Peer-to-peer repo: A game-changer for repo markets
State Street Investment Management has recently completed its first peer-to-peer repo (P2P) transaction. This innovative procedure facilitates borrowing money on better commercial terms than a traditional repo transaction and has potentially significant beneficial consequences for LDI participants. Diversifying funding sources away from traditional lenders not only reduces costs, it can have other benefits, such as helping mitigate roll risk. The structure is facilitated and supported by State Street systems and processes. A guarantee mechanism further enhances the transaction.
What is peer-to-peer repo?
Peer-to-peer repo allows buy-side firms to directly borrow from – and lend to – other buy-side firms and non-bank participants. A traditional repo, which is intermediated via a bank, will have a relatively wide bid/offer spread, reflecting the cost of balance sheet usage by the bank. In contrast, peer-to-peer repo allows participants to bypass banks, leading to both lower interest rates for borrowers and higher interest rates for lenders, as both sides of the transaction are likely to benefit. By bringing in a range of lenders and borrowers to the peer-to-peer repo market, participants can achieve higher levels of diversification than they would when restricting themselves to the conventional repo market.
How does a peer-to-peer transaction work?
- Clients signed on to State Street’s P2P program negotiate trade terms bilaterally. State Street may facilitate transmission of information between counterparties.
- State Street reviews the terms of trade as agreed to by counterparties, validates adherence with the Program Agreement, and issues a Guarantee.
- Cash and collateral are settled bilaterally between counterparties and confirmation is sent to State Street – or settlement can be handled by State Street as tri-party agent.
- State Street provides Repo Buyer and Repo Seller daily reporting of outstanding guaranteed transactions and margin requirements.
What are the benefits of peer-to-peer repo?
- Diversification and Flexibility
Clients on the P2P program can access liquidity providers that would not normally be available to them, such as money market funds. Clients may be able to pledge a broader range of collateral and have flexible tenor points. - Competitive Rates
By removing intermediaries, balance sheet costs that would be typically passed on to repo users can be eliminated. - State Street Guarantee
Lenders of cash will benefit from the State Street Guarantee, reducing the complexity of assessing counterparty credit risk. - Onboarding and Operational Efficiency
Streamlined and standardised documentation eliminates the need for numerous bilateral contracts. The settlement and margin process is handled by State Street where trades have tri-party settlement.
Any disadvantages? How can these be mitigated?
Repo sellers (the counterparty that borrows cash) will have counterparty risk and so must be comfortable with the credit risk in the transaction. This can be mitigated by restricting counterparties to highly rated funds and entities like highly rated money market funds.
Why is peer-to-peer repo a valuable part of an LDI fund’s toolkit?
For LDI funds that look to use a prudent amount of leverage, peer-to-peer repo allows access to cheaper sources of funding and greater counterparty diversification, which reduces repo roll risk. As the Bank of England continues to reduce the size of its balance sheet, we are likely to see a greater term structure to repo rates, greater variability in repo quotes and greater levels of volatility, particularly around month/quarter ends. By using peer-to-peer repo, LDI funds can mitigate some of these risks by reducing reliance on the banking sector.