Angela Osborne at Newedge sees repo market change in response to overnight cash demands
The days of relying on banks to accept unsecured overnight cash and be paid for it are no longer a guarantee says Angela Osborne co-head of Agency Cash Management at multi-asset brokerage and clearing house Newedge.
Before the collapse of Lehman Brothers in 2008, unsecured cash, was the oil that kept the cogs of the financial system turning smoothly. Cash was not considered as an asset class that was actively managed, it was relegated to the realms of a ‘borrowing class’ and therefore low on the list of asset managers’ priorities. All that changed with the financial crisis as cash-managers scrambled to secure their cash in an environment when the risk of bank-default was sky high.
On a daily basis trillions of dollars flowed from corporates and financial institutions such as asset managers, money-market funds and corporates to investment banks that offered an overnight interest rate on any cash deposited.
Banks used this cash to shore up their own positions, make up cash shortfalls for their global franchise and generally smooth the edges off their daily activities.
It worked well until the collapse of Lehman, when many firms realised that the cash they had deposited the previous night wasn’t coming back. The IOUs that provided ‘security’ for the cash weren’t worth the paper they were written on.
Five years on, thousands of these creditors to Lehman are still trying to recoup some of the money they loaned the bank ahead of the collapse. Estimates suggest that this process could take more than twenty years to complete.
Of course, the irony is that many of the firms who freely lent to Lehman and others on an unsecured overnight basis would never consider themselves to be risky in their endeavours. They saw themselves, and continue to see themselves, as risk averse.
Today the lessons of Lehman have largely been learned. Many market participants rightly recognise the need to accurately evaluate the potential threat of counterparty risk alongside traditional market risk.
But unfortunately many institutions continue to ignore the warnings of the past choosing to put their faith in the old adage: too big to fail.
Habit often encourages maintenance of the status quo. Many market participants tell me that onerous documentation needed as part of a transference process to a secured environment also plays a role in the inertia.
But change is being foisted on the unsecured cash markets, whether participants like it or not, as regulators around the world seek to curb banks’ ability to participate in the unsecured overnight cash market.
Authorities have recognised the potential threat that over reliance on ‘bad cash’, as it is increasingly being dubbed, is a systemic threat to successful functioning of the wider financial system.
Basel 3 rules are forcing investment banks to consider where they secure their funding and for how long. They are being told to diversify into new sources or pay the price of inaction.
This means that banks are searching out longer term collateralised loan agreements that come with less burdensome capital requirements.
So banks are turning away once staple overnight cash, meaning that many buyside firms face the prospect of being unable to invest their cash overnight, costing them considerable sums of money which eats into their overall performance – not helpful in a low interest environment.
The perceived value of this cash is further diminished because the buyside has much more to lend than in the past. Cautious investors now hold larger amounts of liquid, less risky assets, so yield on deposited overnight money is falling.
Repo markets, traditionally dominated by the investment banks but increasingly being used by new participants such as hedge funds and corporates, are a way that many firms can access a secured environment whilst reaping returns scooped via overnight loans.
Newedge, partnering with MTS and Euroclear, has developed a system whereby cash-rich investors are given direct access to enter into secured money market investments via the tri-party repo mechanism as an alternative to the traditional suite of unsecured money market products.
New participants are able to ‘plug and play’ on our FCA & SEC regulated auction-based platform that provides competition for the cash with a seamless straight through processing functionality thereby reducing administrative risk. Further to this, we have developed a document-lite solution which help investors fast-track the process of gaining access to the secured repo markets.
Our offering, alongside others in the market, is helping develop a genuinely diversified and secure alternative to the traditional overnight cash markets upon which there has been too great a reliance.
Overnight cash might have turned bad in the eyes of the banks, but tri-party repo is showing that cash can still be good in the right circumstances.