Research firm Finandium published a report entitled, "Beyond the Bulge: Foreign Banks and Smaller Dealers in US Repo" recently. The Executive Summary tells us, "The focus on balance sheet and return on capital constraints faced in the repo business by bulge bracket US banks has often drowned out the vitality of foreign and non-bank players. This Finadium research report focuses on the challenges and opportunities faced by foreign and non-bank US repo market participants. Foreign banks have always been a fixture in the US repo markets, but the emergence of highly levered non-banks is fairly recent. Foreign banks and nonbank independent dealers have taken advantage of wider spreads in the market as bulge bracket banks stepped back. But there is evidence that this trend may have runs its course as larger banks dedicate more balance sheet to securities financing, pushing down spreads in the process."

The report continues, "The DTCC's Fixed Income Clearing Corporation (FICC) is driving one of the most important new developments, the Capped Contingency Liquidity Facility (CCLF), which will alter market structure and the flow of liquidity and collateral in US markets. All market participants will feel the impact of the CCLF, but smaller non-bank dealers may be most affected on a daily basis. CCLF requirements are expected to go live in November 2018."

It explains, "This report should be read by repo market participants across the sell-side and buy-side and by financial market participants more broadly. Our discussion of foreign and smaller non-bank dealers is relevant for directly impacted firms, competitors, clients, and anyone interested in US repo market liquidity. While this used to be a small audience, the introduction of the Secured Overnight Financing Rate (SOFR) means that repo liquidity now has implications for pricing and stability in other financial markets."

Finadium writes, "The repo business in the US is often seen as monolithic, but this view hides the diversity of players and objectives of dealers in the market. US repo dealers are sorted into three primary groups: bulge bracket US and UK banks, other foreign banks, and smaller non-bank dealers who have, more often than not, entered the market post-financial crisis. The three groups have different business models, often different regulatory constraints and in certain cases very different clientele."

They also say, "The new realities of the balance sheet and capital police looking over the shoulders of big bank financing businesses were daunting but not insurmountable. These constraints, however, fed the growth of foreign banks and small independent dealers. By taking advantage of being under different regulatory regimes, foreign banks and small independent dealers as non-banks (under the aegis of their home regulators and the SEC, respectively) had flexibility to grow their books in a way that the bulge bracket players did not."

The paper explains, "This report has been written to uncover the drivers of different segments of the US repo market. As US Treasury repo is now critical for the calculation of the Secured Overnight Financing Rate (SOFR), changes to market structure can also impact this benchmark. This report should be read by US repo market participants and financial market participants in general."

The paper states, "It is well known that most foreign banks operating in US repo markets play by a different set of rules than US banks. The most popular example is French banks that have for years been large suppliers of repo collateral to US cash investors. At the end of April 2018, French banks accounted for 34% of US Treasury repo market transactions with money funds, according to the US Office of Financial Research."

It comments, "In US repo, the combination of large bank balance sheet contraction and new demand from money market funds produced a unique trend not seen on Wall Street for decades: small independent repo dealers and prime brokers were created, often with the backing of venture capital or a deep pocketed financial backer. These smaller dealers were able to prosper in part due to prime brokers parsing their customer bases.... At the same time, asset managers were keen to establish multiple prime relationships to ensure stability and access. The new dealer startups were able to pick up smaller clients who had no place else to go as well as larger relationships looking to diversify their sources of financing."

In a section entitled, "Where the Market Goes from Here," Finadium writes, "Many of the reasons that prompted the growth of foreign banks and non-bank dealer books may fade in an environment of tighter repo spreads and greater balance sheet availability. Market participants report that there is more balance sheet available from large banks for securities financing trades today than in recent years. Will the pendulum of competitive advantage swing back in favor of the bulge bracket firms?"

They answer, "The theory behind more engagement by large banks is that the increased profitability in US repo that came with wider spreads was proof that markets can be efficient, providing a proper risk adjusted return. Management likes the revenue and has loosened up on balance sheet limits to capture even more. An intense focus on balance sheet efficiencies has also paid off, providing some room for repo dealers to seek new trading opportunities. Netting trades whenever possible is made easier by FICC's work."

Finally, the piece concludes, "Competition in the repo markets brought by foreign banks and independent nonbanks is good to see. A market driven response to bottlenecks that would have otherwise severely constrained supply is a testament to the creativity of the finance community. Whether these participants are taking advantage of regulatory loopholes will depend on the point of view of the reader. But one thing is certain: in this era of big data, there is no excuse not to collect data on securities financing trades and ensure information is centralized so we can know just how big the market is, who owns what risk, and where liquidity is coming from and going to."

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