A Thought on Repo Market Haircuts

A Thought on Repo Market Haircuts Joo, Hyunsoo Repo is a money market instrument that works in a similar way to a secured loan where a cash borrower provides its securities as collateral to a cash lender. During the process, a haircut is applied to ensure that the value of the collateral remains higher than the borrowed amount. When the Bank of Korea (BOK) implements open market operations with repos using government bonds as collateral, a uniform margin requirement is applied regardless of the collateral s maturity. But this is not efficient because the value of short-term securities changes less than securities with longer maturity. Furthermore, the application of a uniform haircut to collateral securities for all maturities makes repo financing using short-term securities more costly compared to long-term securities. To facilitate Korea s repo market and improve its efficiency, the BOK s Detailed Enforcement Rules should be revised to allow for different haircuts according to collateral security type, credit rating, and maturity. In the long run, the current haircut level should be lowered. Also necessary is more stringent monitoring of Korea s repo market by including haircuts in mandatory disclosure in the triparty repo market. A repurchase agreement is a transaction where a security is sold (bought) under the condition that it will be bought (sold) back later. Unlike unsecured call loans or call money, repos are secured by collateral and thus considered safer. Most of the securities offered as collateral in repo transactions consist of top-rated, liquid securities such as government bonds. The value All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Research Fellow, International Finance Department, Tel: 82-2-3771-0837, E-mail: joo@kcmi.re.kr 1

of collateral securities may fall abruptly according to the market environment, sometimes even to a level lower than the size of the loan. To prevent this, a repo transaction usually requires the market value of collateral securities to be higher than the purchase price. A haircut refers to the difference between the two, expressed as the percentage of the difference to the collateral s market value. The size of haircuts may vary depending on collateral securities credit rating and residual maturity. Although haircuts are important to guarantee repo transactions, excessive haircuts may increase transaction costs for cash borrowers. Therefore, haircuts should be set at an appropriate level. During the global financial crisis, fire sales were triggered by defaults of major market participants in the US repo market, which abruptly increased the haircuts in the bilateral repo market. This shows the procyclical aspect of haircuts when no relevant regulations are in place. The Financial Stability Board (FSB) has led discussions about applying numerical haircut floors to abate the procyclicality and announced a regulatory framework. In Korea s repo market, a significant quantity increase is observed since 2008, but the problem is that repo transactions for the BOK s open market operations adopt a uniform haircut for all collateral securities. This article compares Korea s haircuts with those in other countries and those proposed in the FSB framework, and then draws out recommendations for improvements. Repo haircuts in major countries Basically, haircuts carry insurance-like characteristics because they are meant to provide additional guarantee to money lenders in case of value fluctuations in collateral securities. Hence, the level of haircuts changes according to the type and residual maturity of collateral securities. For example, the highest-rated government bonds are subject to lower haircuts relative to corporate bonds, and long-term bonds are prone to price fluctuations and therefore have higher haircuts than short-term bonds. This basic principle is confirmed by a brief look at repo haircuts across major countries. According to market participants, repo transactions can be divided into two categories: nongovernment transactions and central bank transactions for open market operations. While the haircuts for the latter are widely disclosed, the former data are generally closed to the public. But the Federal Reserve Bank of New York (the NY Fed) publicizes some useful information, more specifically, the haircuts in the tri-party repo market in the US. That data show that as of 2

October 9, 2014, the median value of haircuts in the market is 2% for Treasury securities, 5% for investment-grade ABS and corporate bonds, and 8% for speculation-grade ABS and corporate bonds. Also, the haircuts and their variance increase as the quality of collateral assets decrease. For example, a difference barely exists between the 10 th percentile and 90 th percentile haircuts for Treasury securities. But there is a wide gap between the 10 th percentile (5%) and the 90 th percentile haircuts (25%) for speculation-grade ABS. Koulischer and Struyven (2013) provide the haircuts in repos used by Fidelity money market funds and show the average haircuts: 3.2% for Treasuries, 4.9% for corporate bonds, and 8.1% for equity securities. This is all consistent with the FRB data. 1) As briefly mentioned above, there are many data available for repo haircuts used for central banks open market operations. While the US does not release all information in this area, it offers some data about the Primary Dealer Credit Facility (PDCF) and Term Security Lending Facility (TSLF), which were used to provide short-term liquidity to primary dealers during the global financial crisis. The haircuts for the PDCF were different depending on residual maturity of collateral securities: 1% for those with less than three years of residual maturity, 2% for 3-5 years and 5-10 years, and 3% for 10-30 years. 2) Also notable is that the US Fed applies slightly higher haircuts to MBS and other corporate bonds, compared to Treasury securities. The Bank of England also uses differentiated haircuts across maturities of the eligible securities for its lending operations: fixed-rate, sovereign and central bank debts have haircuts ranging from 0.5% (less than one year of residual maturity) to 7.5% (over 30 years). 3) The same goes for the ECB. It adopts different haircuts for sovereign and central bank debts with different maturities (0.5% for less than one year of residual maturity and 5% for over 10 years). 4) Last, Australia also has different haircuts depending on residual maturity, e.g., 1% for government bonds with a residual maturity of less than one year, and 2% for those with over one year. 5) 1) Koulischer, F., Struyven, D., 2013, Central bank liquidity provision and collateral quality, MIT, manuscript. 2) The haircuts released first on March 17, 2008 were lower, but have been raised to the current level mentioned here since March 27. 3) Bank of England, Sterling monetary framework: summary of haircuts for securities eligible for the bank s lending operations, November 13, 2014. Zero-coupon sovereign debts are subject to slightly higher haircuts than those mentioned here. 4) European Central Bank, Press release, ECB further reviews its risk control framework allowing for a new treatment of asset-backed securities, July 18, 2013, <http://www.ecb.europa.eu/press/pr/date/2013/html/pr130718.en.html>. 5) Reserve Bank of Australia, Eligible securities and margin ratios, December 1, 2014. 3

FSB s regulatory framework for repo haircuts On October 13, 2014, the FSB unveiled its regulatory framework on haircuts in repos and securities lending that are regarded as shadow banking. 6) Among the recommendations for lowering the shadow banking risk were numerical haircut floors for short-term borrowings through repos and securities lending. The final haircuts are higher than those proposed earlier in August 2014. In the October framework, collateral offered by financial institutions in the repo market are subject to a 1.5% haircut for corporate bonds with a residual maturity of one to five years, higher than the 1% haircut in the August recommendation. Also, the haircut for equity securities rose from 4% to 6%. The increase in haircuts might represent the FSB s desire to prevent excessive leverage and liquidity risk at a time of market stress. While the FSB focuses on corporate bonds and equity securities, the recommendation has yet to set haircut floors for government bonds that in fact account for a significant part of repo collateral. This may be explained by the fact that a counterparty of a repo transaction can easily dispose government bonds offered as collateral if the other counterparty defaults. However, regulatory uncertainties still linger because of speculation that the idea of setting haircuts for government bonds was opposed by some governments worrying about the shock of such an idea to the sovereign debt market. Korea s repo haircuts Collecting data about Korea s repo haircuts is more difficult than in the other countries mentioned above. Korea has no detailed regulatory framework on haircuts, and currently, interinstitutional transactions are not subject to any haircut regulation while customer transactions face the 105% margin requirement under the Korea Securities Depository (KSD) regulation. 7) For open market operations by the BOK, different margin requirements are applied: 105% for government bonds and government-guaranteed bonds, and different margin requirements depending on maturity for MBS issued by the Korea Housing Finance Corporation. In Korea, all securities issued pursuant to the Financial Investment Services and Capital 6) FSB, 2014, Regulatory framework for haircuts on non-centrally cleared securities financing transactions, October 13, 2014. 7) Article 6 in the Regulation on Open Market Operations defines the margin requirement as the percentage of the market price of securities traded to the purchase price on the contract day. The margin requirements become roughly similar to a haircut if we subtract 100% from the margin requirements. 4

Markets Act are eligible for institutional repos. But customer repos can only use limited securities, including government bonds, municipal bonds, special bonds, guaranteed bonds, publicly offered corporate bonds issued by listed companies and government enterprises, and publicly offered ABS and MBS with BBB or higher ratings (A or higher for CMA repos). In practice, institutional repos mostly use safe assets (e.g., government bonds, monetary stabilization bonds, special bonds, etc.) while non-government bonds, such as corporate bonds and financial institution bonds that offer higher returns, represent a large proportion in customer repos. In short, there is no general regulation on haircuts for the aforementioned securities. The KSD s Regulation on Collateral Management of Securities set a margin requirement of 105% or higher only for customer repos. 8) This requirement covers only tri-party repos traded through the KSD. A market participant said in an interview that the margin for some quality collateral in institutional repos was 102%. Repo haircuts in BOK open market operations An open market operation is a policy tool through which a central bank trades securities, including government securities, in the financial markets and adjusts the liquidity held by financial institutions in order to control the monetary supply and short-term interest rates. This is done in order to control both short-term and long-term liquidity. Repo transactions are used for short-term liquidity management by adjusting temporary liquidity shortages or excess. Seven-day repos are the most fundamental open market operation tool used by the BOK. The securities eligible for BOK repos under Article 4 of the Regulation on Open Market Operations include government bonds, government-guaranteed securities, monetary stabilization bonds (only if they are bought under a repo contract), and MBS issued by the Korea Housing Finance Corporation (only if they are bought and sold under a repo contract). The BOK s Regulation on Open Market Operations and the Detailed Enforcement Rules for Open Market Operations prescribe that the BOK Governor shall set different margin requirements across eligible securities, with the minimum margin requirement at 100% when selling repos 8) Article 58 (Substitution of Securities Sold) 1 Investment traders, etc. may request the KSD to substitute the securities sold with other types of securities. In such case, the investment traders, etc., shall ensure that the market value of the substitute securities remains more than and including 105% of the purchase price. (Section 4, Chapter 5, Regulation on Collateral Management of Securities, KSD, Amended on February 19, 2014). Section 4 covers customer repos only. Institutional repos are regulated by Section 3 that includes no market value provision. 5

and at 105% when buying repos. According to the margin requirements set forth in the Detailed Enforcement Rules for Open Market Operations, haircuts applied when buying repos are shown in the table below. Residual maturity Table. Haircuts to repo collateral US UK ECB Australia FSB Korea 9) Government bonds (PDCF) Fixed-rate government bonds Sovereign and central bank debt Sovereign debt Corporate bonds ABS Government bonds 10) (Unit: %) MBS 11) Under 1 year 1.0 0.5 0.5 1.0 0.5 1.0 5.0 6.0 1~3 years 1.0 1.5 1.0 2.0 1.5 4.0 5.0 6.0 3~5 years 2.0 2.0 1.5 2.0 1.5 4.0 5.0 6.0 5~7 years 2.0 3.0 2.0 2.0 3.0 6.0 5.0 7.0 7~10 years 2.0 3.0 3.0 2.0 3.0 6.0 5.0 7.0 10~20 years 3.0 4.5 5.0 2.0 4.0 7.0 5.0 9.0 20~30 years 3.0 6.0 5.0 2.0 4.0 7.0 5.0 9.0 Over 30 years 7.5 5.0 2.0 4.0 7.0 5.0 9.0 Sources: Federal Reserve Bank, Bank of England, ECB, Reserve Bank of Australia, Financial Stability Board, Bank of Korea. 9)10)11) The table shows two important points. First, Korea has higher haircuts for government bonds than other countries. For example, while most countries have 1% or lower haircuts for collateral securities with a residual maturity of less than one year, Korea s haircut is 5% regardless of the residual maturity. Such a high rate is applied to sovereign debt with 20 years or longer maturities in the UK, and sovereign or central bank debt with 10 years or longer maturities in the ECB. Second, while major developed countries use higher haircuts for issues with a higher residual maturity, Korea has a uniform haircut level for all maturities. With the exception of Korea, haircuts in all countries listed in the table above increase according to the residual maturity. 9) The Detailed Enforcement Rules for Open Market Operations shows the risk-adjusted collateral value as margin requirements (e.g., 105%). But for convenient comparison with haircuts in other nations, I subtracted 100% from the margin requirements. 10) In Korea, government-guaranteed bonds and monetary stabilization bonds are subject to the margin requirement same to government bonds. 11) The MBS issued by Korea Housing Finance Corporation became eligible securities on March 27, 2014 in order to facilitate the mortgage securitization market, which is expected to improve household debt structures and financial stability. The rates shown in the table are for only AAA-rated (or higher) MBS issued by the Korea Housing Finance Corporation. Issues with ratings under AAA are subject to higher haircuts. 6

Australia places the 2% haircut for all issues that mature over one year, but it has separate categories based on residual maturity in preparation for future adjustments to haircuts. Korea also uses different haircuts according to residual maturity and credit ratings for MBS that recently became eligible. But this is not the case for the securities whose haircuts were set before that, e.g., government bonds, government-guaranteed bonds, monetary stabilization bonds, etc. Considering that most collateral securities in repo transactions belong to the latter, it is necessary to subject the latter securities to different haircuts depending on their maturity. Implications A comparison with other countries reveals Korea s inefficiency in using a single haircut in repos, one of the BOK s open market operation tools. The application of a single haircut on collateral securities regardless of their maturity is problematic because it pushes up repo transaction costs, especially when the repo uses collateral securities with a short-term maturity. Taking into account the haircut floors presented in the FSB framework, Korea needs to differentiate its haircuts by collateral security type, credit rating, and maturity. It should also lower the overall level of haircuts in the long run in order to facilitate the repo market and improve market efficiency. Considering the rising dependency on the repo market among securities firms and asset management firms that are restricted from accessing the call market since the 2008 global financial crisis, such cost-saving efforts will help these players greatly ramp up their competitiveness. Another area that should be improved is Korea s tri-party repo market. For now, it is difficult to measure the actual haircut levels. Since the global financial crisis, the US has regularly released repo market data including haircuts and tri-party repo transactions. Accordingly, Korea should strengthen its monitoring on its repo market by expanding the scope of mandatory disclosure to include haircuts. 7