High Line Advisors LLC

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Out of the Shadows: Central Clearing of Repo

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High Line Advisors has published a white paper entitled Out of the Shadows: Central Clearing of Repo – A Transparent Market Structure for Cash Borrowers and Lenders.

“Although personally I am quite content with existing explosives, I feel we must not stand in the path of improvement.” — Winston Churchill

Article at a Glance

Repurchase agreements (repo) are the largest part of the “shadow” banking system: a network of demand deposits that, despite its size, maturity, and general stability, remains vulnerable to investor panic. Just as depositors can make a “run” on a bank, repo lenders can take their money out of the market, thereby denying the lifeblood of cash to broker-dealers (stand-alone or those owned by banks or bank holding companies), which rely on leverage to operate.

The entire shadow banking system has been demonized as a place where loans are hidden within derivatives among nonbank counterparties rather than displayed on the balance sheets of traditional, regulated banks. In reality, the shadow banking system is a legitimate market for secured financing, in which cash is lent in exchange for collateral. Repo in particular has many positive attributes, including disclosure on the balance sheet; nevertheless, the financial crisis exposed several flaws in the secured financing markets in general and repo in specific, and the Federal Reserve System ultimately interceded with liquidity to prevent the further collapse of banks and broker-dealers.

While not categorized as a “derivative,” repo is an over-the-counter (OTC) contract that shares many key characteristics with derivatives, including a reliance on its counterparts to meet obligations over time. The inability of regulators to measure activity in OTC derivatives resulted in the passage of the Dodd-Frank legislation, which requires that certain instruments be moved to a central counterparty clearing house (CCP). As the nexus of all trades, a CCP provides visibility to regulators and credit intermediation for all market participants.

The benefits of central clearing are directly applicable to the repo market and are crucial to the global money markets that are relied on as a safe, short-term investment for individuals and institutions alike. Central clearing is needed to provide lenders with guaranteed return of cash without sensitivity to collateral or credit. A CCP also lays the groundwork for lenders to interact directly with borrowers in a true exchange with transparent pricing.

Central clearing of repo can also provide capital efficiency and more stable funding for banks and broker-dealers. Ultimately, a CCP for repo can evolve into a hub of funding activity for many forms of liquid collateral, thereby bringing the majority of the shadow banking system into full view.

Download a PDF of the article here.

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