. Repos in the Australian market are generally traded over the phone or using Bloomberg or Reuters messages; although there are some interdealer broker platforms available. These trades are then managed separately by each counterparty using internal systems. When a leg of a repo transaction or net gains or losses are due for settlement, instructions are sent to the debt securities settlement facility, Austraclear.

In contrast, some markets support a high level of automation and straight-through processing. In Switzerland, for instance, while repos are not centrally cleared, the market uses an integrated trading and settlement system. This system also incorporates an automated collateral management system (see ‘Box B: The Swiss Value Chain’).

2.4 Settlement Arrangements

In Australia, repos are generally settled on a DvP model 1 (DvP 1) basis in Austraclear. That is, settlements occur on a trade-by-trade basis, with the transfer of cash and securities obligations between the buyer and seller occurring simultaneously. Austraclear is a licensed clearing and settlement facility that provides securities settlement facility services for trades in debt securities, including outright CGS transactions and repos.^[7]

Counterparties to a repo may nevertheless choose to settle on a non-DvP basis. However, in doing so, the institution that settles its obligation first is exposed to principal risk as its counterparty could default prior to settling its linked obligation. In the past, counterparties sometimes chose to do this when they were part of a chain of participants buying and selling the same face value of the same security on the same day (possibly at different prices). Settlement of chains on a DvP 1 basis requires that at least one participant in the chain owns the security and can initiate the chain of settlements. However, in a market where securities are scarce, a chain could develop in which no participant owns the security and therefore settlement cannot occur on a DvP 1 basis. In the early 2000s, the market practice in Australia was to settle such chains by ‘deeming’ that securities had been transferred upon payment of the cash leg. This practice meant that the participant making the first payment in the chain faced principal risk until settlement of the chain was completed.

Such chains are now uncommon, particularly with CGS issuance having increased markedly since the early 2000s. Furthermore, there is greater access to securities lending facilities to support settlement. For instance, a participant that is short a security may obtain it from a stock lending facility such as that offered by the AOFM (see ‘Box C: AOFM Stock Lending Facility’). The AOFM does not charge interest intraday. Use of such a service may, however, involve a cost if an institution retains the security overnight.

2.5 Central Clearing of Repos in Australia

While there is currently no repo CCP in Australia, between September 2001 and July 2004 ASX Clear (Futures) (at that time known as SFECC) operated the BRC service.

The design of BRC was similar to other repo CCPs operating at that time (Table 2).^[8] Trades were executed bilaterally over the phone; repos or outright bond transactions were registered with BRC and novated within 30 minutes of the trade being matched in Austraclear. Repos against all CGS and most semi-government securities (or ‘semis’) were eligible for clearing through BRC. For settlement, trades were netted by settlement date and line of security. Figures provided to the Bank in 2004 suggest that at that time around 40 per cent of debt securities transactions were cleared through the BRC service.

However, a number of market participants did not use the service and, when combined with the low level of CGS on issue at the time, this led to difficulties settling chains when a participant in the chain was short the relevant security. Trades cleared through BRC were required to be settled on a DvP basis to ensure that BRC was not exposed to principal risk. Consequently, in the event that some of the parties in the chain remained outside of the CCP, one of the participants would have needed to obtain the security so that settlement could occur on a DvP basis. This reduced the attractiveness of the BRC service. Use declined until ASX eventually suspended the service as it was no longer commercially viable.

With settlement practices in the fixed income market having evolved over the past decade, and CGS issuance having increased significantly, settlement issues arising from chains of trades are uncommon. Since securities can now also be more easily obtained, including from the AOFM, settlement may be less of a concern for any future repo CCP, even if some participants remained outside of the CCP.

Footnote Box B

For further background on the Swiss Value Chain see Kraenzlin S (2007), ‘The Characteristics and Development of the Swiss Franc Repurchase Agreement Market’, Financial Markets and Portfolio Management, June, 21(2), pp 241–261. [1]

Footnotes

Wakeling D and I Wilson (2010), ‘The Repo Market in Australia’, RBA Bulletin, December, pp 27–35. [2]

This activity is discussed in further detail in Cheung B, M Manning and A Moore (2014), ‘The Effective Supply of Collateral in Australia’, RBA Bulletin, September, pp 53–66. [3]

Details of the haircuts on repos with the RBA are referred to as ‘margin ratios’ and are provided on the Bank's website at <http://www.rba.gov.au/mkt-operations/resources/tech-notes/eligible-securities.html>. [4]

BCBS (2014), Supervisory Framework for Measuring and Controlling Large Exposures, April. Available at <http://www.bis.org/publ/bcbs283.pdf>. [5]

BCBS (2014), Basel III Leverage Ratio Framework and Disclosure Requirements, January. Available at <http://www.bis.org/publ/bcbs270.pdf>. [6]

For further information on Austraclear, including its management of risks, see the Bank's 2013/14 Assessment of ASX Clearing and Settlement Facilities. [7]

Note that the design features described in Table 2 predate the introduction of more detailed international standards in this area. [8]