Central clearing and the growing presence of non-bank financial intermediation in euro area government bond repo markets
The non-bank financial intermediation (NBFI) sector is playing an increasingly important role in euro area government bond repo markets. The NBFI sector’s activity in euro area government bond repo markets has increased rapidly in recent years, particularly in the area of investment funds. The sector’s growth is focused in the non-centrally cleared segment (Chart A).[1] This development may improve market liquidity in normal times. However, recent stress episodes have highlighted the systemic risks posed by deleveraging dynamics stemming from the activities of highly leveraged investment funds in these markets (see Article 1).
Chart A
Share of non-centrally cleared euro-denominated cash-borrowing repo transactions
(outstanding amounts at end-of-month reporting dates in EUR billions)
Sources: SFTDS and ECB calculations.
Notes: The chart displays outstanding repo volumes at end-of-month reporting dates from January 2021 to October 2024. The data considered only include non-centrally cleared euro-denominated transactions with government bond collateral and exclude intragroup trades. The borrower sector classification is based on Letizia and Lenoci (2021).
Mandating the use of central clearing in government bond repo markets is one potential tool for authorities to address NBFI leverage risks. Central clearing mandates were introduced as part of the post-2008 financial crisis reforms to address leverage risks for key over-the-counter derivatives classes, but these reforms did not extend to government bond and repo markets. To address the emerging vulnerabilities due to the growing role of highly leveraged NBFI entities in these markets, policymakers are now considering the increased use of central clearing, including clearing mandates, among their policy options.[2] Most notably, following bouts of turbulence in the US Treasury (UST) markets in December 2023, the US Securities and Exchange Commission introduced rules mandating the central clearing of USTs in cash and repo transactions.[3]
By imposing stricter risk management practices, central clearing can limit the build-up of NBFI leverage ex ante. Leveraged investors such as hedge funds can build significant leverage by borrowing in the repo market against government bond collateral. Haircuts of 0% are widespread in uncleared repo transactions: available data show that in both the European Union (EU) and the United States, approximately 70% of uncleared repo transactions with government bond collateral have 0% haircuts.[4] As centrally cleared transactions are generally subject to stricter risk management practices, mandating the use of central clearing makes it effectively more costly for NBFI entities to build and maintain high-risk leveraged strategies, including by placing a limit on the re-use of repo collateral.
Ex post, central clearing can mitigate counterparty risks and support market resilience in times of stress. Central clearing reduces credit risk exposures by having a central clearing counterparty (CCP) acting as the buyer to every seller and the seller to every buyer. By reducing the net exposures and transferring counterparty risk from the dealer banks to CCPs, this mitigates potential losses from the default of a leveraged entity, reducing risks from growing interlinkages between banks and non-banks. Central clearing may also improve the supply of liquidity during stress, when large one-sided flows triggered by the unwinding of NBFI entities’ leveraged positions can overwhelm dealers’ intermediation capacity. Owing to the increased possibilities of netting, central clearing can reduce the costs of market-making activities, increasing dealers’ ability to accommodate fluctuations in market demand.
The marginal benefit of mandatory central clearing depends on each jurisdiction’s market structure and needs to be weighed against potential costs. In the euro area, a significant share of government bond repo transactions (around 60% of outstanding amounts) is already centrally cleared (Chart B), although the percentage varies strongly across individual issuers. This suggests that the benefits of mandatory central clearing are generally lower than in other jurisdictions which have a lower share, such as the United States.[5] As regards the netting benefits from clearing, the prevalence of central clearing in the euro area is especially high among dealer banks, and netting also occurs in non-centrally cleared trades.[6] This suggests that mandatory clearing offers only limited additional netting benefits, although further efficiencies could be achieved via cross-product (cash-repo) netting.[7] The financial stability benefit of reducing leverage risks in the non-centrally cleared market would need to be weighed against a potential increase in the demand for liquidity from the NBFI sector in stress episodes. Such an increase could result from the need for NBFI entities to meet CCP variation margin calls with cash. If market volatility were to increase, this could potentially make (systemic) liquidity needs even more procyclical.[8] Finally, central clearing could lead to higher trading costs and lower market liquidity in normal times and reduce market access for some end-users that find sponsored access uneconomical.
Chart B
Share of centrally and non-centrally cleared euro-denominated repo transactions
(outstanding amounts at end-of-month reporting dates in EUR billions)
Source: SFTDS.
Notes: The chart displays outstanding repo volumes at end-of-month reporting dates from January 2021 to October 2024. The data considered only include euro-denominated transactions with government bond collateral and exclude intragroup trades.
Mandatory central clearing also needs to be assessed against alternative policies. As shown by the policy response to the liability-driven investments episode, entity-based measures can be an effective tool with which to address leverage risks from investment funds in government bond repo markets, especially when the fund type holds highly concentrated positions (see Article 2). However, such measures may be less appropriate for funds which have a lower share of government bonds in their portfolio, even if they hold a sizeable market share. In addition, their use may not always be feasible, as entities may lie outside the regulatory perimeter. In these cases, activity-based measures such as central clearing can be a viable alternative. Compared with other activity-based measures such as haircuts,[9] which can be aimed specifically at NBFI trades (see Article 5) to directly address their leverage risk, a central clearing mandate would apply more broadly, including to the interbank segment. Finally, unlike tools such as leverage limits and haircuts, which could be introduced strictly on financial stability grounds, mandatory central clearing would also have broader implications for market functioning and monetary policy implementation. A careful assessment of its potential effects is therefore needed, which should also take into account concurrent developments in securities markets, such as the EU’s potential shift to a shorter settlement cycle.
References
Avalos, F., Ehlers, T. and Eren, E. (2019), “September stress in dollar repo markets: passing or structural?”, BIS Quarterly Review.
Baranova, Y., Holbrook, E., MacDonald, D., Rawstorne, W., and Vause, N. (2023). The potential impact of broader central clearing on dealer balance sheet capacity: a case study of UK gilt and gilt repo markets. Bank of England Staff Working Paper No. 1,026, June.
Bowman, D., Huh, Y., & Infante, S. (2024). Balance-Sheet Netting in US Treasury Markets and Central Clearing. Federal Reserve Board Finance and Economics Discussion Series (FEDS), July.
CPMI-IOSCO (2024), Streamlining variation margin in centrally cleared markets – examples of effective practices, BIS, February.
European Securities and Markets Authority (2024), “EU Securities Financing Transactions markets”, ESMA Market Report, April.
Ferrara, F.M., Linzert, T., Nguyen, B., Rahmouni-Rousseau, I., Skrzypińska, M. and Vaz Cruz, L. (2024), “Hedge funds: good or bad for market functioning?”, The ECB Blog, ECB, 23 September.
Financial Stability Board (2015), Transforming Shadow Banking into Resilient Market-based Finance: Regulatory framework for haircuts on non-centrally cleared securities financing transactions.
Fleming, M. J., and Keane, F. M. (2021). The netting efficiencies of market-wide central clearing. FRB of New York Staff Report, (964).
Grill, M., Molestina Vivar, L., O’Donnell, C. and Weistroffer, C. (2024), “Containing risks from leverage in the NBFI sector – insights from recent policy initiatives”, Financial Stability Review, ECB, May.
Hempel, S., Kahn, R.J., Mann, R. and Paddrik, M., 2023, “Why Is So Much Repo Not Centrally Cleared?”, OFR Brief Series, OFR, No 23-01
International Monetary Fund (2024), “Expanding central clearing in Treasury Markets”, IMF Global Markets Analysis, IMF, 24 May.
Lenoci, F. D., and Letizia, E. (2021). Classifying counterparty sector in EMIR data, in Data Science for Economics and Finance: Methodologies and Applications (pp. 117-143). Springer International Publishing.
Vissing-Jorgensen, A. (2021), “The Treasury Market in Spring 2020 and the Response of the Federal Reserve”, Journal of Monetary Economics, Vol. 124, pp. 19-47
The footprint of NBFI entities, and hedge funds in particular, has increased in the euro area government bond markets in general, and not only in the repo market. See Ferrara et al. (2024).
See Grill et al. (2024). Authorities may also take an incentives-based approach to increasing the use of central clearing, without mandating its use. Such an approach would aim to make central clearing less costly relative to bilateral trades.
Avalos et al. (2019) and Vissing-Jorgensen (2021).
ESMA (2024). Similarly, the US Office of Financial Research’s 2022 pilot data collection in the non-centrally cleared bilateral repo market found that over 70% of Treasury repo trades were conducted with zero haircut. See Hempel et al. (2023).
In the United States, only approximately 30% of all repo and 40% of reverse repo volumes were centrally cleared as at the end of 2023. See IMF (2024).
In the US, over 60% of all Treasury repo trades in the non-centrally cleared bilateral market are already netted; see Hempel et al. (2023).
The actual magnitude of netting benefits from mandatory central clearing in different jurisdictions remains unclear. Fleming and Keane (2021) suggest that central clearing in the US cash government bond market could cut dealers' settlement obligations by up to 70% during busy trading times. Similarly, Baranova et al. (2023) note significant netting efficiencies in the UK's repo market. By contrast, Bowman et al. (2024) find that central clearing in the US repo market would only slightly reduce balance sheet costs linked to the leverage ratio.
Work is being carried out at international level to identify effective practices for easing liquidity pressure on clearing participants stemming from intraday variation margin calls. See CPMI-IOSCO (2024).
The FSB’s regulatory framework for haircuts on non-centrally cleared securities financing transactions deliberately excludes government bonds. See Financial Stability Board (2015).