Repo fear

24 November 2010

One lesson of 2008 was that selfprotective mechanisms like margin requirements and credit insurance could inadvertently amplify risk in the financial system. As the euro zone crisis spreads, these poorly understood tools may be fuelling contagion.

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The Spanish/German 10year government bond yield spread was on Nov. 24 at a eurolifetime high of 260 bps. The equivalent Portuguese spread touched a eurolifetime record of 481 bps and the cost of insuring Spanish and Portuguese debt against a default rose to new highs at 311 bps and 510 bps respectively.

The Irish/German spread widened to 645 basis points after Standard and Poor's cut Ireland's credit rating to A from AA and placed the sovereign on creditwatch negative.

According to a survey published by the International Capital Market Association (ICMA) on Sep. 15, the size of the European repo market was 6.979 trillion euros as measured by the value of outstanding contracts.

Clearing house LCH.Clearnet acts as a central counterparty for the repo market, and claims a 85 percent share of the market with average monthly volumes of 11 trillion euros per month.

LCH.Clearnet sets margin requirements for European government debt collateral, and states that debt trading at a spread of more than 450 basis points over the Bund benchmark is likely to require a 15 percent margin. This margin requirement was imposed on Irish debt on Nov. 17, and subsequently increased to 30 percent.

According to figures from the Depository Trust and Clearing Corporation (DTCC), the net notional amount of credit default swap protection purchased on Spain rose to a record level of $17 billion on Nov. 19.

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