Interesting Article Regarding the 'Repo' Market
From Financial Times:
Regulators issue a warning at bond trading’s wild frontier
By Michael Mackenzie and Saskia Scholtes
Published: November 12 2006 18:41 Last updated: November 12 2006 18:41
It has long been part of folklore among bond dealers that the “repo” market for US Treasury paper is the last outpost of the “wild west”, where traders can still get away with market manipulation unchecked. Now, however, the sheriff is in town.
US regulators are investigating trading practices in the Treasury bond market and, in the process, are bringing to light such arcane and nefarious practices as “Treasury squeezes” and “slamming the wire”.
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Those happen when a bank tries to make money at the expense of its rivals by covertly depriving them of bonds to which they were expecting access – in effect cornering the market for a particular issue or causing dealings in those instruments temporarily to “fail”.
Cornering the entire $4,000bn Treasury bond market is, of course, impossible. However, the market is made up of many different issues, some of which will from time to time run into shortages. It is part of a trader’s job to spot pricing irregularities that result from short term effects in demand and supply.
However, if a trader deliberately corners an issue that is already in short supply, that is deemed to have crossed the line from skilful arbitrage to market abuse.
The problem for regulators is to draw that line. Traders rightly complain that in practice it can be very difficult.
Treasury officials’ concern about the the government repurchase, or “repo”, market, has been mounting for years. The repo market provides the plumbing that keeps the Treasury bond market functioning smoothly, and yields in the Treasury market provide the benchmark of the world financial system.
An incident earlier this year, when the two- and five-year notes were briefly and sharply squeezed, together with other questionable activities sparked a more critical tone from Treasury officials. They now seem determined to force market participants to clean up their act.
In a September speech to the Bond Market Association, the traders’ main industrial body, James Clouse, the Treasury Department’s deputy assistant secretary for federal finance, said he was worried that firms had at times “gained a significant degree of control” over highly sought-after Treasury issues and used those positions to their advantage.
He signalled that the issue had been referred to the Securities and Exchange Commission and the Commodity Futures Trading Commission, the regulators responsible for policing brokers and markets, which were pursuing cases related to these activities.
The fracas culminated in the Federal Reserve Bank of New York and the Treasury summoning 22 big investment banks to a meeting last week, to be told to get their act together. Otherwise, it threatened, they would have to operate in a more heavily regulated market.
All types of securities, from mortgages and corporate bonds to derivatives such as interest rate swaps, are priced and valued using the rates prevailing in the Treasury bond market.
The repo market differs from the market for Treasuries, however, in that traders do not buy or sell bonds but rather use them as collateral for short-term financing; in a repo agreement, a trader will borrow a bond for a short period. When the demand for the collateral – bonds – goes up, that financing – cash – becomes less expensive, that is, interest rates fall. To get this cheap financing, traders have been known to restrict artificially the supply of the bonds as collateral, driving up demand. In effect, this gives borrowers of cash in the repo market an interest-free loan – a huge advantage in a market where fortunes can be made on hundredths of percentage points.
Another technique to lower repo borrowing costs is “slamming”: repo traders both borrow and lend a hefty supply of bonds. Then they return a large volume of the borrowed bonds all at once, in the last few seconds of the trading day. They profit from this if they succeed in returning the bonds they have borrowed while other banks are not left with enough time to do so. This leaves the “slamming” bank clear of its obligations, while also holding the cash it earlier received in return for the bonds it had lent out. The effective interest rate it has paid for this overnight borrowing is zero.
One reason for the government’s deep concern is that any serious problem in the repo market could have profound repercussions for world markets. Without easy cash, the volume of trading would be dampened and risk-management harder.
It would also be a problem for the US government. International investment in Treasury bonds is immense. Serious question marks over the liquidity of the market would drive some investors away and force the government to raise the interest rates on its bonds – or in other words, increase Uncle Sam’s borrowing costs.
The glare of regulatory scrutiny is unwelcome among repo traders, who are imbued with the notion that making money is a zero-sum game, that the line separating legitimate repo trading and unethical behaviour is blurred. As Mr Clouse put it: “Strategic behaviour in the Treasury market is viewed by some as an integral part of the game, and the potential to gain control over an issue is simply part of the reward that dealers and others reap as a return for assuming risks.”
On a day-to-day basis, a trader’s job is to spot temporary kinks in supply and demand, and take advantage of such imbalances when they occur.
As one trader puts it: “The industry needs to know what to look for. Dealers want to know what compliance means, and compliance with what exactly?” But another says: “I think it has been overdue...If there’s a cleansing, it will be a healthy one so we can move on and restore the integrity of the market.”
Part of the problem is that it is a line even regulators have a hard time defining. This leaves them urging market practitioners to abide by the spirit of ethical behaviour and resist the lure of pushing the limits in order to boost trading profits.
As far as most traders are concerned, “slamming” is unacceptable. But that does not stop some repo traders from trying it.
One measure for drawing the line between clever practice and market abuse involves looking at market failure. Amid severe bond shortages, borrowed bonds can “fail”. This means that they stop being returned as the chain between borrowers and lenders is stretched and breaks.
Michael Cheah, portfolio manager at AIG Sun America Asset Management, likens the Treasury’s dilemma to dealing with heavy road traffic: “When there is a traffic jam, you can either shut the road or widen it. The Treasury has to decide on what approach it will take.”
The authorities could either require large holders of particular Treasury issues to declare their holdings – when they exceed 10 per cent, say. Another approach could entail the Treasury “widening the road” by reopening old issues and selling more securities, to deepen supply and offset any repo squeeze.
There may be lessons from the UK’s Debt Management Office. Five years ago it introduced a system that allowed those in the repo market to borrow any security from the government if they were suddenly in very short supply. This was then the first system of its kind in the global capital markets. It has since been copied in New Zealand and Australia.
Since the system was introduced in London, market fails – or overt squeezes – have fallen sharply in number, traders say.
The US Treasury is understood to have been talking to the British government about its practices, exploring their possible use in the US.
But for the moment at least, it looks as though dealers have been left to implement their own internal procedures to ensure that manipulation does not lead to bond shortages. The hope is that the threat of the SEC and CFTC hanging over their heads will ensure they do so.
Copyright The Financial Times Limited 2006
From Financial Times:
Regulators issue a warning at bond trading’s wild frontier
By Michael Mackenzie and Saskia Scholtes
Published: November 12 2006 18:41 Last updated: November 12 2006 18:41
It has long been part of folklore among bond dealers that the “repo” market for US Treasury paper is the last outpost of the “wild west”, where traders can still get away with market manipulation unchecked. Now, however, the sheriff is in town.
US regulators are investigating trading practices in the Treasury bond market and, in the process, are bringing to light such arcane and nefarious practices as “Treasury squeezes” and “slamming the wire”.
ADVERTISEMENT
Those happen when a bank tries to make money at the expense of its rivals by covertly depriving them of bonds to which they were expecting access – in effect cornering the market for a particular issue or causing dealings in those instruments temporarily to “fail”.
Cornering the entire $4,000bn Treasury bond market is, of course, impossible. However, the market is made up of many different issues, some of which will from time to time run into shortages. It is part of a trader’s job to spot pricing irregularities that result from short term effects in demand and supply.
However, if a trader deliberately corners an issue that is already in short supply, that is deemed to have crossed the line from skilful arbitrage to market abuse.
The problem for regulators is to draw that line. Traders rightly complain that in practice it can be very difficult.
Treasury officials’ concern about the the government repurchase, or “repo”, market, has been mounting for years. The repo market provides the plumbing that keeps the Treasury bond market functioning smoothly, and yields in the Treasury market provide the benchmark of the world financial system.
An incident earlier this year, when the two- and five-year notes were briefly and sharply squeezed, together with other questionable activities sparked a more critical tone from Treasury officials. They now seem determined to force market participants to clean up their act.
In a September speech to the Bond Market Association, the traders’ main industrial body, James Clouse, the Treasury Department’s deputy assistant secretary for federal finance, said he was worried that firms had at times “gained a significant degree of control” over highly sought-after Treasury issues and used those positions to their advantage.
He signalled that the issue had been referred to the Securities and Exchange Commission and the Commodity Futures Trading Commission, the regulators responsible for policing brokers and markets, which were pursuing cases related to these activities.
The fracas culminated in the Federal Reserve Bank of New York and the Treasury summoning 22 big investment banks to a meeting last week, to be told to get their act together. Otherwise, it threatened, they would have to operate in a more heavily regulated market.
All types of securities, from mortgages and corporate bonds to derivatives such as interest rate swaps, are priced and valued using the rates prevailing in the Treasury bond market.
The repo market differs from the market for Treasuries, however, in that traders do not buy or sell bonds but rather use them as collateral for short-term financing; in a repo agreement, a trader will borrow a bond for a short period. When the demand for the collateral – bonds – goes up, that financing – cash – becomes less expensive, that is, interest rates fall. To get this cheap financing, traders have been known to restrict artificially the supply of the bonds as collateral, driving up demand. In effect, this gives borrowers of cash in the repo market an interest-free loan – a huge advantage in a market where fortunes can be made on hundredths of percentage points.
Another technique to lower repo borrowing costs is “slamming”: repo traders both borrow and lend a hefty supply of bonds. Then they return a large volume of the borrowed bonds all at once, in the last few seconds of the trading day. They profit from this if they succeed in returning the bonds they have borrowed while other banks are not left with enough time to do so. This leaves the “slamming” bank clear of its obligations, while also holding the cash it earlier received in return for the bonds it had lent out. The effective interest rate it has paid for this overnight borrowing is zero.
One reason for the government’s deep concern is that any serious problem in the repo market could have profound repercussions for world markets. Without easy cash, the volume of trading would be dampened and risk-management harder.
It would also be a problem for the US government. International investment in Treasury bonds is immense. Serious question marks over the liquidity of the market would drive some investors away and force the government to raise the interest rates on its bonds – or in other words, increase Uncle Sam’s borrowing costs.
The glare of regulatory scrutiny is unwelcome among repo traders, who are imbued with the notion that making money is a zero-sum game, that the line separating legitimate repo trading and unethical behaviour is blurred. As Mr Clouse put it: “Strategic behaviour in the Treasury market is viewed by some as an integral part of the game, and the potential to gain control over an issue is simply part of the reward that dealers and others reap as a return for assuming risks.”
On a day-to-day basis, a trader’s job is to spot temporary kinks in supply and demand, and take advantage of such imbalances when they occur.
As one trader puts it: “The industry needs to know what to look for. Dealers want to know what compliance means, and compliance with what exactly?” But another says: “I think it has been overdue...If there’s a cleansing, it will be a healthy one so we can move on and restore the integrity of the market.”
Part of the problem is that it is a line even regulators have a hard time defining. This leaves them urging market practitioners to abide by the spirit of ethical behaviour and resist the lure of pushing the limits in order to boost trading profits.
As far as most traders are concerned, “slamming” is unacceptable. But that does not stop some repo traders from trying it.
One measure for drawing the line between clever practice and market abuse involves looking at market failure. Amid severe bond shortages, borrowed bonds can “fail”. This means that they stop being returned as the chain between borrowers and lenders is stretched and breaks.
Michael Cheah, portfolio manager at AIG Sun America Asset Management, likens the Treasury’s dilemma to dealing with heavy road traffic: “When there is a traffic jam, you can either shut the road or widen it. The Treasury has to decide on what approach it will take.”
The authorities could either require large holders of particular Treasury issues to declare their holdings – when they exceed 10 per cent, say. Another approach could entail the Treasury “widening the road” by reopening old issues and selling more securities, to deepen supply and offset any repo squeeze.
There may be lessons from the UK’s Debt Management Office. Five years ago it introduced a system that allowed those in the repo market to borrow any security from the government if they were suddenly in very short supply. This was then the first system of its kind in the global capital markets. It has since been copied in New Zealand and Australia.
Since the system was introduced in London, market fails – or overt squeezes – have fallen sharply in number, traders say.
The US Treasury is understood to have been talking to the British government about its practices, exploring their possible use in the US.
But for the moment at least, it looks as though dealers have been left to implement their own internal procedures to ensure that manipulation does not lead to bond shortages. The hope is that the threat of the SEC and CFTC hanging over their heads will ensure they do so.
Copyright The Financial Times Limited 2006
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