Corporates lending directly in tri-party repurchase agreements (repos) remain rare, and short-term investment alternatives such as Treasury securities, bank deposits and money market funds (MMFs) are far more popular. However, recently issued rules impacting MMFs may shift those dynamics.
Repo financing has typically been employed by Wall Street broker-dealers to fund their activities. Mutual funds and other institutional investors capture returns on the short-term loans that vary in attractiveness to those of MMFs or bank deposits of comparable maturities. Unlike those alternatives, repos are fully collateralized, usually by high quality securities.
Corporates have become significant players in Europe’s repo market, where they represent as much as 15 percent of activity conducted over Euroclear and Clearstream, industry utilities that provide a platform to match the bilateral transactions. In the United States, J.P. Morgan and BNY Mellon actually clear tri-party repos, and BNY, which clears the vast majority, says the number of corporates participating in its program has grown to the low single digits over the last few years.
That number could increase noticeably following the Securities and Exchange Commission’s final rules issued July 23 that flip MMFs’ fixed net asset value (NAV) to floating, and impose redemptions in the midst of a run on a fund. Some corporates are already considering alternatives such as repos.
Lance Pan, director of research at Capital Advisors Group, said his firm has provided a service for more than two years as part of separately managed portfolios that includes repo transactions for corporate clients. Until now, however, treasury executives have often viewed the investment alternative as overly complicated.
“What we’ve found recently is that people are more receptive to the idea, at least as a backup plan,” Pan said. “If MMFs are going to float, then this is something they’re willing to look into now.”
Wait and see approach
Pan noted that the change in attitude is still a distance from actually pulling the trigger to set up a program, which requires the counterparties, the clearing bank, Capital Advisors and sometimes even the custodian bank to negotiate and document their relationships, a process that may take six to nine months.
Pan said that if a client has $100 million to invest, Capital Advisors may recommend devoting 10 percent of that to repos. The advisor may in turn execute a block trade that is split and settled among several client accounts. He added that Capital Advisors typically works with smaller, unrated broker-dealer counterparties that may not be qualified to trade with MMFs but have strong collateral, sprucing up the yield.
Pan said his firm may recommend tenors up to seven days but no more than a month. He added that corporates have an advantage over many funds, whose liquidity restrictions forbid them to hold collateral for extended periods, requiring them to sell the underlying assets quickly, even in an adverse environment, should a counterparty fail.
The financial crisis illuminated significant weaknesses in the tri-party repo market, and regulators have prompted the industry to introduce changes aimed at improving the resilience of its infrastructure. Those include pushing market participants to reduce their reliance on intraday credit and making risk management practices more robust.
BNY Mellon, for example, is instituting new functionality and requiring more disciplined participation from dealers and lenders, in a program that is scheduled to roll out through the end of this year. John Vinci, managing director at the New York-headquartered bank who heads up product management and strategy for its broker-dealer services business, said so far BNY Mellon has yet to see a significant increase in corporates directly participating in the tri-party repo market
Corporates and their advisors are likely looking at the changes taking place as a result of tri-party-repo reform and saying, ‘Let’s see how this thing works out,’” Vinci said.
Commercial paper also an option
Corporates may also opt for products that resemble repos. Vinci added that in recent years dealers have increasingly relied on collateralized commercial paper (CP) programs, which provide the collateral security of tri-party repos and are operationally similar. Issued through a trust, the securities are distributed in smaller portions among a broader investor base in smaller portions, and looking at the prospectus investors can see the exact schedule for the CP’s eligible collateral.
“So, indirectly that corporate investor—if you look at the overall picture—is doing a tri-party-like transaction, but there are multiple investors each taking up a piece of the pie,” Vinci said.
The Association for Financial Professionals’ 2014 Liquidity Survey found that 52 percent of companies’ short-term investment balances were maintained in bank deposits, up from 50 percent last year. That increase was attributed at least in part to the SEC’s anticipated MMF rules, and also because the Fortune 1000 companies responding to the survey tend to have broad relationships with, and closely monitor, the global banks at which they deposit their funds.
In addition, the earnings credit rate (ECR) banks pay on idle funds reduces their service charges. David Neshat, treasurer for Akamai Technologies, said that over the past four years the ECR boost to the bank deposit rate has made it more financially attractive than MMF yields. Any Akamai cash balances in excess of what is required to offset fees through ECR, he said, have been “put on the curve” and invested in short- and long-term securities.
Nevertheless, Neshat said, the new MMF regulations will likely make repos a more attractive option, especially given most MMF holdings are in repos anyway. Investing in repos directly is more cumbersome operationally, and MMFs can offer greater diversification, “but that diversification now comes with a new risk, namely floating NAV,” Neshat said.
In addition, investing directly in repos allows the lender to decide what collateral is acceptable, and that can be beneficial in terms of complying with its investment policies. For example, Neshat said, most companies’ investment policies permit repo investments that must be collateralized by Treasury or U.S. agency securities with a value of not less than 102 percent of the face value of the repurchase agreement.
“If you look up the holdings in different MMFs, you will find many repos that are collateralized by corporate bonds and not government bonds,” Neshat. “I’ve even come across funds that had equities as collateral as opposed to fixed-income securities.”