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Study | Repo and Collateralised Funding

Study | Repo and Collateralised Funding

An Analysis of theSecured Money Marketin the Euro-Zone(4th Extended Edition)


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Repo and Collateralised Funding | Study2

Table of Contents

Executive Summary 5

1 Introduction Whats New? 9

2 Key Definitions 11

3 Impact of the Credit Crunch 153.1 Volumes Developments 15

3.2 Our Key Interview Observations 17

3.3 Summary 23

4 Electronic Markets Competitive Analysis 254.1 BrokerTec 26

4.2 Eurex Repo 28

4.3 MTS Group 304.4 Collateralised Funding 32

4.5 Key Success Factors 34

5 Securities Lending and Borrowing Market 365.1 SLB Loan Structures and Volumes 36

5.2 Impact of the Credit Crunch 37

5.3 Impact of Technology 37

5.4 Electronic Markets in Securities Lending and Borrowing 38

6 Collateral Management The Critical Success Factor 416.1 Risk Monitoring and Controlling 42

6.2 Collateral Mobilisation and Pooling 44

7 Settlement Efficiency Initiatives under Way 467.1 TARGET2-Securities 46

7.2 Clearstreams Link Up Markets and Euroclears Approach 47

7.3 Collateral Central Bank Management 2 49

8 Outlook Collateral Mobilisation will be Key 51

Appendices 55Appendix I: Table of Abbreviations 55

Appendix II: References 56

Appendix III: Glossary 58Appendix IV: About BearingPoint 61


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Repo and Collateralised Funding | Study 3

Table 0f Exhibits

Exhibit 1 Aggregated turnover of the Euro money market between 2000 and 2007 11

Exhibit 2 Development of daily outstanding repo transactions in Europe 16

Exhibit 3 Development of e-Mid average daily volumes Inter-Bank-Deposits 18

Exhibit 4 Analysis of repo trading channels 21

Exhibit 5 Development of BrokerTec average daily turnover volumes 26

Exhibit 6 Development of Eurex Repo average daily outstanding volumes 28

Exhibit 7 Development of MTS average daily turnover volumes 31

Exhibit 8 Development of Euro GC Pooling outstanding volumes in 3/2005-3/2008 33

Exhibit 9 Changes from CCBM to CCBM2 50


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Acknowledgements

This edition provides a comprehensive overview of the European electronic repo and

secured money market, covering, trading, clearing and settlement.1 This research paper

aims to provide an independent perspective, regardless of any previous experience that

BearingPoint has gained on project work with any of the survey participants.

This research would not have been possible without the support of the members of

the European repo and money market industry. The results presented in this edition are

based on more than 15 in-depth interviews with industry experts from the following

institutions:

Bundesrepublik Deutschland Finanzagentur GmbH, Frankfurt

Citigroup, London European Repo Council, London

Clearstream Banking, Frankfurt Fortis Bank, Brussels

Commerzbank, Frankfurt ICAP/BrokerTec, London

Deutsche Postbank, Frankfurt ICMA, London

Dresdner Bank, Frankfurt JP Morgan Chase & Co, London

DZ Bank, Frankfurt MTS, London

Eurex Repo, Frankfurt UniCredit Group, Munich

We are grateful to them for their help in creating the questionnaire, taking the time to

participate in the survey and helping us analyse and review the results. The interviewees

will not be quoted directly in this report but we hope that you will recognise that theirthoughts and ideas make this survey interesting reading.

1 Please also see BearingPoints publication The Electronic Repo Market 2006 (3rd Edition).


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Executive Summary

This 4th edition of BearingPoints electronic repo market survey provides an updated

overview and analysis of latest developments in the European secured money market.

We analyse the impact of the Credit Crunch on the European money market in general

and place a special focus on repurchase agreements (repo). In addition, we analyse the

impact of the Credit Crunch on collateral management and expected developments in

collateralised funding.

As in previous studies, we give an update on the major electronic markets and their

current positioning, product offering, competitive strengths and weaknesses as well

as their clearing and settlement architecture. We devote a chapter to the latest devel-

opments in the securities lending market as well as on various settlement initiatives

underway across Europe. As a result of recent events, we conclude our discussion by

providing an outlook on the major developments in the European money market; espe-

cially the secured money market.

This study is based on in-depth interviews held with more than 15 industry experts in

early 2008, as well as BearingPoints latest project experience and independent research.

Major findings can be summarised as follows:

The repo market did not work as market experts hadanticipated before the crisis

The liquidity of the European repo market was affected by recent turmoils. The

December 2007 ICMA figures show the first decrease in overall outstanding volume

since the survey started in 2001 (EUR 6,382 billion in 2007). Although overall outstan-

ding volumes are still solid, market experts expected that the repo market would

gain additional momentum during recent events.

Before the subprime crisis, market experts anticipated that during a shortage ofliquidity, trading volume would shift from the unsecured to the secured money

market instruments such as repos. However, our interviewees confirmed that market

liquidity in the repo market did not increase (see also ICMA figures). In addition,

numerous segments of the repo market have not operated as efficiently as predicted

by market experts. As a result, some treasury desks had to change their funding

policy and look for alternative markets to secure their liquidity needs since the start

of the crisis.


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Banks focusing on securing liquidity were reluctantto lend cash to other institutions

The unsecured money market no longer offers banks a simple and attractive way

of getting liquidity in and out of the market (as it was the case before the crisis

has started). Today, banks provide cash on an unsecured basis very selectively. For

example, borrowing money from other banks, or even between different depart-

ments of the same bank for more than a day, has become very difficult.

The secured money market and especially the European repo market has fundamen-

tally changed since the beginning of the subprime crisis. Funding, and therefore

cash-driven trading, has become the key driver in the secured money market. Banks

are focusing on securing liquidity and are reluctant to lend cash to other institutions.

This development has resulted in five distinct changes for the European repo market:

1) The shifts between different transaction types/markets;

2) The demand for high-quality collateral in General Collateral (GC) transactions;

3) The reduction in trading activity in the special market;

4) The vanishing of the market for term business;

5) The increase in counterparty risk consideration.

The European electronic repo landscape has taken shape

The market share of electronic repo trading is estimated to be 21.2% according to

ICMA. According to our interviews, electronic trading volumes peaked in June 2007

and have since reduced. This was also confirmed by our interviewees. The volume

decrease is a result of overall market conditions. A large share of the electronic

trading is Special trading. The volume of the Special market has, however, reduced

since the beginning of the crisis. Nevertheless, electronic markets (ATS) providers are

confirming that volume numbers have increased since the beginning of 2008 and are

now returning to pre-crisis levels.

The electronic repo market is taking shape. The key players BrokerTec, Eurex Repo and

MTS are all well positioned as liquidity providers in the European repo market.

1) BrokerTec is the dominant player in the electronic space particularly in the Special

repo segment. BrokerTec is an electronic trading application run and managed

by ICAP Electronic Broking owned by ICAP PLC, one of the largest voice brokers.

BrokerTec offers both electronic and voice broker trading to their clients.


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2) Eurex Repo has gained market share through its collateralised funding segment

Euro GC Pooling. Eurex Repo GmbH, a subsidiary of Eurex Frankfurt AG, is the

trading entity of an integrated clearing and settlement environment for sale and

repurchase agreements.

3) Finally, MTS asserts its position in the Italian repo market. The MTS network

is today owned by London Stock Exchange (following their acquisition of BorsaItaliana) and major financial institutions which have a strong presence in the

European secondary government bond markets.

BrokerTecs and MTSs change in corporate structure indicate that two distinct

ownership/trading models have emerged since our previous repo survey. The

electronic broking model, followed by BrokerTec, and the integration into an

exchange environment, applied by Eurex Repo and MTS. Reasons for this change

in corporate structure are:

1) Voice brokers are realising the importance of electronic trading over other

channels of trading.

2) Exchanges are looking for new markets to expand their business. In addition,exchanges try to leverage their existing trading and post-trade infrastructure by

handling multiple market segments over a common interface.

A new aspirant in the electronic repo market will most likely be the new electronic

broking offering from Tullet. Tullet, one of the leading voice brokers for repo trans-

actions, is planning to launch a new electronic broking platform in Europe for elec-

tronic repo trading in 2008. The platform will mimic, for the most part, the function-

ality and organisational setup of BrokerTecs electronic trading system. The platform

however, has to show that it can attract market share away from established

electronic providers. Major market participants have confirmed that they support

the new initiative which will in consequence increase competition in the European

market for electronic repo trading.

Another major development of the electronic repo market during the last two years

has been the increase of liquidity in Eurex Repos Euro GC Pooling segment. Euro

GC Pooling is a collateralised funding market jointly developed with Clearstream

Banking and Eurex Clearing. This market has gained large acceptance with market

participants as it offers a unique way of participating in an ECB tender and at the

same time access collateral for repo transactions with other banks. Some banks

stated that they are shifting, or intend to shift, collateral from Euroclear to Clear-

stream Banking in order to participate in Euro GC Pooling.


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Collateral management will become a more importantsuccess factor for banks than ever before

Since the beginning of the Credit Crunch, collateral management has become an

even greater factor in determining success for banks who want to participate in the

secured money market. Two areas of collateral management are currently in focus of

market participants.

1) Mobilisation and collateral pooling to quickly allocate collateral and to use this

collateral most efficiently in each currency zone/across locations.

2) Risk monitoring and controlling as it involves the timely reconciliation and

valuation of portfolios.

The market situation demonstrates that the current fragmented settlement and

clearing infrastructure still limits banks to mobilise their collateral quickly across

borders. This limitation, however, should be overcome in Europe as regulators and

central banks are assisting in removing the various regulatory and operational

barriers. In addition, banks also recognised, during the recent months, that they

need to improve upon internal risk management processes. The accurate and timely

valuation of collateral has increasingly become an issue within the financial commu-

nity. As a result, the demand for external valuation of collateral positions

has increased and will continue to grow.

The importance of collateralised funding will increase

The future trend is increased standardisation of the secured money market. Recent

liquidity shortages paired with recent improvements in the trading and settlement

infrastructure will encourage banks to move some of their liquidity away from the

unsecured to the secured money market. Electronic trading will hereby play a crucial

role because it offers participants an easy way to access liquidity in this market

segment. If market conditions reflected such a development, we believe marketshare of electronically-traded repos could grow by as much as 50 percent. However,

market players have to find a way to consolidate their business or seek communica-

tion and common market standards to reduce their set up costs and effectively pool

their collateral across borders. Therefore, the importance of collateralised funding

should increase as banks look for new ways to fund themselves in difficult market

conditions and across different markets.


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1 Introduction Whats New?

The European repo market has experienced a fundamental change since the beginning

of the US subprime crisis. To a large extent, repo markets have not provided the levels of

liquidity expected by market participants and experts. The range of accepted collateral

has been reduced significantly. Banks have been less willing to lend money for longer

durations. The key motivation for trading has become funding. Cash-driven secured trans-

actions rather than securities-driven transactions have become more important.

This updated edition focuses on these changes and describes the impact of the Credit

Crunch on the European unsecured and secured money market and the increasing need

for more efficient collateral management. As mentioned above, during our research we

recognised the increasing importance of funding activities due to the Credit Crunch.

In this regard, we have extended our interviewee base to include the heads of Treasury

and Money Market desks of European key market players in Europe.

Therefore, significant additions have been made to this fourth edition:

The report begins by providing the reader with key definitions of the European moneymarket which will be used throughout the study;

The following chapter will provide a brief update on the latest ICMA survey and the

current size of the European repo market. In addition, we describe the effects of the

crisis on the unsecured and secured money market as observed during our interviews.

We highlight how market participants have reacted to these developments and have

adjusted their internal structures and behaviours to cope with these changing market

conditions. We look in detail at the effects of the crisis on the electronic repo market as

well as the securities lending market;

Additionally, we examine post trade efficiency and the monitoring of collateral expo-

sures. We devote a chapter to the latest developments in the collateral management

areas. Finally, we discuss the latest initiatives of the clearing and settlement landscape

and how these initiatives are affecting the way banks are trading secured money market

instruments.


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New topics, which are included in this edition, are summarised in the table below.

New Topics Overview

Updated figures on repo market volumes in the Euro-zone

Implication of the Credit Crunch on the European secured and unsecured

money market

New product/service offerings of major electronic market providers and

updated strategic evaluation

Trends in electronic securities lending market

Trends in collateral management


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2 Key Definitions

We will begin our discussion about the secured money market by outlining key defini-

tions. These definitions will be used throughout this report and provide the reader with

an understanding of common terminologies.

An overview of the European money market

The European money market provides a way for transferring funds from lenders to

borrowers. Financial institutions use this market to borrow and lend money for periods of

a year or less. The European money market is very efficient in that it enables large sums

of money to be transferred quickly and at low cost.

The core of the European money market, according to a European Central Bank (ECB)

study from 2007, consists of Secured Transactions (34.3%), Unsecured Transactions such

as Inter-Banking Deposits (20.6%), Overnight Index Swaps (14.4%) and FX Swaps (18.5%).2

For funding purposes, the secured and the unsecured money market are of relevancewhereas the other money market segments mentioned above are mostly used for

hedging purposes. This edition places significance on the secured money market as it

presents the largest market segment. Nevertheless, we will briefly discuss the impact

of the crisis on other market segments in addition to providing a comprehensive view of

current market conditions.

The following exhibit gives an outline on turnover development in the European money

market.

Exhibit 1

Aggregated turnover of the Euro money market between 2000 and 2007 3

2 ECB: Euro Money Market Survey, 2007, p. 14.3 ECB: Euro Money Market Survey, 2007, p. 14.


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The secured money market and its composition

The largest segment of the secured money market in Europe is the repurchase agreement

(repo). There are two main types of repos that need to be differentiated:

General Collateral (GC) repos are securities that satisfy the general requirements

of a lender of cash to collateralise its cash lending. General collateral comprisessecurities which are not in particular demand in the market. GC repo is primarily

considered as a form of financing or re-financing.

A Special repo is often used to cover an existing or future short position in specific

classes of securities. A Special is therefore a security that is highly sought-after in the

market by borrowers. Thus, the repo rate for a Special tends to be higher.4

In addition, securities lending and buy/sell back transactions are also important instru-

ments of the secured money market. Although these trading types are somehow related

to repos, they are different in the context of the underlying legal framework, their

application and operational workflows.

For details regarding characteristics and differences of the secured transaction types,please refer to our 2006 edition.

Trading channels in the European secured money marketand their primary usage

All secured money market transactions can be either done bilaterally (Direct), via voice

broker, tri-party or over electronic trading systems with or without a central counterparty.

In addition, a new trading channel has emerged in the last couple of years for Collate-

ralised Funding activities such as the Euro GC Pooling product of Deutsche Brse Group.

We add this channel to the existing trading channel terminology used in this survey.

Direct: The Over-the-Counter (OTC) market can be described as a non-centralisedmarketplace for financial products. A secured money market transaction takes place

whenever a buyer and a seller agree to a price. The direct market is concentrated on:

Dealer to customer trades;

Structured products that require highly personalised services, justifying the

increased cost compared to more automated trading channels;

Smaller financial institutions, where the benefits of participating in other

markets is not justified by the added integration cost and operational cost;

Less developed markets where the liquidity is not sufficient to be traded

electronically;

Collateral not listed in any other market.

4 Corrigan, Danny and Tern, Natasha de: Collateral: Securities Lending, Repo, OTC-Derivativesand the future of Finance, 2007, p. 293 294.


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Voice brokers act as an intermediary in a transaction. In contrast to the direct

market, the broker facilitates the deal by bringing the buyer and a seller together.

Voice Brokers often offer better spreads in markets that have little or no

liquidity.

Voice Brokers are the preferred transaction type where difficult market condi

tions exist because they can offer anonymity to market participants. Larger

transactions, for example, can be placed by a broker in the market without

necessarily disclosing the identity of the counterparty and thereby offering an

advantage to other channels of trading.

Voice Brokers concentrate on structured products where participants require

highly personalised services, justifying the increased cost compared to more

automated trading channels.

Tri-party: Tri-party repos are similar to bilateral repos with the exception that a third-

party agent acts as a custodian and manages the administration of the transaction

including collateral allocation, marking to market, and substitution of collateral.

Like bilateral repos, they are widely used for investing surplus funds short termor for borrowing short term against collateral. Larger banks have discovered

tri-party repos as an alternative to the GC market to receive additional funding.

Tri-party repos also offer an efficient way to use non-government or illiquid

collateral in secured money market transactions. In addition, banks also use

tri-party agents for other collateral types as an alternative way to borrow or

lend money.

Electronic Trading: Electronic markets, also referred to as alternative trading systems

(ATS), are transforming the OTC driven market towards a fully-integrated electronic

value chain. The trades are entered and executed via an electronic venue of an elec-

tronic market provider. ATS trades are either processed bilaterally or via a clearing-

house also called central counterparty (CCP). In the case of a CCP, the clearinghousetakes the role of a buyer to a seller and a seller to the buyer, thus creating two new

contracts that replace the original single contract.

Electronic trading is the preferred channel for standardised transaction types.

The volume is largely concentrated on short term business where the liquidity

is generally high.

In addition, the market for Special repos in Europe is, to a large extent, trans

acted via electronic markets.


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Collateralised Funding is a relatively new trading channel in the Euro-zone which

was first introduced three years ago by Eurex Repo. Collateralised funding can be

described as a secured funding activity on harmonised collateral baskets. It offers

all the advantages of electronic trading through a CCP combined with a centralised

collateral management system for cash-driven secured money market transactions.

Euro GC Pooling was jointly developed by Eurex Repo, Eurex Clearing and Clearstream

Banking and launched in March 2005.

Collateralised funding offers financial institutions a way to use ECB-eligible collateral

in a repo transaction with another bank or the pools collateral can be re-used as

collateral to participate in the European Central Banks (ECB) open market opera-

tions.

The London Clearing House (LCH) launched a similar basket trading product, which

went operational in April 2008. However, the service does not currently offer a link

to a central bank as well as it restricts the tradable collateral to Euro-dominated

government debt. In addition, the product is limited to each collateral management

location within Euroclear or Clearstream i.e. fragmentation of market places for GC

trading will remain.


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3 Impact of the Credit Crunch

In this chapter we present the main observations during our interviews with regards to

the impact the crisis has had on the unsecured and secured European money markets.

As interviewees confirmed, fundamental changes have occurred to those markets since

2007.

We start our discussion by looking at the latest volume developments in the European

repo market.

3.1 Volumes Developments

Why the secured money market is gaining importance

As a general trend, the European secured money market continues to increase in impor-

tance. According to the ECB Euro Money Market Study of 2007 5, the following reasons

can be recognised as key drivers:

1. The use of repos as a key source of funding for fixed income market makers and

primary dealers;

2. The increasing need to limit credit risk exposures and constraints resulting from

capital adequacy requirements;

3. The need for effective collateral management;

4. Banks increasing use of collateral for the Euro-systems open market operations.

This enables banks to use more liquid types of collateral.

In addition, further automation and standardisation are other reasons why the secured

money market is increasing in importance. For example, the wider use of electronicmarkets offering a CCP are helping banks to reduce counterparty and operational risks as

well as offer increased post-trade efficiencies compared to other trading channels. Today,

trading of GC repos has become widespread because it is an easy mechanism for banks to

use where execution can be done easily via an electronic market.

5 ECB: Euro Money Market Survey, 2007, p. 18.

The US subprime crisis

The US Subprime crisis is basedon the increasing complexity ofthe world financial markets. Newproducts like credit default swaps,

asset-backed securities etc. onunsecured or bad secured creditsand their brisk trade complicatesthe analyses of who has taken thefinal risk.

When the crisis first becameevident in the middle of 2007, alarge number of bad or unsecuredmortgage loans could not be paidback by US citizens which led to thefirst evidence of massive liquidityproblems.

Not long after the middle of 2007,Bear Stearns reported the break-

down of two of its own hedge fundswhich included highly speculativedeals with US mortgages. As timewent by, the first German Banks,most famously IKB DeutscheIndustriebank, were also forced toreport about their dealings in thesespeculative financial segments andresulting huge write-downs.

With the trust in the Europeanfinancial markets lost, almost allCentral Banks felt impelled to pushstabilizing money into the marketsto avoid a far more dangerous inter-

national liquidity crisis.

Nevertheless, all over Europe, banksreported write off in 2008. Somebanks cannot maintain the losses,e.g. the collapse of Bear Stearnsin March 2008. Up to May 2008all major banks have continued toreport write offs due to the CreditCrunch. Experts are still unsure asto whether the end of the crisis isin sight.


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Growth in European repo markets has stagnated in 2007

The December 2007 figures are the first decrease in overall outstanding volume since

the survey started in 2001 (EUR 6,382 billion by end of 2007). ICMA states that overall

outstanding volumes are still solid and support the fact that the repo market provides

a sound foundation for banks to fund themselves during a crisis situation. Total

outstanding volumes were reported at EUR 6,382 billion, compared with EUR 6,430billion in December 2006 and EUR 5,883 billion in December 2005.6 However, our inter-

viewees confirmed that numerous segments of the repo market have experienced

a significant lack of liquidity in the second half of 2007 and that the repo market is

undergoing a transformation affecting some market segments.

Voice Broker temporarily increased in importance

The EUR 6,382 billion outstanding volume was distributed among five different methods

of transacting repos; direct, voice-brokered, tri-party, electronic trading, and Collate-

ralised Funding activities. Electronic trading and collateralised funding activities are

currently not outlined as a separate category in the ICMA survey rather than grouped

together with the ATS business. The direct business constitutes the majority share ofthe transaction methods at 45.4% in December 2007 (47.6% in June 2007) followed by

voice-brokered at 24.3% in December 2007 (up by 5.6% from June 2007), ATS 21.2% at

December 2007 (down by 0.7% from June 2007) and tri-party at 9.1% in December 2007

(down by 2.7% from June 2007). The graphic below shows the distribution in terms of

volume and share between the different transaction types since 2001.

6 ICMA Repo Survey Nr. 14, December 2007, www.icma.org; In December 2007, the ICMA conducted

its 14th Repo Market Survey. The ICMA survey was the first to give a general statistical overviewof the European repo market. In the latest survey, 62 financial groups (compared to 66 in year 2006and 71 in June 2007) helped characterise the current outstanding volume by supplying demo-graphics and methods with which they transact repos in the European market.

7 ICMA Repo Survey Nr. 14, December 2007.

Exhibit 2 Development of daily outstanding repo transactions in Europe7


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3.2 Our Key Interview Observations

Why Recent turmoil has impacted on theunsecured money market

In previous editions of BearingPoints repo study we pointed out that the unsecured

money market still offers banks a simple and attractive way of getting liquidity in and out

of the market. However, this has changed quite dramatically since mid 2007.

Today, banks only selectively provide cash on an unsecured basis. For example, borro-

wing money from other banks or even between different departments of the same bank

for more than a day has become very difficult.

Interviews and a recent speech given by Jos Manuel Gonzlez-Pramo of the European

Central Bank, confirmed that the unsecured money market is even more concentrated

on the overnight segment than before the crisis. In money markets the impact of the

turmoil was initially felt mainly in the longer-dated unsecured inter-bank market. It can

be said that liquidity in the unsecured deposit markets almost completely dried-up inmaturities beyond 1-month (although it should be noted that these were not the most

liquid ones even in normal times). These frictions eventually spilled over to the very

short-term money markets (i.e. below one-week), at first in the US dollar market, where

banks particularly, from Europe encountered difficulties in raising short-term liquidity.8

This was also confirmed by our interviewees, who stated that liquidity in the unsecured

market is currently concentrated on Overnight transactions.

Liquidity, even in the unsecured overnight market, has been affected by the crisis. For

example, e-MID, the most active inter-bank electronic trading system for trading on the

unsecured market in the Euro area, has experienced a volume decrease of up to 50% from

June 2007 to today (please see Exhibit 3). This clearly indicates that banks are reluctant

to lend on an unsecured basis to the wider market or even to each other, except for shortperiods (overnight), since the freeze in liquidity.9

8 Collateral Framework Group August 2007.

9 ICMA Regulatory Policy Newsletter Quarterly Assessment Issue No. 9: April 2008


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Fundamental structural changes in the secured money market

In such an environment, one might expect that the repo market would gain momentum.

However, this did not happen as the latest ICMA figures reflect. Our interviewees

confirmed that during the second half of 2007, the European repo market, even the

market for some government bonds, didnt provide sufficient liquidity. It was not until

the ECB intervened that the liquidity in secured money market came back to more

normal levels. Today, the liquidity in the repo market has been largely restored. Never-

theless, the impact of the crisis can still be clearly observed by the following:

1. The shifts between different transaction types/markets;

2. The demand for high-quality collateral in GC transactions;

3. The vanishing of the market for term business;

4. The reduction in trading activity in the Special market; and

5. The increase in counterparty risk consideration.

To understand the full implications of the crisis on the repo market we need to analyse

the aforementioned points in more detail.

Exhibit 3

Development of e-Mid average daily volumes Inter-Bank-Deposits10

10 www.e-mid.it, March 2008


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1) The shifts between different transaction types/markets

Traders started to shift some of their volumes from tri-party and direct to voice

broker since the beginning of the crisis. The impact of the crisis on the different trading

channels can be summarised as follows:

Direct: According to our interviewees, the volume traded directly has been affected.We believe that the reduction of volume over this trading channel represents a shift

from direct trading towards voice brokered trades (similar reasons as for tri-party).

The ICMA survey also indicates that the direct business was somehow affected by

the crisis as the share of this trading channel went down from 47.6% in June 2007 to

45.4% in December 2007;11

Voice Broker: Voice brokers are generally a profiteer of a crisis situation since they

are able to provide liquidity in difficult market conditions. Market participants

confirmed that they preferred using a voice broker because of a higher degree of

anonymity and additionally liquidity a voice broker provides in comparison to other

trading channels. The share of voice broker increased from 18.7% in June 2007 to

24.3% in December 2007;12

Tri-Party: Interviewees said that the missing confidence in the global markets duringthe Credit Crunch resulted in shifts from trading all kinds of collateral to the

acceptance of only high rated collateral such as government bonds. Collateral such

as Asset Backed Securities or Credit Debt Obligations were quickly removed from the

list of acceptable collateral for tri-party transactions. As mentioned before, some of

the ECB-eligible collateral was also moved out of tri-party into ECB pledge accounts.

This has an additional impact on the liquidity of this trading channel. Finally, tri-party

transactions are bilateral transactions where the buyer and the seller are disclosing

their intention to borrow or lend money. In crisis situations participants can be

affected quite severely by disclosing their funding needs. A financial institution for

example, where the market anticipates a problem, will quickly find itself in a liquidity

squeeze, which can result in bankruptcy. Therefore, banks try to move over to more

discrete markets e.g. voice brokers or ATS. ICMA supports our finding as the share oftri-party fell from 11.8% in June 2007 to 9.1% in December 2007;13

Electronic Markets: Interviewees stated that volumes in some segments have

decreased since the mid of 2007. The decrease in trading volume can be explained by

analysing the instruments traded over electronic markets:

A large percentage of the electronic markets are Special repo transactions.

According to interviews, the market for Special repos almost disappeared in the

third and fourth quarters of 2007. Repo trading was primarily concentrated on

GC trading. However, the Special repo market has regained some of its

momentum and volumes on the electronic markets are slowly coming back

up since the beginning of 2008 (see volume graphs for the individual platform

provider in Chapter 4);

11 ICMA Repo Survey Nr. 14, December 2007.12 ICMA Repo Survey Nr. 14, December 2007.13 ICMA Repo Survey Nr. 14, December 2007.


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On the other hand, electronic markets were able to attract some liquidity

because banks preferred using a CCP (basically a CCP is risk-free in terms of

counterparty risk) rather than lending/borrowing money on a bilateral basis.

In the end, the crisis should have a positive long term effect for electronic

trading systems. Banks mentioned that they will shift volumes over to elec

tronic trading whenever it is feasible because they will save on processing cost,

reduce risk (haircuts) as well as reduce their capital requirements (Basel II) ifthe transaction is cleared over a CCP.

ICMA underlines our findings as volume numbers provided by the three major

European electronic trading market providers BrokerTec, Eurex Repo and

MTS indicate. The aggregated volume went down from EUR 961.1 billion

in June 2007 to EUR 689.6 billion in December 2007.14 The overall share of

electronic markets, as reported by ICMA, fell from 21.9% in June 2007 to 21.2%

in December 2007;15

Collateralised Funding: The Euro GC Pooling facility experienced the most notable

volume increase since the beginning of 2007. Volumes in the Euro GC Pooling

segment went up from EUR 10 to EUR 32 billion from the beginning of 2007 to

February 2008.16 We will discuss the volume developments in more detail duringour analysis of the electronic markets (Chapter 4).

The ECB open market operation was one of the most important sources of liquidity

at the beginning of the crisis, especially for institutions, which were cash-short. Our

interviewees confirmed that they therefore shifted some of their ECB-eligible colla-

teral away from other transaction types such as tri-party into ECB pledge accounts

(collateral accounts) at the various central banks. Euro GC Pooling offered them

a new opportunity to not only participate at the ECB tender, but also re-use their

collateral surplus in a repo transaction with another bank. This combination proved

to be a very powerful combination and not surprisingly volumes went up since the

beginning of the crisis. Interviewees even stated that Euro GC Pooling offered them

an alternative to the unsecured market to get additional liquidity from and to the

market.

The graphic below summarises the distribution of the different trading channels from

2001 to December 2007 (as mentioned before the ICMA figures include collateralised

funding volumes in the ATS numbers but do not include ECB tender volumes).

14 ICMA Repo Survey Nr. 14, December 2007 as well as verified with providers.15 ICMA Repo Survey Nr. 14, December 2007.16 Eurex Repo, 2008, p. 8.


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2) Flight to quality18 The demand for high-quality collateralin GC transactions

According to our interviewees, the repo market continues to provide sufficient liquidity

for government securities but repo trades based on any credit-related products are

struggling to find finance. The liquidity in the secured non-government repurchase

agreement (repo) markets was heavily impacted, as many banks no longer wanted to

accept the types of securities mentioned above (MBSs, ABSs at large, and CDOs) as

underlying collateral in repo transactions. As a result, primarily only the repo markets

based on government bonds remained fairly liquid, but even in these markets the degreeof price differentiation across repos transactions with different types of government

bonds was larger than before the crisis.19

In the middle of last year, AAA rated asset backed securities were traded close to EONIA.

Today, the repo market for asset backed securities or credit default obligations has

vanished unless the underlying security can be used for central bank tender. Even those

instruments, which are ECB eligible, are difficult to repo out.

Risk premiums across all asset classes have gone up significantly since the crisis started.

For example, credit default swap spreads, which indicate the risk premiums between the

risk free rate and a particular asset class, have jumped significantly from the beginning

of 2007 to today (premiums for example on US banks were up over 250 basis points

before the rescue of Bear Stearns by JP Morgan).

Exhibit 4

Analysis of repo trading channels17

17 Illustration by BearingPoint based on ICMA surveys, 2001 2007, www.icma.org.18 Definition from Investopedia, 2008, http://www.investopedia.com/terms/f/flighttoquality.asp.19 ICMA Regulatory Policy Newsletter Quarterly Assessment Issue No. 9: April 2008.


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Government bonds, which normally are perceived as a secure assets class, are now

traded at different levels depending on the issuing country. For example, in Europe

a repo with Greek and Italian government bonds has a risk premium priced in and is

trading at higher lending rates than a repo on a German Government bond. Other Euro-

pean markets have been even hit more severely. The repo market for Spanish covered

bonds, for example, has little to no liquidity anymore (liquidity of other covered bond

markets is also affected). Finally, the repo market for corporate bonds has also becomeilliquid and traders ask for haircuts much higher than before the crisis had started, to

cover for the additional risk.

3) The vanishing of the market for term business

Banks confirmed that since the beginning of the Credit Crunch, the repo market saw a

clear shift to shorter maturities e.g. mainly Overnight to Spot Next.20 As one interviewee

explained, the market for term business has dried up significantly since the third quarter

of 2007. In addition, spreads in the longer maturities have reached quite unattractive

levels so that the repo market is currently concentrated on maturities of less than one

week.

The trend towards transactions with shorter maturities is also confirmed by observing

the yield curve since the beginning of the subprime crisis. Spreads between overnight

and longer maturities have widened significantly. For example the spread between the

European Interbank Offered Rates (Euribor) and what are seen as risk free rates defined

in Overnight Index Swaps also referred to EONIA Swap rate, have gone up dramatically.

Repo traders often use these two rates as reference to determine repo rates for the diffe-

rent maturity brackets. The perceived inherent risk of lending money for longer periods of

time between banks is high and currently experts do not see any prospects for the spread

to tighten in the near future.21 Thus, borrowing money for periods longer than two days

has become quite unattractive and banks are concentrating on securing liquidity on the

shorter end of the yield curve. This behaviour increases the risk for banks to run into

liquidity squeeze during periods of high market stress.

4) The reduction in trading activity in the Special market

As our interviewees stated, collateral normally traded as Special was instead used for

borrowing cash and to secure the banks funding needs. The trading volume in the Special

repo market thereby went down significantly in the second half of 2007. Our inter-

viewees, however, have also stated that Special trading activities are picking up again

since the beginning of 2008 but are not yet at pre-crisis levels. In our opinion, the volume

in the Special repo market will not come back to normal levels as long as banks focus on

securing liquidity rather than optimising their profit and loss statements.

20 ICMA trading data, however, indicate an increase in volumes with maturities longer than a week

and a decrease of volumes shorter than one week (e.g. 54.7% from 62.4% in June 2007).21 ICAP economist Don Smith, Daily News April 19, 2008.


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5) The increase in counterparty risk consideration

Another observation as a result of our interviews is that some market participants face

more difficulties in securing their funding requirements over the traditional channels of

liquidity provision. Counterparty risk consideration has increased and as a result some

banks have difficulties in getting inter-banking funding. For such institutions, repo

trading is today, to a large extent, limited to CCP trading. In addition, these counterpar-ties have to turn, for the most part, to the ECB to receive short term funding. On the

other hand, we interviewed some banks which did not have problems getting liquidity

from and to the market. These institutions had the advantage of being able to access

different pools of liquidity so that they were able to secure their funding needs. Thus,

these institutions are largely unaffected by the crisis.

3.3 Summary

European repo market was affected by the liquidity crisisThe turmoil has had an impact on the repo market in terms of the type of transaction

being used, a reduction in the term business, banks focusing on liquidity management

and the acceptable collateral for repo transaction. Before the crisis, spreads between

secured and unsecured money and between government and non-government collateral,

have tightened to record levels. At the same time, repo volumes have soared, margins

reduced and, in all likelihood, lending criteria has slackened.22 However, this has

changed quite significantly and banks have tightened their lending standards e.g. by

1.) Raising financing costs, which is perceived as an increase in interest,

2.) Raising the haircut, which reflects the maximum leverage and

3.) Excluding certain types of collateral as cash counterpart.

The repo market did not work as efficientlyas market participants had anticipated

The fact that the volumes have only changed by a little, compared to the ICMA survey

of December 2006, makes the reader think that the repo market was continuing to work

well. However, the latest market developments coincided with sharp price declines

in some securities (AA or worse rated) used as collateral for repo loans. Investors and

financial institutions who lent in this market have become worried about losing money

on securities used as collateral. Determined to protect themselves, they pulled back from

offering repo financing to each other.23 This behaviour from market participants draws

22 Financial News Online, 20 August 2007, p. 12.23 Wall Street Journal, 16 March 2008, p. 7.


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liquidity out of the repo market and can cause serious problems for investors (e.g. hedge

funds) who use the repo market as short and medium-term financing of their positions

(e.g. as happened to Bear Stearns Hedge Funds in 2007 and its recent consequences).

To avoid this massive reduction in liquidity and as a reaction to it, the ECB has been

stabilising the repo market since the second quarter of 2007 by providing large amounts

of money to market participants. However, central bank money is not a long term solu-

tion and banks and regulators have to find ways to handle such market conditions moreefficiently going forward. In the end, this crisis somewhat represents a market correction

and encourages banks to rethink their overall funding policies.

Banks unable to fund themselves in the repo marketfelt the effect even more severely

The liquidity crisis was even more severely felt by financial institutions that were unable

to refinance themselves in the secured money market. Those banks relying heavily on the

unsecured funding found themselves struggling for cash. Some of these institutions were

forced to fund themselves with the help of the central banks. The crises highlight the fact

that financial institutions need to be able to efficiently participate in the secured money

market to cover their liquidity needs. Banks are realising now, more than ever before,that the unsecured money market will be insufficient to raise the funding necessary to

overcome a short squeeze in the markets. Therefore, the crises should help the repo

market in the long term by supporting further standardisation of the electronic markets,

as well as of the clearing and settlement institutions.

The following two chapters provide an overview of the latest development of the elec-

tronic provider servicing the repo and securities lending market.

We provide an overview of how the major providers of electronic markets have been

coping with current market conditions. In addition, as in previous studies, we also give

an overview of the latest volume statistics, new product offerings and technological

developments.


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4 Electronic Markets

Competitive Analysis

This chapter analyses, in detail, the European electronic repo market. We update and

analyse the current positioning of the three major electronic markets; BrokerTec, Eurex

Repo and MTS, compared to the situation described in our 2006 survey. We examine

the critical success factors of the different system providers that have been identified

through our interviews with specific regard to recent developments as well as Bearing-

Points project experience within banks. In conclusion, we summarise the most impor-

tant findings by providing a strategic assessment of the three markets.

One key development in recent years is the change in corporate structure of BrokerTec

and MTS. BrokerTec is an electronic trading application run and managed by ICAP

Electronic Broking owned by ICAP PLC, the largest voice broker. On the other side, the

majority stake of MTS is now owned by the London Stock Exchange. MTS hereby follows,

in some regards, Eurex Repos corporate structure, which is a subsidiary of Eurex Frank-

furt AG, one of the largest exchange for derivatives trading.

Today two distinct ownership/trading models have emerged and are servicing the elec-

tronic European repo market:

1. The Electronic broking model offering a combination of voice brokerage and

electronic trading over one common interface;

2. The integration into an exchange environment followed by Eurex Repo and MTS.

In addition, Tulett plans to enter the European electronic repo market by 2008 with

a new electronic broking system called Trade Blade. We devote a special section to

this new service offering because Tulett could provide an interesting alternative to

BrokerTecs electronic repo trading facility.


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4.1 BrokerTec

BrokerTec is the dominant player in the electronic spaceparticularly in the special repo segment.

BrokerTec, an electronic trading application managed by ICAP Electronic Broking, isthe market leader for electronic repo trading in the European market with a total

outstanding volume per Dec 12th 2007 EUR 445 billion.24 A large percentage of trading

executed via BrokerTec are Special repos. As we mentioned in the previous chapter, the

volume in the Special repo market reduced since the beginning of the crisis. This develop-

ment was also felt by BrokerTec as they experienced a decrease in outstanding volumes

in the second half of 2007 (outstanding volume went down by estimated 30% from June

2007 to December 2007). Company officials have confirmed that BrokerTecs volumes

have since retuned to almost pre-credit crisis levels. The graphic below shows the single

sided daily turnover on the BrokerTec system for European repos..

Exhibit 5

Development of BrokerTec average daily turnover volumes (single counted)

24 Figures provided by BrokerTec (ICMA reporting, Dec 2007).


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Model: The ICAPs Electronic Broking model owned by ICAP PLC brings together the

flexibility of a voice broker with the speed and efficiency of electronic brokering

across asset classes. ICAPs customers can transact deals via a voice broker and,

at the same time, use ICAPs Electronic Broking straight-through functionalities to

process the deal. Parallel to that, ICAP customers can still use the existing electronic

interface of BrokerTec to execute, as well as transact their business directly over

the electronic market. Thus, ICAP Electronic Broking offers its customers a flexibleand cost-efficient method to execute their trades. In the repo market, however,

the combination of voice and electronic broking is not often selected by financial

institutions. Banks confirmed they prefer a clear separation between voice broker

trades and trades executed electronically. Nevertheless, the combination between

the largest voice broker and the leading electronic trading platform proves to be a

powerful mechanism and should ensure their market position in the future.

CCP trading: The CCP service has helped BrokerTec become widely accepted in

the trading community since it first started in 2000. In 2007 about 91.5 percent of

European repo business was transacted via CCP. In the past, however, dependency on

the performance and capabilities of its clearing provider LCH.Clearnet has had some

shortcomings. For example, the integration of LCH and Clearnet did not work as well

as planned. Technology advancement on the clearing side experienced some delays

because of it. Today, according to our interviewees, most of the issues related to the

merger have been overcome and the performance of LCH.Clearnet is now aligned

with progress. In fact, new developments such as the product launch of GC indicates

that LCH.Clearnet is back on track. Developments like GC should continue to encou-

rage further growth for LCH.Clearnet customers, e.g. BrokerTec as well as MTS.

Increasing competition in the electronic broking market space. In January 2006,

Tullett Prebon launched a new electronic trading platform for the US repo market.

According to our interviewees, it is expected that a corresponding trading platformfor the European market will be launched in 2008. The product is intended to compete

with BrokerTecs repo trading facility. Tulletts European repo trading platform will

mimic most functionality like the hybrid trading, interfaces and trade handling to

BrokerTecs setup as confirmed by our interviewees. Banks mentioned that the internal

set up costs for the new system will be relatively low as the new system does not

require a new back-office interface. In addition, the front-office requires just one extra

interface from its gateway provider to get connected to the new trading platform. In

general, interviewees are showing their support for Tulletts new electronic platform.

They mentioned that they like the fact that the platform will increase competition in

the European electronic repo market. On the other hand, it has to be seen if one of the

major voice brokers servicing the repo market is able to attract volumes from already-

established providers such as BrokerTec, Eurex Repo or MTS.


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4.2 Eurex Repo

Eurex Repo has gained market share through its newcollateralised funding segment Euro GC Pooling

Amongst the major electronic markets in Europe, Eurex Repo shows the highest growthrate based on success of Euro GC Pooling. Eurex Repo has increased its market share

since the end of last year and the average daily outstanding volume increased to EUR

123,6 billion as of March 2008 (see exhibit No. 6). As a result, Eurex Repo was able to

strengthen its position as number two in terms of outstanding volume in the European

repo market.

In contrast to BrokerTec, Eurex Repo is not as dependent on Special repo trading. Indeed

two-thirds of its trading volume is based on GC trades and only one third is based on

Special trades. Therefore, the overall effects of the crisis were not felt as strongly as its

competitors. On the other hand, trading activities in the covered bond market reduced

as result of recent market conditions. This downturn had an effect on Eurex Repo as this

electronic marketplace is one of the premier providers for trading European covered bond

repos. Nevertheless, the downturn of this market segment was more than compensated

by the increased volume of Euro GC Pooling. Banks stated that they used the Euro GC

Pooling facility as a new and robust trading venue during the crisis to provide them with

an efficient way to gain liquidity in and out of the market.

Exhibit 6

Development of Eurex Repo average daily outstanding volumes (single counted)


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Model: Eurex Repo is the trading entity of an integrated clearing and settlement envi-

ronment for sale and repurchase agreements. It is a multi-market and multi- currency

trading environment, which focuses on two repo markets with different value chains:

The Swiss Franc repo market (since June 1999) run by Eurex Zrich is embedded

into the Swiss Value Chain among SIS SegaInterSettle and Swiss Interbank

Clearing SIC;

The Euro market (since July 2001) is being operated by Eurex Repo GmbH,

a subsidiary of Eurex Frankfurt AG, with Eurex Clearing acting as Central

Counterparty and Collateral Management/Settlement with Clearstream

Banking (FFM + LUX).

As a new centre of competence, Eurex Repo also has become frontrunner in collate-

ralised funding. Eurex Repo is integrated within the Deutsche Brse Group network

(part of the Eurex family). This network covers the entire value chain of exchange-

traded products. This integrated structure, being part of Deutsche Brse Group, has

helped Eurex Repo to utilise synergies through its parent company. For example, the

Euro GC Pooling product of Eurex Repo was developed in close co-operation with the

clearing and settlement units within the Deutsche Brse Group.

Technology: In recent years, Eurex Repo has developed into one of the leading

system providers for European repo trading. This multi-market environment has been

designed to cope with a rising pace in terms of system load - such as number of banks

being connected - as well as number of transactions. Eurex Repo has overcome its

technological shortcomings mentioned during previous editions of our survey. Today,

the technology is regarded as state of the art by our interviewees.

CCP trading: Eurex Repo GmbH was founded in February 2001 as a subsidiary of

Eurex Frankfurt and started its operations in July 2001. The front-end of the system

was adopted from the Swiss model but the clearing and settlement operations were

entirely redesigned. The clearing and settlement concept in the Euro market focuses

on anonymous CCP trading. In the Euro market Eurex Clearing AG acts as the CCP forbuyers and sellers and thus guarantees both the trading and settlement anonymity

of all transactions executed via the system. As mentioned before, the combination

Eurex Repo and Eurex Clearing has proven to be a powerful mechanism in recent

history. Current product developments on Eurex Repo proved successful because

of this co-operation. From a business perspective, the internationalisation of its

collateral pool helped to gain additional market share. Furthermore, products such

as Euro GC Pooling helped Eurex Repo to position themselves as the premier provider

in the secured money market in Europe.

Eurex Repo in the Swiss Franc repo market: The Swiss franc repo market started in

June 1999. Developed and marketed in close cooperation with SIS SegaInterSettle as

well as the Swiss National Bank SNB, the success resulted in steadily rising trading

volumes over the past years (15% year on year growth). Today more than 130 partici-pants use the Eurex Repo Swiss Franc repo market facility. The strong growth has not


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only been due to Eurex Repos strong ties with the Swiss National Bank (SNB), which

auctions central bank money exclusively on Eurex Repo. Banks trade repos among

each other in the inter-bank market. But the close link to SNB with fully automated

STP allows intra-day repo trading as part of an efficient liquidity supply program

within the Swiss Interbank Clearing. The multi-currency capability also enables repo

trading in other currencies with the use of SIS Triparty arrangements. Eurex Repo

assisted the SNB during recent events by providing a facility to fine-tune their openmarket operation as well as participating in the worldwide USD liquidity supply

program lead by the FED. The functionality provided proved to be a very effective

mechanism during the crisis.

4.3 MTS Group

MTS asserts its position in the Italian repo market andcontinues to grow in other European repo markets

MTS has increased its share of the European repo market since our last survey. After

the introduction of its Money Market Facility (MMF) in 2005, MTS has made significantimprovements to its liquidity and the average number of daily transactions has increased

to over 2,600. As of today, MTS trading volumes concentrate primarily on the Italian

market. Here, MTSs close ties to the central banks, a broad range of instruments and

the loyalty of major Italian banks, places MTS in the position of premier provider for

this market. Even though BrokerTec is expending considerable effort to enter the Italian

market, MTS is still the preferred domestic trading platform. This was confirmed by our

interviewees who stated that MTS is still seen as the major liquidity provider for the

Italian repo market.

Furthermore, MTS has also been able to increase its European government bond repo

volumes outside the domestic Italian market. These volumes constituted up to 9 percent

(compared to 7 percent end of third quarter 2007) of total MTS repo trading volumes by

the end of March 2008 and have been steadily increasing.25 Today MTS has reached an

average daily volume across all repo markets of almost EUR 80 billion (as of March 2008,

see Exhibit 7).

Finally, MTS also felt the effects of the Credit Crunch as trading volumes fell by around

1/3 in the 4th quarter from the record highs achieved in the first half of 2007. It should

be noted that a number of significant mergers were taking place in Italy at this time and

volumes in 2008 have increased strongly and are close to the pre-crisis levels according

to volume information provided by MTS. The dip in the 4th quarter trading volumes can

be observed in the quarterly average daily turnover and average daily term adjusted

volumes, as can a rapid rebound and continued growth in 2008.

25 MTS, http://www.euromts-ltd.com, figures provided by MTS March 2008.


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Model: MTS S.p.A. is majority-owned by the London Stock Exchange (60.37%)

following their acquisition of Borsa Italiana (previous majority shareholder) in

October 2007. The remaining share is owned by major financial institutions which

have a strong presence in the European secondary government bond markets. Whilst

some European Issuers have opened their cash market to competition, MTS is stillperceived as a market leader and an excellent provider for electronic trading as

recent volume trends show. One unique characteristic of MTS is its trading model.

In contrast with other electronic markets, MTS offers its customers a combination of

all domestic cash markets Italy, France, Germany and some benchmark markets

for sovereigns, agencies and covered bonds. MTS enables banks to have access to all

markets through one single trading platform with benefits in terms of costs, global

coverage and reliability. Through this innovative approach, MTS has been able to

position itself as the frontrunner in cash bond markets for penetrating new emerging

markets prior to its competitors. When referring to repo markets, all European

Issuers are managed by MTS S.p.A. through its MMF platform.

Technology: The new MMF platform is seen as major advancement for MTS, as

market participants have confirmed. After its launch in 2005, the platform has beenupdated continuously and now offers state of the art functionality.

Exhibit 7

Development of MTS average daily turnover volumes (single counted)


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Recently the MMF system was upgraded to integrate both the EONIA swap and repo

market onto one common trading platform/interface and although the EONIA swap

and the repo trading desks are often separated from each other within most finan-

cial institutions, it is also the case that some repo traders and Treasury desks can

execute their own OIS directly in the market. The new multi-product trading facility

offers traders an efficient way to quickly reference different price information and

also to execute swap contracts directly from a single trading platform. European repotraders, who are dependent on the EONIA swap prices to calculate repo rates, will

potentially benefit form MTSs new multi-product trading facility. As a recent develop-

ment, the success of such a combination is not yet visible at this point in time and so

its effectiveness cannot be assessed.

CCP Offering: MTS integrates both CCP and bilateral trading in a single hybrid order

book as the Italian market was traditionally a predominantly bilateral market. The

use of the CCP has increased significantly over the past 2 years and CCP volumes now

account for over half of all volumes traded on Italian repo. The flexibility of the hybrid

order book means that smaller institutions are not excluded or segregated from the

main markets and trading hours can be extended over and beyond those supported

by the CCPs.

4.4 Collateralised Funding

Euro GC Poolings success story

The product Euro GC Poolings daily outstanding trading volume has increased even

during the crisis to EUR 32 billion in February 2008. This is an outstanding growth of 320

percent compared to EUR 10 billion in February 2007. The collateral basket can be used

as collateral for refinancing within the framework of ECB open market transactions. By

offering this opportunity, Eurex Repo has developed a unique selling proposition. As a

result, Eurex Repo has become the first electronic market in Europe enabling cross-border

liquidity management via a wide range of ECB-eligible collateral. Significantly increasedtrading volumes within the last number of months underline the benefits of Euro GC

Pooling for participants.


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Since European banks have expressed their support for the Eurex Repo system, it is to be

expected that its current market share will grow in the near future.26

Internationalisation key to the success of Euro GC Pooling

By the end of 2007, Eurex Repo internationalised its Euro GC Pooling by offering a wide

range of European collaterals in addition to German bonds. The extension allows tradersin the international market, who use or choose to use Clearstream as a custodian for

such collateral, to electronically trade a large basket of international securities as a

single instrument in the repo market. This has the advantage in that all the securities

in the basket will be re-usable at the Bundesbank to assess liquidity at the ECB. This

creation of an effective pan-European market for collateralised money market transac-

tions will have far-reaching implications for the European financial markets, particularly

in times where liquidity is under threat.27 The development of Eurex Repo in the liquid

short-term money market is highly-regarded by the European repo community and will

differentiate Eurex Repo even more from its competitors.

26 According to Eurex Repo 2008.27 The Trade Magazine, 16 October 2007.

Exhibit 8

Development of Euro GC Pooling outstanding volumes in 3/20053/2008 (single counted)


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LCH.Clearnet launches GC in an attempt to competewith Eurex Repo

The new GC service was developed by LCH.Clearnet and is based around the tri-party

settlement models of Euroclear and Clearstream.28 The new service is initially based on

the clearing and netting of trades in standard baskets of Euro area, Euro-denominated

government debt, traded either anonymously on electronic markets or bilaterally. It is

an extension of the sterling GC service launched by LCH.Clearnet in March 2007 and will

provide enhanced STP. Since September, the Sterling GC product has seen record volumes

of GBP 31 billion, with average outstanding volumes running at around GBP 20 billion

per day. The GC product offering, however, has one competitive disadvantage to Euro

GC Pooling. Currently, the product does not offer the possibility to use the collateral in

an ECB tender. This absent functionality makes the product less interesting and only

offers marginal benefits in comparison to other channels of trading as confirmed by our

interviewees. In addition, the product is limited to each collateral management location

within Euroclear or Clearstream i.e. fragmentation of market places for GC trading will

remain.

Nevertheless, in the future, other baskets could be added. This way banks could use theirnon-government collateral in a repo transaction and at the same time have it managed

by a CCP. This could prove to be a powerful combination going forward. We will describe

the potential of the GC product in detail during our discussion Outlook - Collateral

Mobilisation will be Key.

4.5 Key Success Factors

The fundamental success factors and business drivers

In the previous survey edition, we looked at the critical success factors of the different

system providers that have been identified through our interviews with the business

community, through internal research by BearingPoint and through BearingPoints

project experience within banks and electronic market providers. In the past it was

possible to narrow these success factors down to four distinct categories; liquidity, tech-

nology, efficiency and legislation. Whereas the system providers can directly influence

the first three, legislation is an external factor and is influenced by various regulatory

bodies and interest groups throughout Europe.

Today, BrokerTec, Eurex Repo and MTS have been able to combine all the aforementioned

success factors and are now well established in the European repo market. In the future

therefore, providers have to shift their focus on new success factors to gain additional

market share. Factors such as Innovation and Time-To-Market will become more

important for established providers to attract new volumes. The importance of flexible

trading systems to enable improvements and increments within short time frames and

28 Nigel Bradley, LCH.Clearnet, Securities Lending and Repo Committee, 11 March 2008.


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trading systems aligned to current market situations, will be important business drivers

going forward.

Recent events have shown how changing market conditions can affect the way banks

are able to fund themselves. An electronic market provider needs to be able to identify

these trends quickly and adapt their infrastructure accordingly. As a result, an electronic

market is able to provide their members access to different liquidity pools and thereforeensure further market penetration.

Additionally, all our interviewees attested that a third factor is becoming more impor-

tant: Collateral Management. The ability to move collateral in short time frames to

places where it is needed most will be of great importance for further market develop-

ments. The success of products which already offer this service, e.g. Euro GC Pooling, is

self-explanatory.

As collateral management is increasing in importance we will devote a special chapter

on this topic (see chapter 6).

Furthermore, the European Securities Lending and Borrowing (SLB) market is able to

bridge the short comings in the collateral management environment. The followingchapter will therefore analyse latest developments in this market segment.


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5 Securities Lending and

Borrowing Market

The market interest and demand for securities lending and borrowing is on the rise. Asset

managers and pension funds are increasingly turning to lending as an important source

of revenue. Commercial banks and prime brokers are trying hard to secure business from

hedge funds and other specialised investors, who continue to drive demand for securi-

ties. The arrival of fresh lenders and the opening of new markets (e.g. Asia) have created

promising opportunities, but also complexity and operational risks. The market turmoil in

2007 actually pushed lending fees up as the demand for high quality collateral is soaring.

From a procedural point of view, market practices in international SLB have the greatest

opportunities for improvements. One might say that from a technology and processing

point of view, it is not much more advanced than other financial market products. SLB

is in fact in a state of underdeveloped auto-immunisation and standardisation. Tradi-

tionally, SLB loans have been negotiated between counterparties on the phone or by

exchanging mails over common communication networks used in the financial industry.Signs of technological developments include the increase in the amount of automated

borrowing whereby securities are automatically matched as available. In typical elec-

tronic SLB markets, lenders publish their security inventory daily and selected borrowers

compete to locate and borrow those securities. More advanced electronic market places

provide real value added, if a prime selection of pre and post-trade services will be

offered.

5.1 SLB Loan Structures and VolumesSecurities lending and borrowing transactions involve the swap of a specific security

against other securities or cash. The structure of the SLB market is still less standardised

than that of other markets, such as repos. Generally, the term of an SLB loan is open-ended, although in most cases they are made on a 48-hour recall basis. SLB transac-

tions, however, do share similarities with Special repo trades, even if they are subject to

different contractual rules (OSLA and GMSLA).

While Special repo is essentially focused on fixed income financing, SLB facilitates fixed

income and equity financing. The proportion of equity to fixed income in SLB transac-

tions is around 2:1. In general, the amounts traded in SLB are comparatively small and

typically range from EUR 100k to EUR 1 million, but larger sizes tend to become more

common. According to the latest survey from ICMA, the volume of repo driven by securi-

ties lending amounts to approximately 20% of the overall European repo market. In

addition, the driving force behind SLB in Europe is high grade Equity and Fixed Income

financing. Other Volume estimates do not exist, and assumptions towards the EUR 10

trillion figure are most likely not exaggerated.


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5.2 Impact of the Credit CrunchAs the repo market expands it is also increasing the level of SLB with all trading means

to attract liquidity. However, for the leading providers in electronic trading, it is often

events outside of their control which drive growth. The key factor is market volatility. The

increase in volatility demonstrably led to an increase in volumes, driven by sustainable

demand in high quality securities on either side corporate earnings and rating.

In Chapter 3, we derived the outcomes of the Credit Crunch in the repo market.

The Securities Lending market has experienced similar developments except for the

following:

Securities lenders earn exceptional returns: tightening demand on mortgage lenders

was evident which led to deeper spreads as stocks became hard to borrow. Despite

the fact that it cant easily be stated who is going to be the winner and the loser of

the Credit Crunch, it can be suggested that beneficial owners have experienced

record earnings due to increased spreads for cash collateral reinvestments. Securities

lenders can outperform upside and downside to the current crisis.

In general, lending programmes have changed since the beginning of the crisis.Today, beneficial owners need to manage their collateral and re-investment guide-

lines more precisely. The focus on risk and measurement of risk-adjusted returns has

therefore increased.29

It has to be seen if volatility of the market and the shortage of cash will lead to further

specials and re-investment opportunities. We now turn our analysis towards develop-

ments in the major electronic trading systems within the securities lending market.

5.3 Impact of TechnologyWhile bouts of volatility are not always predictable or sustainable, it is clear that there

are established trends in areas like technology, the legal and regulatory environment andvalue chain consolidation, even if these trends sometimes appear to be slow-moving.

However, these aspects all need to be considered in combination. When markets are

volatile, efficiency across the deal chain becomes of significant importance. Electronic

markets in securities finance have become a must have and investment in electronic

marketplaces will reap benefits for years to come.

Today technology has clearly reshaped the lending market already. It has helped

to reduce the workload of traders and strategists in the mass GC SLB business. As

mentioned above, technology in SLB is still relatively immature compared to other

markets and, therefore, the opportunities for further improvements are evident. In the

Special segment, the negotiation methodology and price discovery mechanism can be

improved. Electronic SLB markets are bringing together agent lenders with an increased

number of potential borrowers on an easily-accessible screen. Putting this together with

further automation in GC is the way the market will move forward.

29 www.spitalfieldsadvisors.com, March 2008.


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Transparency has become a mantra, even in the SLB market which has strong and

long-established bilateral dynamics. Trades done and fees paid in many OTC markets are

not always fully apparent, especially at the time of the transaction. There is, however,

a move towards transparency in SLB and data service companies are now starting to

provide fee and volume information. This is not as simple a task as it perhaps should be,

because even trading on electronic markets tends to be based on established market

protocols, which in SLB is bilateral. However, advanced electronic markets do and canpromote wider price distribution. The ultimate level of transparency still depends on the

market participants wish to disclose trade information and that is unlikely to change

unless a MiFID-type regulation is put in place for those markets.

Another driver of change is the evolving way fund managers are running and managing

their portfolios. A current example is the growth of active extension strategies (AES). AES

began less than a year ago in the US and fund managers are now starting to adopt them

in Europe. AES are a way for fund managers to benefit from short selling, even if they are

traditional long-only players. An example is a 130/30 strategy, where the fund manager

establishes a short position equal to 30% of the portfolios value; with the proceeds from

the short sale, the fund manager buys other securities resulting in the fund being 130%

long and 30% short. This strategy increases the possible returns of the entire portfolio,

both longs and shorts, which is how many traditional hedge funds operate.

5.4 Electronic Markets in Securities Lending

and Borrowing

Further development in electronic trading

In the Securities lending is an established practice and has developed from a back office

function to an investment management discipline. Therefore, the choice of the business

partner becomes a more important decision. Despite the increased use of electronic

systems, the market is still dominated by other trading channels. Market participants donot expect that the SLB business will become completely electronic, as there will always

be the need for negotiation of complex deals and unique client requirements.30 Voice-

brokered deals constitute the majority of todays securities lending transactions, but

electronic securities lending markets are gaining more acceptance as the standardisation

of processes develop and more sophisticated systems to support the use of the platforms

are introduced.31

30 www.financialnews-us.com, The securities lending landscape is being reshaped,published December 11, 2007.

31 Investor Services Journal, 2008, p. 12.


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Electronic trading is still not as accepted as in the repo market

Today, there are a number of securities lending markets operating in the European

market. Our interviewees mentioned four markets frequently; EquiLend, Eurex SecLend,

SecFinex and ICAP. In contrast to the repo market electronic trading, however, electronic

trading is still not as accepted by market participants.

EquiLend: Market for processing the mass GC Business

EquiLends market, operating since 2002, is a message-based platform designed

to process equity and fixed income securities transactions on a global basis and to

increase efficiency by standardising, centralising and automating front and back-

office processes. Since its launch, EquiLend has introduced a number of new func-

tions and functional enhancements and has introduced the platform to the global

fixed income securities finance community. EquiLend was initially perceived by the

industry as being only viable for large firms due to the expense required for smaller

banks. However, EquiLend has subsequently changed its model to enable smaller

players to buy certain elements of the whole application. The client base is increasing

and today 29 financial institutions are trading on the EquiLend platform.

32

Furtherservices like AuctionPort, AutoBorrow, AutoBorrow Express and Availability

have been added. In 2008, EquiLend added Trade20 which automates the negotiation

and agreement of trade terms for global Equities and Fixed Income secur

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