The departure of J.P. Morgan Chase & Co. from settling tri-party repurchases of U.S. Treasuries is yet another byproduct of reduced fixed-income liquidity caused by regulatory constraints.
J.P. Morgan Chase announced in July it would close its tri-party U.S. Treasury repo business by the end of 2017, leaving Bank of New York Mellon Corp. the only firm to offer such a service. J.P. Morgan only had about 15% of the market, with BNY Mellon taking an 85% share.
But it’s yet another sign, sources said, that banks are getting out of fixed-income-related business segments like repo, which are collateral agreements used for short-term financing. The exits are due to low margins and higher costs resulting from increased capital requirements in the Dodd-Frank Wall Street Reform and Consumer Protection Act and Basel III. According to Securities Industry and Financial Markets Association data, the repo market’s value fell to less than $4 trillion at year-end 2015 from $7 trillion in early 2007.
“And that will be headed lower,” said Brian Svendahl, managing director, co-head of U.S. fixed income, RBC Global Asset Management (U.S.) Inc., Minneapolis. “J.P. Morgan closing its tri-party settlement business is just another one of the casualties of reduced liquidity in the Treasury market … it definitely is the new normal with Treasuries.”
And that makes buying and selling in the secondary fixed-income market increasingly difficult.
“With less liquidity, it’s more expensive to trade, harder to reallocate and (causes) more volatility because it puts the bid/offer spread wider,” said Mr. Svendahl. “The fair value of a Treasury is out of whack because of this. If you have large amounts of Treasuries you need to buy or sell, (with) less repo, the costs of trading those could become punitive and force the investor to just sit on it.”
“The decline in repo is more of a symptom (of declining liquidity) as well,” Mr. Svendahl said. “It’s kind of the cause, but also the effect as well. If there’s no repo, you can’t short, so I wouldn’t be willing to sell.
Daniel Lomelino, director, head of North American fixed-income manager research, Willis Towers Watson, Chicago, called J.P. Morgan’s exit another example of the declining “second leg” of liquidity reduction, the first leg being the effects of tighter capital restrictions on banks. “The less availability of repo impacts the secondary fixed-income and the derivatives markets,” he said.
Mr. Lomelino said Willis Towers Watson has told its corporate pension fund clients that reduced repo “could have lots of impacts. Repo alone won’t directly impact investment performance, but repo leading to even tighter liquidity means far-reaching impacts. It could mean asset owners will need a larger cash buffer for liquidity needs, which would mean a drag on returns; and it might mean greater use of derivatives.”
At its core, Mr. Svendahl said, the repo market serves to finance trades of Treasuries and cover short positions. “Both are key activities to market participants,” Mr. Svendahl said. “The less activity in the repo market, the more expensive it is to trade ... For example, proprietary trading desks were levered players that provided a source of liquidity… Not so anymore. It’s the same with the Treasury market.”
Mr. Svendahl said the decline in repo highlights the need for asset owners to “have a much more thoughtful liquidity strategy.” Most institutions hold Treasuries for their liquidity needs, he said, but with added costs and reduced access to repo, “those who need to hold real liquidity are going into government money market funds, but those could be a drag on returns.”