The vulnerabilities in the wholesale funding and in particular short-term (overnight) repurchase agreement (repo) markets were significant sources of systemic risk in the Global Financial Crisis (GFC). The excessive dependence on such funding instruments contributed to the failure of some of the largest investment banks, such as Bear Stearns and Lehman Brothers. In addition to maturity and liquidity transformation, repo transactions involve varying degrees of financial leverage depending on the level of haircuts or initial margins. The levered maturity mismatch combined with the lack of access to government safety nets contribute to the fragility of the repo markets and the financial system. Unlike US repo markets, which faced significant distress during the GFC, the relevant EU markets experienced less stress. Nonetheless, in the aftermath of the crisis, international regulatory fora as well as supra-national and national regulators on both sides of the Atlantic were given the arduous task of reforming the legal environment of the short-term financing channels.
Numerous studies have investigated the role of repos in the financial crisis, but only a few scholars have explored why the European repo markets have weathered the crisis much better than their US counterparts. Our recent paper endeavors to fill this gap. We sketch the key differences in the EU and the US repo markets that we deem necessary to highlight potential vulnerabilities and eventually to inform the policy recommendations for harmonization and standardization of rules governing repo contracts. In so doing, we examine three main aspects of the repo markets. First, we highlight the differences in the legal framework governing repos, such as legal construction of repo contracts, special insolvency treatment, and legal treatment of the reuse of collateral. Second, we discuss the composition, structure, and organization of the repo markets, such as differences in the composition of repo participants, maturity of repos, and the composition of the underlying collateral in repo contracts. Finally, we investigate the differences in the issues related to the market infrastructure of repo markets such as differences in the clearing and collateral management stages.
Regarding the differences in the legal framework, the legal title of the underlying collateral in repos is considered to be transferred in Europe, whereas in the US, under the New York State law, the collateral is pledged, but it is exempt from certain provisions of the US Bankruptcy Code which apply to pledges (automatic stay). However, the pledgee or the buyer is given a general right of use of collateral, which is also known as rehypothecation. This gives rise to different regulatory approaches as to bankruptcy treatment and reuse of collateral. The reform of bankruptcy safe harbors for repos has always been a key controversial issue and more recently such reforms have been implemented or under discussion across the Atlantic.
With respect to the composition, structure, and organization of repos, based on latest data provided by the International Capital Market Association (ICMA) and the Federal Reserve Bank of New York, the US repo market is widely used by securities dealers, whereas the EU markets are dominated by banks, central banks and other risk-averse investors, possibly having access to European Central Bank’s (ECB) liquidity facilities. Regarding the repo term, the US repos often have shorter maturity and higher reliance on commercial paper, whereas in the EU repos are mainly collateralized by government bonds and have longer maturities. This difference could explain the higher levels of volatility and greater haircuts in the US repo markets during the GFC.
With regard to market infrastructures, the European repos are largely cleared by Central Counterparties (CCPs) which contribute to the stability of repo markets in Europe. Through multilateral netting and applying more rigorous risk management methods, CCPs contribute to mitigation of the risk of fire-sales. They also help increase the overall market transparency. For the US repo markets, we focus on the reform of the tri-party collateral management stage. As discussed in Copeland, Martin, and Walker (2010), the time gap between unwind and rewind process in tri-party repos has posed a major threat to the overall US financial system. During the GFC, the two clearing banks, namely the Bank of New York Mellon and JP Morgan Chase, have served as intraday creditors for as long as 10 hours on a daily basis. By providing de facto massive uncommitted loan facilities to dealers without submitting themselves to capital charges, the flawed design in US tri-party repos creates perverse incentives for repo investors to run at the first sign of distress of a borrower.
Although the post-GFC regulatory reforms including the Dodd-Frank Act, the European Market Infrastructure Regulation (EMIR) and a plethora of different legislative and regulatory measures, such as the Securities Financing Transactions and Reuse Regulation (SFTR) and the Bank Recovery and Resolution Directive (BRRD) in Europe, share the same objectives, the means to achieve those ends differ. These ends include avoiding fire-sales, mitigating systemic risk, improving market transparency, and ensuring the smooth operation of financial markets. Our findings suggest that multiple legal and regulatory divergences persist in repo markets across the Atlantic even after taking account of the post-GFC regulatory reforms. This is manifested, for example, in the treatment of repos in the insolvency proceedings.
Our paper recounts a cautionary tale of the divergences, idiosyncrasies, and differences in the global financial markets, which could inform the international efforts to harmonize applicable rules and standards addressed to the markets replete with such salient idiosyncrasies. We conclude that such differences and idiosyncratic features of repo markets should not be swept under the rug by the international fora having the mandate of promoting global financial stability.
Songjiwen Wu is a Mag. iur Candidate at the Faculty of Law, University of Heidelberg and a guest contributor to the Oxford Business Law Blog.
Hossein Nabilou is a postdoctoral researcher in Banking and Financial Law at Faculty of Law, Economics and Finance, University of Luxembourg and a guest contributor to the Oxford Business Law Blog.