De-mystifying the repo market

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Aaron Carter: I think in the piece you put out the other day, you kind of had those three steps that it will eventually work its way towards neutral, then reinvestment, and then eventually things will mature off.

Bipan Rai: Thanks for the plug by the way.

Aaron Carter: You’re welcome. It was an excellent piece. I suggest everyone read it. I printed it out and I have it on my bedside.

Bipan Rai: Welcome, everyone, to this fourth edition of The FX Factor podcast, I’m your host Bipan Rai, North America Head of FX Strategy here at CIBC. This time around, we thought we’d take a different approach and address a market that isn’t really well understood by many capital market professionals, but still is very important to the functioning of the financial system. And I thought, who better to have on than one of our Repo and collateral experts here at CIBC, Aaron Carter. Aaron, how are you?

Aaron Carter: I’m doing great, Bipan. Thanks for having me.

Bipan Rai: Excellent. Excellent. So why don’t we start off with the basics, Aaron? Why don’t you tell us what a repo is and why it’s so important?

Aaron Carter: Sure. So, I mean, at the basics repo is a repurchase agreement. So what that means is it’s an agreement to say buy a bond and then to sell it back to someone after a certain period of time, whether that’s a day, a week, a month, a year. And to use the difference in prices that are set on that bond to reflect an interest rate or the repo rate. So what that basically boils down to is it’s a short term collateralized loan and it can be used to either source collateral. So if you want to short a bond, you can borrow that from someone else and essentially pay a rate to get that short covered or vice versa. You can use it to finance a portfolio. You can lend your bonds out and take in cash and then pay in interest rates on that cash as a collateralized loan.

Bipan Rai: Excellent. So another question, I guess, is tied into this. Can you explain what the difference is between a repo and a reverse repo? That would trip me up a lot of the time. And I know that’s probably not the first time you’ve been asked that question.

Aaron Carter: I’d say it’s the exact same as the difference between a buy and sell for every repo there’s two parties, right? A reverse repo is generally referred to as the person who is receiving the asset, and a repo is the person who’s selling the asset.

Bipan Rai: And so with that in mind, can you explain a little bit as to how the repo market works here in Canada and also in the United States?

Aaron Carter: Yea, So the main differences between these markets is going to be the size and the depth of the participants. In Canada, right, you really only have five or six big banks then all the big pension fund versus the US. You’re going to have a lot more players, many more banks involved, many more financial institutions. So you’re going to have much deeper more liquid markets. Will really just reflect in how hard it can be to cover particular bonds. Like in the US there’s going to be a lot more happening in corporate space than there is in Canada. And you’ll also see a lot more variability in the demand and the repo rate on specific issues like in Canada, everything tends to trade pretty closely together. You’re not going have as wide of spreads as you would in the US.

Bipan Rai: And why is the repo market so important to the functioning of the financial world?

Aaron Carter: That’s a great question. So repo is often called like the plumbing of the financial markets. As you know, all markets are interconnected. What happens in one impacts another. So repo rates are kind of directly tied to the ability to leverage up portfolios to do relative value trades, butterflies, swap spreads, anything where you need the ability to kind of take multiple approaches on how to put on rate views, you need to short bonds against a lot of these to do risk neutral trades. So you have to go source those bonds somewhere. So it all is dependent on repo to provide people with the ability to do that and to provide people financing so that they can lever up their portfolios and put on, say, credit overlays with kind of the core holding of, say, government bonds.

Bipan Rai: So what about in terms of the big players here, like, say, the bank of Canada wants to adjust the overnight rates somehow? How does it work mechanically with the banks and whatnot? Can you walk us through a little bit of what happens to the bank of Canada’s balance sheet or what it means for the market at large?

Aaron Carter: That’s kind of a timely question based on everything that’s happened, I guess, recently. So the Bank of Canada is very involved in the repo market. We’ve got an ongoing dialogue with them and they keep close tabs on what’s happening. Just try to make sure the market is working, I guess, as intended. So the way that they would interact with the market is they have numerous programmes to help make bonds available. So you mentioned their balance sheet. Let’s talk specifically about that. With all the QE that’s going on, they now own. I mean, you probably know this number down to the decimal point, but it’s got to be close to 40 percent of the outstanding Canadian bonds that’s owned by the Bank of Canada. So with that much of the market essentially held by one participant, if you’re on the other side of that, if I need to source bonds, if people want to do a pair trade and short one of those bonds and they need to source it, well, now I’ve got 40 percent. And in some particular bonds, it’s maybe up to 60 plus percent of an issue is owned by the bank. So those are bonds that used to be held by other participants who are active in repo. So we would go find bonds from one participant. I would bid them or reverse repo them from one participant, and then I would go and deliver them to someone else so that they could sell them onwards as a short. With the bank having such a large balance sheet. Now, that reduces the availability of those bonds in the marketplace. It really means there’s just one person who owns the majority of that asset. So we have to be much more active in sourcing it from the bank. And as I’m sure you’re aware, with the securities repo operation that they’ve recently opened up, they kind of addressed that need of the market to get access to their portfolio that used to otherwise be sitting at custodian’s or sitting in various other portfolios that we would have access to,

Bipan Rai: Good point with respect to the securities repo operations, they went from, what, a billion a week to two billion, right?

Aaron Carter: Yeah. So it started at half a billion at a 10 rate. And then they increased the capacity to a billion at 15. And then just it was two weeks ago now they increased the capacity again to two billion. So there’s 11 dealers that have access to that programme. So if you look at that, we just very simply, there’s twenty two billion dollars total supply could come into the market through that programme across the various participants, whereas previously it was 11 billion, and before that it was five and a half. So they’ve really made it much easier for us to access their portfolio. And they kind of did that responding to a need in the marketplace for kind of collateral in general and specific bonds that were becoming harder to find and just generating more settlements failures.

Bipan Rai: And how are we seeing that in the market? I Remember, we had this conversation a couple of weeks ago, and you pointed out the fact that the repo rate in Canada in the way was moving. Can you detaigain, to the audience here, what you are seeing, what really indicated the fact that the Bank Canada needed to do something like this.

Aaron Carter: Yeah, that was participated when we saw Corra kind of drop, it had been hovering around 20 plus or minus a basis point. And again, that’s generally it should be close to the bank’s target rate of twenty five. So for quite a while now, we’ve been about five basis points below that, which is reasonable, just somewhat reflective of what’s been going on in the funding markets. So you saw that start to drop in about, say, the mid-February to the end of February, kind of a boat at the same time as rates started to back up across the curve, we start to see some signs of inflation and everyone starting to think, OK, it’s time for tapering to occur. It’s time for the bank to start looking at when they might hike. That created a bunch of things happening in the market at the same time. So first, as rates start to go up, I mean, you probably saw the two year, right? We went from like a twenty five year old to mid thirties, right back to twenty five, multiple times. So you have a few things that happen there. You’ve got a lot more active trading, which just means portfolio turnover in general. So say some of the stable supply of bonds I have are no longer stable. So I have to be much more active to cover positions because things that I had availability to are now gone. So I have to go cover those because I’m now short. Things that I was short, I’m now long. So it’s a lot of back and forth there. You have people increasing their shorts. You have a lot of relative value players putting on new positions. So you had a large turnover in portfolios. For one, you had a large demand for specific issues. As with the repositioning of the curve, new shorts are being put on, swap spreads are more active. So you have some large short positionings building, which means that at the same time that the stability of the supply of bonds is being reduced, we’re also having increased demand for particular issues. We were speaking to the bank and I said I kind of need access to more bonds. If you own 60 percent of something in the belly and I’ve got a larger short position, I just can’t buy it anywhere else. There’s no other holders. And like I said, we’ve got a good dialogue with the bank and they’re very understanding of their position in the market and wanting to make sure that by their actions, they don’t inadvertently cause any illiquidity issues. And so that’s one thing that happened there. And another one is at the same time, repo rates in the US are going down to zero, like the front end of their curve is pretty flat. So you had a lot of north mounding of US cash coming into CAD. Another function of the repo market is it’s a proxy for short term investments. So people will look to put their cash out via repo and then they’ll take in bonds. And then it’s just a way to invest that at some short term rate with triple-A counterparts with very high quality collateral. So that’s driven not by a need for specifics, but it’s driven by a need to invest the cash. So we have, on the one hand, strong demand for specifics. And the other hand, we have a strong demand for really any collateral in the front end. And those two things combined just drove that overnight repo rate down into the low teens. And we haven’t really seen a swing like that before. So it was kind of on that, that the Bank of Canada stepped in and increase the size of the SRO operation just to relieve kind of both of those, because by giving out access to the entire portfolio, they not only allow us to cover any particular shorts, but with a general dearth of collateral in the market, I can now go and just buy more of whatever bond I want and use that as general collateral to fulfil my obligations.

Bipan Rai: That’s a good summary. Now, you also spoke a little bit about short term rates. And Corra, can you explain to the audience here what Corra is and how it’s different than CDR?

Aaron Carter: Sure. So starting with CDR is meant to be reflective of a market in that it’s just combined from the level that is put together by various participants. Right. So I think we’ve got all the banks submit what they say their rate would be for essentially a short term loan, like a one or three month loan to various counter parties. So that kind of incorporates a credit component to it for one. But also it is just a level that the banks place. It’s not built upon. Actual transactions, even though there are things that trade there, it’s an average of these various rates. Now, Corra, on the other hand, especially with there was an update about a year ago to what we call E-Corra way it was enhanced Corra, the way it was measured. It is directly reflective of many transactions in the market. So on a daily basis, you’re looking at anywhere from 10 to 15 billion dollars of real funding transactions. The bank cuts off the lowest rated trades to try to avoid the demand for any specific issues and then looks at the median of the remaining amount. So it gives you a pretty accurate view of where funding markets are. Again, if we look at how Corra used to trade, it was based on a much smaller set of trades done through inter broker dealers. So you could occasionally have volatility in it just from a very low volume day. So it wouldn’t always reflect what’s happening in funding markets. But since we moved to enhanced Corra, it’s now very reflective of the actual transactions. Like 10 to 15 billion dollars a day is a pretty good sample size to know where people are funding themselves.

Bipan Rai: And I guess the time moving on the that card is going to switch more to the Corra dramework. We’re going away from the CDR framework as well. Is that what the gist of it is?

Aaron Carter: Yeah, I think that’s a broader push, as you’ve seen across markets everywhere, is to move away from rates that are set off of submission’s and move directly to things that you can have observable market transactions.

Bipan Rai: Excellent. Let’s talk a little bit about what the Bank of Canada did this week. They allowed a few key facilities that helped with market functioning lapse. Why did they do this? Can you just walk us through that.

Aaron Carter: I think to look at why they did that, you first have to start at why they put those programmes on to begin with. So you remember about a year ago, yea just over a year, really, there’s a lot more uncertainty in the market. People thought, what happens if mortgages can’t be paid? What happens if we’re going to see a lot more defaults on debt? We want to make sure that our financial system has enough liquidity and that the banks in particular have enough liquidity to manage that. So that’s really why the bank put on all these programmes to make sure that no matter what Canadian financial market would be, okay, that there would be plenty of liquidity. And you can see that reflective in the like say our LVTS balances are still about three hundred and eighty billion dollars of let’s just call it like reserves that are sitting there in cash. So there’s clearly ample liquidity in the market. Many of these programmes also hadn’t been used for quite a while. So some of the bond purchase programmes, as you know, they didn’t have a lot of uptake. They were designed to help make sure those markets kept functioning and those markets are functioning well. There’s plenty of liquidity and there’s not a lot of uptake in the programmes. Some of them were slated for a one year term, which is basically coming up. So they’re letting those roll off. And the term repo in particular, the bank used to have a programme where they would lend cash to dealers for either one or three month term against collateral at market rates. And they extended that to a two year term. And that was very useful at the start of this. Right, when we had a lot of demand for people were trying to shore up their financing on any leverage portfolios for years. And we didn’t really have the other side of that. No one was willing to lend money to banks for a year or two when COVID first started. So the bank stepping in there really helped ensure that there was a transmission mechanism to keep the market functioning, to keep clients funded. But the need for that has really gone away. There’s plenty of liquidity in the market. And you can see that in that term repo programme, the one year, the two year terms, there hasn’t been much uptake on it for three to six months now, like very low volumes. So it’s just kind of time. They said they’ve gone past when they were needed. They’ve gone past when they’ve really been used. So it’s probably about time they can wind them down safely without any worries of removing liquidity from the market.

Bipan Rai: And speaking of removing liquidity from the market that wasn’t the only thing that they said this week. They also strongly hinted at a taper, at least another edition of the taper to come at the April meeting. Will this impact the repo market in any way? I guess there’ll be more collateral available on the market now in theory going forward, correct?

Aaron Carter: Eventually there will be. But as we mentioned earlier, the amount of the bonds that they hold, it’s not changing immediately with tapering. So the first step is going to be just a reduction. How much are they buying? Right. I think in the piece you put out the other day, you kind of had those three steps that it’ll eventually work its way towards neutral, then reinvestment, and then eventually things will mature off.

Bipan Rai: Thanks for the plug by the way. 

Aaron Carter: You’re welcome. It was an excellent piece. I suggest everyone read it. I printed it out and I have it on my bedside.

Bipan Rai: Okay.

Aaron Carter: To us in the repo market if they still own those bonds. Right. Let’s just say when they first go to a neutral state, that stock is still there. It’s still available from them, but it is not being sold back into anyone else’s portfolio. So I still have to go to the bank to access that programme. That’s not going to go away for a while, even when they start reducing their purchases until it starts maturing and rolling off and we see new bonds are being issued that the bank is not purchasing and those bonds remain entirely in the hands of other financial institutions. It’s at that point that I’ll have kind of how the repo market would normally function, that I’m going between the various participants to find the bonds and sell them on a repo basis.

Bipan Rai: Interesting. So it’s a little bit different for foreign exchange. I mean, in my market, we don’t really pay that much. Much attention to the inner workings of the repo market that often. It does become a factor whenever the bank signals that a change is coming in the way of a hike or a cut, and that’s usually the way that’s channelled is via interest rate futures or just moves in the cash market and in the extreme front end. But for my market, if the bank does taper in April, I kind of wrote just a couple of days ago as well, I’m not really expecting $CAD to move that much. Instead, where you’re going to see most of the move is potentially on the crosses, especially for Aussie CAD and for our listeners out there. Believe it or not, there’s actually a pretty strong correlation between the change in the Bank of Canada’s balance sheet and also in terms of Aussie CAD price price action. So we did hear Deputy Governor Gravelle indicate the other day that they’re looking at taking the balance sheet down to around four hundred fifty billion in assets. And to us, that portends to an Aussie cat valuation to ninety two cents. So again, that is the view that we’re holding on to and one of our strong conviction that plays for right now. But that being said, thanks again, Erin, for joining us today. I mean, you’ve had a really lively and interesting conversation with respect to the repo market and why it’s so important. And we’d love to have you back here whenever you can and whenever you have something else to say.

Aaron Carter: Yeah. Thanks very much for having me, Bipan.

Bipan Rai: Excellent. Thank you, everyone, for listening to this edition. Be sure to subscribe on Google, iTunes or Apple, and we’ll see you next time.

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