The repo market is one of the largest in the world. It has experienced dramatic growth over the last 30 years, mainly because it provides a cheap source of funding for financial institutions. It allows for the borrowing and lending of cash, using securities as collateral. Though a derivative, it trades over-the-counter (OTC), it is regulated, highly liquid and transparent. It became more efficient when central counterparty clearing (CCP) was introduced through the Fixed Income Clearing Corp. (FICC) 15 years ago (see “Change is good," below).
The swaps market is even larger, more liquid and efficient, but it’s mostly unregulated with limited access. Most significantly, there is no CCP. But that is changing and soon will change more dramatically.
The need for change
The repo market changed voluntarily 15 years ago, migrating to a CCP in the late 1990s. This change was influenced by the need to reduce dealer balance sheets and counterparty risk. A repo matched-book business made a bank appear more leveraged. Banks and broker-dealers needed a CCP to net assets and counterparty risk.
Swaps, on the other hand, do not affect a bank’s assets. The transactions are off-balance-sheet. Instead of exchanging actual assets, swaps are a commitment to exchange cash flows. It always was in the banks’ interest to keep the swaps market closed to protect revenue, spreads and customers. But change in the swaps market recently was mandated by the Dodd-Frank Act. The swaps market, especially interest rate swaps, will migrate to a CCP.
There are parallels between the repo market of the past and the swaps market today. The future of the swaps market and its migration to a CCP will look like the repo market’s migration 15 years ago.
Benefits of the CCP
In the 1990s, the repo market saw a definite need for a CCP. Previously, dealers were “grossing up” their assets. Inter-dealer trades were spread across the entire dealer community in a web of trades. Once a CCP was established, inter-dealer trades moved to one central CCP, allowing offsetting trades to net. Consequently, the repo market enjoyed a significant boost, moving from a gross to net asset business.
To understand the netting process, you must look at the before and after. Suppose Goldman Sachs owned $100 million of a U.S. Treasury bond that they loaned to Salomon Brothers, who in turn loaned it to Paine Webber, who then loaned it to Dean Witter. Each firm had $100 million in assets and $100 million in liabilities on their books. In total, there were $400 million in assets and $400 million in liabilities.
Now, here is the same transaction today with clearing. Goldman Sachs still owns $100 million of a U.S. Treasury bond and loans it to Citibank, who loans it to UBS, who loans it to Morgan Stanley. Morgan Stanley has $100 million in cash and holds the Treasury collateral against its cash investment. At the end of the day, there are only two trades that exist “on balance sheet:” 1) a trade between Goldman Sachs and the CCP and 2) a trade between the CCP and Morgan Stanley. Goldman Sachs has a repo with the CCP and Morgan Stanley has a reverse-repo with the CCP. The transactions net off the balance sheets of the two other banks and overall industry assets are cut in half.
Evolution of the repo market
Simply put, it was a dealer world. The repo market originally was based on a traditional dealer-customer model. It was dominated by the large dealers who maintained significant barriers to entry. The dealers were the “Primary Dealers” recognized by the Federal Reserve (see “Insiders,” below). They were allowed to buy securities at auction and trade directly with the Fed.
The primary market was established by the Fed, and only recognized Primary Dealers could buy Treasury securities at auction. The secondary market was OTC and traded through the Inter-Dealer Brokers (IDBs). It was protected by the market participants who limited access to the IDB market. Some broker-dealers and large banks were “allowed” to act as dealers and market makers, but they could not trade directly with the Fed.
In the 1990s, IDBs provided voice execution for U.S. Treasury, agency, repo and other bond trading. The IDBs did no principal transactions, they simply arranged the trade and brought buyers and sellers together. IDBs acted as “give ups,” meaning the counterparty’s name would be “given up” to the other counterparty. As a result, Primary Dealers knew their counterparty. That knowledge allowed them to enforce access to the trading screens.
The brokers naturally wanted to expand their business and allow as many participants as possible to access their markets. However, only Primary Dealers were allowed to trade on the IDB broker screens. Primary Dealers controlled enormous trading volume, which they used to limit market access. For example, if an IDB tried to book a trade with a new institution, one or more Primary Dealers would threaten to “pull” their business. The broker was left with an easy decision. They could do business with a new small dealer who might generate $500 million a day in volume or continue to do business with a major dealer, perhaps generating $20 billion a day in volume. The Primary Dealers always won.
“Central Clearing,” as the name implies, works best when there’s only one central clearinghouse. In the mid 1990s, two rival clearinghouses, Delta Clearing Corp. and Government Securities Clearing Corp. (GSCC), fought to become the preeminent repo clearinghouse.
Delta was owned by two IDB brokerage firms, Intercapital Group Ltd. and EXCO plc. It was first incorporated as Delta Government Options Corp. in 1988. At the time, they provided counterparty clearing for OTC U.S. Treasury options. In 1996, they changed their name to Delta Clearing Corp. to reflect the broader range of clearing services, including repos.
GSCC was established in 1986 as a subsidiary of the National Securities Clearing Corp. to provide general clearing and settlement services for U.S. Treasuries. They entered the repo clearing business in the mid-1990s. They were purchased by Depository Trust Clearing Corp. (DTCC) in 2002 and became FICC.
Delta and GSCC were competing for dominance of the repo clearing business between 1997 and 1999. Back then, when you traded on the broker screens, you had three options: Give-up, GSCC or Delta. Because the same security could be cleared three separate ways, it created a distortion in the market. A dealer might bid for a security on the GSCC line at the same rate as the offered side on the Delta clearing line. Sometimes the give-up market traded through the GSCC or Delta market.
By 1999, all dealers and liquidity migrated to GSCC. Delta and “give-up” markets were dropped. Today, any bank trading on the broker screens must be a member of FICC. GSCC won the CCP battle and now is the market standard.
The repo market today
The repo market has changed significantly over the last 15 years. It is still OTC and there is still no exchange, but many of the barriers to entry are gone. As the barriers fell, more participants entered the market. Volume and efficiency increased, it became electronic and spreads narrowed. With the elimination of inter-dealer credit risk and balance sheet usage, dealers worked for smaller spreads. Bid/offer spreads were 25 basis points in the early 1980s, 10 basis points in the 1990s and are between 1 and 3 basis points today. To compete today, a dealer must run a book of business by matching client long and short positions, making markets and taking risks.
Becoming a dealer is easy. Trading on the brokers’ screens only requires FICC membership. Membership means one counterparty, one legal agreement, one margin payment and only net securities deliveries. As a member, a bank or broker-dealer has no counterparty risk or balance sheet implications from trading with other dealers.
The dealer community no longer controls access and there are no hierarchical rules. The IDB brokers are principal for the on-leg of the trade, so other dealers are blind to who is trading. Most of the market trades electronically. The dominant IDB is BrokerTec, which trades more than 50% of the daily volume. Overall, the repo market is now liquid, electronic and efficient.
The swaps market was nonexistent 30 years ago and since has grown to be seven times larger than the futures market. Today’s swaps market is similar to the repo market before FICC. It is OTC, name “give-up” and has significant barriers to entry. Institutions need credit lines, ISDA agreements and acceptance by other dealers to trade in the brokers’ markets.
The market operates under the dealer-customer model. Dealers are market makers and trade through IDB brokers. Only dealers can trade on the broker screens, which are all “voice brokers.” The brokers control price dissemination, access and liquidity. There is no electronic interest rate swaps broker. Prices are published, but the “inside” market is only available in the IDB shops. This practice secures an “inside” market for the dealers.
The “business” of interest rate swaps is similar to the repo business. Swaps dealers must run a “book” of business and act as a market maker to generate sufficient returns. There’s a large divide between the first and second tier in the market. The largest bank dealers have the significant franchises. They “own” the market because they have the capital, credit ratings and customer flow. Their business is highly profitable and they seek to protect their market and preserve profitability. Not surprisingly, the dealer community resisted exchange trading and CCP.
Regulation will effect change
The swaps market is on the cusp of dramatic change. Regulation will impact trading. The Dodd-Frank Act will ensure swaps market transparency, increased reporting requirements and migration to an exchange or CCP. The market will open to non-dealer banks and trading will become electronic. Swaps will become transparent, electronic, commoditized and regulated.
A substantial amount of U.S. dollar swaps is booked from London affiliates of U.S. banks or broker-dealers because of U.S. regulatory constraints. The Commodity Futures Trading Commission will regulate swaps in the U.S., the Financial Services Authority in London and Basel III globally. However, there will be regulatory arbitrage between locations. Different capital rules and regulations will make one location preferable to the other. The capital and regulatory charges on swaps in the U.S. already have driven a substantial amount of U.S. dollar swaps business offshore. While the geography makes a clear-cut distinction between products and currencies in the repo market, it is not the case for swaps.
There are three main CCPs competing for interest rate swaps clearing in the U.S. (Eris Futures, IDCG and the CME Group) and just one in Europe. About 50% of U.S. dollar interest rate swaps are cleared on the CME. LCH.SwapClear is the largest overall Swaps CCP globally, clearing about 50% of the entire market.
The swaps brokerage model will change. Swaps will move to electronic trading, the IDB brokers will lose their monopoly. Dealers will lose exclusive access to the “inside market.” Under Dodd-Frank, swaps must trade on a Swaps Execution Facility (SEF). About 25 brokers and exchanges have registered as SEFs so far, but competition will reduce that number. There will be fewer and fewer SEFs as time goes by.
The repo market had a significant reason to change 15 years ago, but the swaps market never did. The repo market recognized the need for a CCP earlier to address balance sheet and counterparty risk mitigation. The swaps market was forced to change through regulation. The success of the CCP became clearer after the bankruptcy of Lehman and the minimal market disruption that occurred. Now the swaps market is following the repo market. Ultimately, mandated change will lead to a more transparent, electronic and efficient swaps market.
Scott Skyrm has worked in the repo market for more than 22 years, most recently at Newedge.