Derivatives funding: smart solutions for a complex environment

Eurex’s cleared repo and GC Pooling offerings are helping market participants overcome challenges in the funding, financing and collateral markets

Of all the factors of interest to derivatives market participants, the funding environment warrants careful attention. It defines, among other things, balance sheet capabilities, collateral pricing and trading risk appetites.

Funding has remained a priority as we progress into a year characterised by geopolitical uncertainty and macroeconomic fluidity, while market players keep watch for central banks’ moves to lower base rates.

The funding environment appears to have settled after two years of inflationary intensity that roiled markets worldwide. Market participants also had to grapple with significant credit events – notably the collapse of Credit Suisse in Europe and, in the US, of regional banks, including Silicon Valley Bank.

Even before these events, banks and other counterparties in Europe were dealing with a significant transition in the funding environment, as liquidity support and access to funding that has been provided by the European Central Bank (ECB) since before the Covid‑19 pandemic were gradually unwound. As a result, banks sought funding in the market instead.

“There has been a big transition in the funding markets,” says Arne Theia, head of short-term funding, and interest rate and cross-asset management at UniCredit in Milan. “We came from more than a decade of low and negative interest rates in Europe.”

Theia describes the unwinding of the ECB’s asset purchase and reinvestment programmes as an additional “paradigm shift” for the short-term funding markets.

Banks have weathered this transition well, according to market participants. The main issues currently affecting funding are regulatory capital – in particular, Basel III and the US Securities and Exchange Commission Treasury clearing mandate – and a weakening macroeconomic outlook. In December, the ECB’s outgoing head of supervision said that, while banks in the eurozone had “solid” capital positions, they should prepare for “more volatile funding sources” amid a weak macroeconomic outlook.

Cosmin Lupea, treasurer at Capstone Investment Advisors, says that, while there is not currently much funding pressure, the environment looks set to change. “Balance sheet availability is not an issue at the moment, but it could become a problem in the near future because banks are having to manage multiple constraints.”

One reason is an increase in the supply of government bonds at a time when broker-dealers’ balance sheet capacity has not changed significantly for years. “The market needs more capacity [and] more intermediation,” Lupea says.

Regulatory capital issues are likely to further constrain the funding environment, and margin funding costs have increased for banks because of the interest rate environment. In short, regulatory capital requirements are driving banks to carefully ration scarce balance sheet capacity, with repo markets most significantly impacted as they consume substantial capacity under the Basel III leverage ratio measure and the global systemically important bank framework.
 

Strategic solutions

In response to these challenges, market participants are reducing their exposures with netting and trade compression services, while dealing with margin cost pressures with collateral optimisation options.

Diversification of collateral is another strategy, says Roelof van der Struik, investment manager at Dutch co-operative fund manager PGGM. “It’s about diversification into T-bills [Treasury bills], commercial paper, debt, money market funds – all kinds of repos with a wide range of counterparties in as many jurisdictions as possible.”

Geographical diversification is a common theme. “This allows greater capacity around reporting days and more flexibility to move balances and get the best liquidity from wherever can support your financing needs,” Lupea explains.

Market participants are also taking advantage of services – including those from central counterparties (CCPs) – to manage liquidity and funding through cleared repo. “Clearing houses such as Eurex Clearing are offering certain tools, which are helpful to address challenges faced by the market,” says Theia.   

Sponsored clearing models – allowing transactions to be netted off between banks and other clearing members – are also being well received by market participants. “Opening up the clearing service to more and more customer groups is a big part of the Eurex model,” explains Theia. “This is interesting for banks, because the more trades there are in a clearing house, the more netting opportunities you have – and the more you can net off your balance sheet.”

Eurex offers a broad range of cleared repo services via its F7 trading venue – an integrated market for electronic trading, CCP clearing, collateral management and settlement of repo transactions. Its GC Pooling repo service is the European benchmark for standardised secured funding with central clearing.

While Eurex’s repo offering has historically focused on interbank financing and funding, Eurex Clearing’s repo clearing access models now offer direct access to CCP-cleared repo for buy-side firms. This allows banks to maintain their repo trading service offerings for buy-side clients without disproportionately high leverage capital costs and depressed returns on equity.

Buy-side firms benefit from improved access to funding and a large liquidity pool through Eurex’s cleared repo services. Compared with bilateral trading, operational efficiencies can also be achieved through settlement netting and reduced documentation. Buy-side firms also benefit from better protection of assets and improved portability in a default scenario.
 

Collateral optimisation

By increasing the range of participants and collateral types accessible via cleared repo, Eurex is bringing greater capacity and intermediation, helping to increase the efficiency of the European repo markets.

Eurex already has more than 160 market participants active in its repo markets, with more to come, says Matthias Graulich, member of the executive board at Eurex Clearing. “With innovative access models, we have successfully connected pension funds and insurance firms to the cleared repo offering, and aim to have the first hedge funds going live in 2024.”
 

Margin efficiencies

Cleared repo is proving useful for managing today’s funding and financing challenges. It also has two distinct and unique benefits over other liquidity management tools.

The first is superior transaction terms for buy-side firms – a better repo rate enabled by greater netting efficiencies and lower capital costs for banks’ repo counterparts.

The second is its proven resilience in stressed market conditions over other tools. As market participants witnessed in previous periods of stress, worrying about bilateral credit risk was a constant issue in the non-cleared market.

“That’s why cleared repo should also be in the toolboxes of buy-side participants,” says Graulich, “creating a virtuous cycle of higher efficiencies, better terms and strengthened market resilience in stressed conditions.”

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