Costs and Benefits of a Repo CCP – Issues for Consultation | Central Clearing of Repos in Australia: A Consultation Paper | Consultations

Central Clearing of Repos in Australia: A Consultation Paper March 2015 4. Costs and Benefits of a Repo CCP – Issues for Consultation

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The foregoing discussion has set out some of the key considerations for the Bank in assessing the costs and benefits of central clearing in the Australian repo market. This section draws together observations in the preceding sections and summarises the key issues on which stakeholder feedback is sought, including some specific questions. The overarching question is:

whether the capacity of the Australian repo market to safely, efficiently and continuously support the funding and liquidity needs of the Australian financial system would be improved by the availability of a repo CCP.

In seeking to answer this question, the Bank invites stakeholders to offer feedback on both the ‘benefit’ and the ‘cost’ sides of the equation.

In terms of benefits, the Bank's focus is on the scope for central clearing of repos to deliver material systemic risk reduction and market functioning benefits through multilateral netting, enhanced risk management, coordinated default management and operational efficiencies. The Bank will be particularly interested in stakeholders' perspectives on the potential magnitude of these benefits, given the prevailing participation structure of the market, and existing risk management and operational practices.
At the same time, the Bank is keen to understand whether there would be material impediments to the safe and efficient operation of a CCP in this market in Australia. In considering this, it will be important to understand whether particular design features of existing repo CCPs internationally could present difficulties or introduce risks in the Australian context. The Bank also acknowledges that ‘the starting point matters’ and welcomes views on whether there are prevailing market practices that would make the transition to CCP clearing costly or challenging.

While the primary focus of this consultation is the repo market, which is consistent with the scope of the FSB's recommendation, many existing repo CCPs internationally also clear outright purchases and sales of bonds. Accordingly, consultation respondents are also invited to offer views on the desirable product scope of any future repo CCP in Australia.

4.1 Overview

In making its recommendation, the FSB noted that there was significant potential for central clearing to reduce the size of credit exposures through multilateral netting as dealers often had offsetting trades with each other. Other system-wide and stability benefits from CCP clearing may arise from enhanced risk management of repos – including settlement of net gains and losses at least daily, and more frequently in periods of market volatility – and coordinated management of participant default. Given their central role, CCPs can also coordinate operational improvements and efficiencies in a market. In other jurisdictions, ensuring the continued functioning of the repo market during a period of instability, or when there are perceived counterparty credit issues, has also been a particular motivating factor in encouraging central clearing of repos.

In its work, the FSB concluded that for interdealer repos against high-quality, liquid collateral ‘existing incentives to use CCPs in these markets seem sufficiently strong (e.g. balance sheet netting) and no further regulatory or other actions appear necessary’. Consistent with this view, if the Bank concluded that there was a net benefit to there being a repo CCP in Australia, it is likely that the Bank would rely on a provider's commercial incentive to introduce such a service, and market participants' private incentives to make use of the service.

A key issue in the consultation will therefore be whether market participants would indeed use a repo CCP if such a service became available in the Australian market. This will depend on each participant's evaluation of the private benefits and costs. In particular, it will depend on each participant's assessment of the scope to reduce its credit exposures in interdealer repos through multilateral netting, and thereby realise both collateral and regulatory capital benefits. Since not all repo market participants may choose to, or be eligible to, centrally clear, the implications for the participation structure of the repo market will need to be considered carefully.

Since a significant share of repo market activity involves the Bank as cash provider, the Bank recognises that its decision regarding participation will affect other market participants' evaluation of the private costs and benefits of using a repo clearing service. The Bank will consider its position in light of stakeholder feedback from this consultation.

Relatedly, it would need to be commercially viable for a CCP to offer such a service. Repos that involve Australian dollar cash and high-quality liquid securities play an important role in funding and liquidity management activities in Australian financial markets. From a regulatory standpoint, therefore, any CCP that cleared even a relatively small share of this market would be considered to be both systemically important and strongly connected to the domestic financial system. Consequently, in order to ensure that such a CCP fell under the primary regulation of the Australian Securities and Investments Commission and the Bank, that its activities were governed by Australian law, and that it would fall within the scope of the proposed special resolution regime for financial market infrastructure, domestic licensing and incorporation of such a CCP would be likely to be necessary at a relatively low threshold market share.^[16]

Before exploring some more detailed matters in the remainder of this section, stakeholders' views are invited on the following high-level questions.

Consultation Questions – Overview

Q1. Do you believe the availability of a repo CCP in Australia could improve the functioning of the Australian repo market and its capacity to safely, efficiently and continuously support the funding and liquidity needs of the Australian financial system? Why/Why not?

Q2. Would you use a repo CCP if there was such a CCP in the Australian market? Why/why not?

Q3. If a repo CCP is desirable, what should be its instrument scope? For example, clearing of repos against general collateral only; or both general collateral and specific collateral? And should it also clear outright purchases/sales of debt securities?

Q4. If a repo CCP is desirable, what additional services should it provide in order to maximise the net benefits of central clearing? For example, auto-collateralisation through a centralised collateral management service, substitution or re-use of collateral, novation of both legs of the repo, (anonymous) trading on an electronic platform?

Q5. To what extent is non-centrally cleared repo trading constrained by counterparty credit concerns? Have such concerns increased in recent years? Is activity typically more constrained during periods of high market volatility?

Q6. Do you believe that it would be commercially viable for a CCP to offer a repo clearing service in Australia? Why/why not?

Q7. Are there alternatives to CCP clearing that would improve the functioning of the Australian repo market and its capacity to safely, efficiently and continuously support the funding and liquidity needs of the Australian financial system? If so, please explain.

Q8. Would there be any material impediments to the safe and efficient operation of a repo CCP in Australia? Are there likely to be aspects of a CCP's design that could not readily accommodate Australian repo market practices? Would there be likely to be material challenges in transition to a centrally cleared environment?

4.2 Access

The FSB's recommendation focuses on central clearing of interdealer repos, noting that small institutions are less likely to have offsetting transactions and also that ‘small institutions are likely to find central clearing costly given the need to pay clearing fees or margins’. This is consistent with the observed low level of central clearing through client clearing services in overseas markets.

As described in Section 3.2.1, a CCP's participation requirements condition the terms of access to clearing for repo market participants. Participation requirements and access arrangements for indirect participants will therefore necessarily have implications for the network of counterparties within the CCP, and in turn the scope for netting. If much of the market moved to central clearing, the CCP's terms of access could influence more broadly the participation structure of the repo market. Consequently, the implications of central clearing for access to the repo market need to be considered carefully.

Access to the repo market may also be restricted by other aspects of a CCP's risk framework, such as position limits.

Consultation Questions – Access

Q9. To what extent would you expect a repo CCP's participation requirements to affect some participants' access to clearing? Are there particular types of repo market participant that you believe would have difficulties in accessing central clearing, either as a direct participant or as a client?

Q10. If there were a repo CCP in Australia, would you expect there to be demand from buy-side clients to centrally clear their repo transactions with dealers? Why/why not?

Q11. Are there alternative models for access to CCPs that you believe would address concerns about smaller institutions' access to central clearing?

Q12. To what extent would you expect a CCP's position limits to restrict activity in the Australian repo market?

4.3 Counterparty Credit Risk

One of the rationales for the FSB's recommendation that consideration be given to the case for centrally clearing interdealer repos is that dealers often have offsetting trades with each other. There is, therefore, likely to be significant potential to reduce the size of credit exposures through multilateral netting. There are also incentives, such as lower capital requirements, for dealers to centrally clear repos. In the dealer-to-client repo market, by contrast, the netting potential is understood to be more limited as transactions are more often ‘one-way’.

Section 3.2 considered the various ways in which central clearing might be expected to strengthen the risk management of repos. For instance, net gains and losses on centrally cleared repos are settled at least daily, and more frequently in periods of market volatility Furthermore, in a centrally cleared repo both parties are protected against replacement cost risk. In the bilateral market, by contrast, only the cash provider has additional collateral (the haircut).

In contrast to haircuts on non-centrally cleared repos, initial margin is generally calculated on a portfolio basis. Therefore, to the extent that risks in a participant's outstanding positions are offsetting, there may be collateral efficiencies. That said, since initial margin is collected from both the cash provider and the securities provider, and since participants are typically also required to contribute to a mutualised default fund, there may be an offsetting additional demand for collateral for some participants.

A CCP also offers the benefit of coordinated close out in the event of a participant default. This could contribute to more orderly market conditions in the event of a participant default, with less price impact and therefore potentially lower replacement costs than participants in aggregate would face in the bilateral market. Furthermore, since the CCP takes on the obligations of the defaulted participant, surviving participants are not only protected against replacement cost risk, but also do not have to incur the liquidity cost of closing out and re-establishing their positions. They are therefore also protected against liquidity risk.

There may nevertheless be design features of a CCP that do not suit all market participants or that may not readily accommodate all market practices. It is important that these are identified and alternative arrangements considered where appropriate.

Consultation Questions – Counterparty Credit Risk

Q13. To what extent is there scope to reduce the size of counterparty credit exposures in Australian interdealer repos through multilateral netting? What proportion of market activity is contributed by participant types with primarily one-way transactions?

Q14. To what extent would clearing interdealer repos reduce the regulatory capital banks are required to hold against such exposures, including under the proposed leverage ratio? And in the absence of central clearing, to what extent would you expect some participants' repo market activity to be affected by the BCBS large exposures framework?

Q15. To what extent would a CCP strengthen processes for margining and collateral valuation in the interdealer repo market, relative to existing bilateral arrangements?

Q16. Overall, to what extent would you expect central clearing to deliver collateral efficiencies?

Q17. Would you perceive a significant benefit from a CCP coordinating the management of the default of a repo market participant? Why/why not?

4.4 Operational Efficiencies

As discussed in Section 3.3, given their central role CCPs can assist in coordinating operational improvements and efficiencies in a market. The Bank is keen to understand whether market participants believe that a CCP could encourage material operational enhancements in the Australian context, or whether alternative mechanisms, such as increased use of centralised collateral management services, would be equally effective in encouraging such enhancements. The Swiss Value Chain, for instance, demonstrates how operational efficiencies can be achieved without a CCP (see ‘Box B: The Swiss Value Chain’).

Consultation Questions – Operational Efficiencies

Q18. To what extent are repo trades processed in a straight-through manner? Are there particular aspects of processing repos that require material manual intervention?

Q19. Would central clearing of such trades encourage more trading on electronic platforms? Why/why not?

Q20. To what extent do you see benefit in auto-collateralisation of repos through a centralised collateral management service such as ASX Collateral? How would you expect central clearing of repos to affect the use of such a service?

Q21. Overall, to what extent would you expect central clearing of repos to encourage greater automation and operational efficiencies in the Australian repo market? Are there other mechanisms that might be equally effective in encouraging such efficiencies?

4.5 Settlement Arrangements

The suspension of ASX Clear (Futures)' BRC service in 2004 was largely due to issues around settlement. 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. Furthermore, securities can now be more easily obtained from the AOFM Stock Lending Facility. Consequently, settlement may be less of a concern for any future repo CCP, even if some participants remained outside of the CCP.

Nevertheless, the design of a CCP's settlement arrangements are fundamental to the efficiencies it is able to provide to the market. It is also crucial for the safety of the CCP that its risk management framework – and in particular its calibration of initial margin requirements – takes appropriate account of the settlement model and in particular un-netting in the settlement process.

Consultation Questions – Settlement Arrangements

Q22. Do you agree that settlement issues arising from chains of trades are unlikely to cause problems in the current market? And do you agree that settlement issues would not be an impediment to the effective functioning of a repo CCP? If not, why not?

Q23. Do you see benefit in settlement netting by line of security? Do you believe that ‘shaping’ of settlement obligations would be beneficial in the settlement of repos in Australia? Why/why not?

Footnote

For more information on the Regulatory Influence Framework for Cross-border CCPs, see CFR (2012), Application of the Regulatory Influence Framework for Cross-border Central Counterparties, April. Available at <http://www.cfr.gov.au/publications/cfr-publications/2014/application-of-the-regulatory-influence-framework-for-cross-border-central-counterparties/>. [16]