Cash settled repo and funding stress September 14, 2013 at 7:53 am
Cassa di Compensazione e Garanzia is part of the London Stock Exchange Group. It offers, according to its website, a variety of different clearing services on securities (stocks, warrants, bonds, CBs, ETFs), derivatives (futures) and repo. Proudly, CC&G says that it
eliminates counterparty risk acting as buyer toward the seller and vice versa, becoming the guarantor of the final settlement of the contracts.
LCH, another part of the LSE group, interoperates with CC&G. Recently, LCH took what might be described as a different view on the elimination of counterparty credit risk by CC&G, at least as regard to Italian bond repo. Matt King and colleagues at Citi research take up the story:
LCH seems to have become concerned that its exposures [in the event of CC&G's failure] would simply be too great, and/or the correlation of the collateral (which is mostly government bonds) with many of the borrowers is too high, for [its usual default management] process to provide sufficient protection.
One possible response would have been to increase haircuts. Instead, what they have done is to introduce a series of Articles to their rulebook moving to what they call “cash settlement” in the event of a default by CC&G. Rather than standing between repo lenders and borrowers, as is normal, in this case they would instead liquidate the collateral held and reimburse each lender only the “close out value” received for each trade.
In this way they protect themselves, passing on the costs of a default directly to repo lenders.
Matt points out that Italian banks are, unsurprising, the largest private repo borrowers in Europe, and much of that borrowing is done with BTP collateral cleared at CC&G. Without clearing house protection, how many of their funders are going to want to face them? And if they do still want to deal, what haircuts will they require?
If the answers to these questions are not helpful to the Italians, then they will go to the ECB. That works, but remember that the ECB’s haircuts increase precipitously from A- to BBB, and Italy is one step away at DBRS, the relevant ratings agency in this case*. This could cause significant funding stress if essentially all italian bank bilateral repo funding is at the ECB when a downgrade hits.
*The ECB uses the best of Moody’s, S&P, Fitch and DBRS. Italy is already BBB at the first three.