Dealers and investors in Europe and the United States are rushing to store the safest assets as collateral, erasing the financial plumbing of the biggest bond markets with echoes of the disruption caused by the 2020 pandemic.
While Russia’s invasion of Ukraine has spurred a disruptive flight to quality, Treasury traders have failed to follow through on their so-called buyout deals in nearly two years.
Across the Atlantic, UK market participants have been forced to repeatedly use a backup repo facility as short-term gilt liquidity dries up. Bund investors, meanwhile, are paying the highest premium since the eurozone sovereign debt crisis to hold cash bonds versus equivalent swaps.
While there is no funding crisis, these are all market disruptions that are sapping liquidity and threatening to obstruct the flow of money for asset-to-asset transactions, particularly in Europe, as the hunt to high quality guarantees rages. The repo market, where large market participants exchange securities for cash, is a crucial part of global bond liquidity and helps keep the wheels of finance running smoothly.
“As soon as things get choppy and bid-to-offer spreads widen, finding paper to hedge trades through the repo market is both more expensive and more difficult,” said strategist Marc Ostwald. worldwide at ADM Investor Services. “The fact that central banks have absorbed so much of the ‘float’ in the markets via quantitative easing clearly also plays a role.”
Developed market government bonds are used as collateral to support repurchase agreements (short-term secured loans) due to their liquidity and creditworthiness. Hedge funds like hedge funds engage in repo activity to fund their leveraged transactions and to borrow securities to take short positions.
Today, as geopolitical tensions spur risk aversion and Russian asset trading freezes, many market participants face exorbitant costs to source the most sought-after financial instruments, especially in Europe.
The so-called asset-swap spread of benchmark German bonds is the widest since the 2011 eurozone crisis, while the premium for holding cash bonds in the US is lower as demand refuge in the United States is more modest.
In the United States, the overnight general collateral repurchase agreement rate traded above the yield offered by the Federal Reserve on its reverse repo facility – currently 0.05% – an indication that funding markets continue to function despite geopolitical turmoil.
It’s a somewhat different story in the UK. Dealers have flocked to a standing facility – whereby the Debt Management Office lends specific gilt for repo purposes – at the fastest pace since the early days of the pandemic.