Bloomberg -- Regulations aimed at reducing the risk of another financial crisis are starting to upend a key part of the bond market that expedites trading in everything from Treasuries to junk bonds.
The U.S. repurchase, or repo, market where banks and investors borrow and lend Treasuries and other fixed-income securities shrunk to $4.6 trillion daily outstanding last month, down 35 percent from a peak of $7.02 trillion in the first quarter of 2008, based on Federal Reserve data compiled from its 21 primary dealers.
From fewer repos to lower inventories of bonds, financial institutions are responding to more stringent capital standards imposed by regulators around the world. Already, the group of dealers and investors that advise the U.S. Treasury say that they see declines in liquidity in times of market stress, including wider gaps between bid and offer prices and the speed of completing trades. The potential consequences are higher borrowing costs for governments, companies and consumers.
“During the market selloff over the past few months, those rules, a lot of which are just proposed or not yet taken effect, already impacted dealers’ willingness to take on inventory of Treasuries, investment grade corporates to emerging market debt,” Gregory Whiteley, who manages government debt investments at Los Angeles-based DoubleLine Capital LP, which oversees $57 billion, said in an Aug. 14 telephone interview. “That exacerbated the intensity of the selloff.”
Dealers are cutting back at the same time volatility is rising amid speculation an improving economy will cause the Fed to reduce the $85 billion it’s spending every month to buy bonds in an effort to boost the economy.
Bonds lost of 2.9 percent over May and June, the worst two- month stretch since the $42 trillion Bank of America Merrill Lynch Global Broad Market Index began in 1997.
That was worse than even the 1.9 percent decline in the height of the financial crisis in September and October 2008, when Lehman Brothers Holdings Inc. collapsed, mortgage finance companies Fannie Mae and Freddie Mac were placed into government conservatorship, insurer American International Group Inc. agreed to a U.S. takeover to avert collapse and Merrill Lynch & Co. was compelled to sell itself to Bank of America Corp.
After a respite in July, bond losses have resumed this month. Yields on 10-year Treasury notes reached 2.9 percent today, the highest since July 2011, and were at 2.89 percent as of 2:19 p.m. New York time. The price of the benchmark 2.5 percent note due August 2023 was at 96 20/32.
Repos are part of the non-bank, or “shadow banking,” sector. Banks use repos to help finance investments in Treasuries, corporate bonds and mortgage-backed securities. Money-market funds such as those used by individuals to park cash and savings, are a major provider of repo financing.
“The repo markets are really the grease in many financial market systems,” Josh Galper, the managing principal of securities-finance consultant Finadium LLC in Concord, Massachusetts, said in an Aug. 14 telephone interview. “Any increased friction in fixed-income markets, such as decreased repo or increased taxation, and the outcome usually is much less liquidity in government-bond markets, higher costs to borrow, more volatility and less security.”
In one example of a repo agreement, a money market fund may lend cash to a dealer overnight, with government securities serving as collateral for the loan.
Obtaining cash by lending securities in repos is a method dealers use to boost leverage, amplifying returns, while money funds and other lenders earn interest on the cash they provide. The average overnight repo rate for Treasuries fell as low as 0.016 percent this year, from 0.29 percent on Dec. 31, according the Depository Trust & Clearing Corp. GCF repo index.
The Fed plans to use the repo market to eventually drain reserves and guide rates higher. The central bank has conducted what’s called reverse repos with dealers and an expanded list of counterparties, including hedge and money market funds, since 2009 to test its ability to one day tighten policy.
“There will be a problem when the Fed begins their exit strategy, through using reserve draining in an attempt to put pressure and torque under the fed funds rate, if the repo market isn’t big and deep for them in Treasuries and mortgages,” Joe Abate, a money-market strategist in New York at Barclays Plc, said in a telephone interview on Aug. 8.
Even though Fed data show primary dealers trade almost $600 billion of Treasuries each day on average, making the market the deepest, most liquid in the world, prices suggest constraints on bank balance sheets are having an impact on trading.
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