Takehiro Sato: Toward further development of the Tokyo financial market
- issues on repo market reform
Keynote speech by Mr Takehiro Sato, Member of the Policy Board of the Bank of Japan, at
the Futures Industry Association Japan (FIA Japan) Financial Market Conference 2015,
Tokyo, 13 May 2015.
* * *
Introduction
It is a great honor to have the opportunity today to exchange views on the further
development of Japan's financial markets with distinguished participants from major financial
institutions, pension funds, and portfolio managers in Japan, the United States, Europe, and
other Asian countries.
Today, I would like to talk about the repo market in Japan. The Bank of Japan, collaborating
with market participants at home and abroad, is taking active steps to help create a
marketwide infrastructure. This is done with the aim of further enhancing the functioning of Japan's
financial markets - which are a focus of the Bank's monetary policy implementation and a
touchstone of policy effectiveness.
The repo market plays the extremely important role of supplying liquidity to the primary and
secondary markets, as does the Japanese government bond (JGB) futures market. Repos
and futures transactions are an integral part of market-making activities and the markets'
price discovery mechanism. In this sense, the futures market works hand in hand with the
repo market. In the same vein, the development of the repo market drives further
development of the futures market by boosting the liquidity of the JGB market. Hoping for
such positive feedback to continue, I would like to talk about the international discussions on
repo market reform. I will also touch on issues related to the role of market participants and
the Bank in such discussions.
As you are well aware, repos are transactions that involve the exchange of cash and
securities for a set of period. The repo market is an important place for borrowing and
lending of cash and securities in many global financial markets. The amount outstanding of
repos in Japan declined temporarily in 2008 due to the collapse of Lehman Brothers, but has
regained its size markedly in recent years. It now accounts for almost half of the total
transaction amount in the money market (Charts 1 and 2).
Currently, market participants are taking initiatives in repo market reform in accordance with
international discussions. In my view, these initiatives center on four key ideas: transparency,
stability, efficiency, and globalization. I would like to touch on each idea.
I. International discussions on repos
Drawing on the lessons learned from the recent global financial crisis, discussions on repos
have taken place at international forums such as the G20 and the Financial Stability Board
(FSB), with the aim of further increasing the transparency and stability of the repo market.
The Bank is also taking part in these discussions (Charts 3 and 4).
The awareness here is that the financial crisis was worsened by the large increase in repos
using illiquid securitized products, particularly in the United States. Excessive leveraging and
risk taking in the repo market posed a serious threat to financial stability. This development
drew attention to the so-called shadow banking problem. To prevent the repo market from
seizing up, the FSB deemed it necessary for regulatory authorities to closely monitor the
repo market. It also required further strengthening of risk management by setting haircuts
appropriately. In sum, from a prudential policy perspective, there has been an international
agreement that increasing transparency and stability of the repo market is an important step
in addressing global financial stability risks.
A. Reforms to increase transparency (building of a data collection framework)
With regard to transparency - the first key idea that I mentioned - the FSB set out its policy
recommendation for strengthening repo data collection at both the national and the global
level. This was aimed at collecting detailed data on repos such as the type of collateral. By
collecting such data, national authorities can monitor financial stability risks such as a buildup
of leverage, the degree of maturity mismatch, and the risk concentration among certain
market participants. An FSB Data Experts Group is working on the details of this data
collection framework, and the Bank is also taking part. A consultation paper containing
details such as the data template was released in November 2014, and the framework will be
finalized by the end of 2015, after taking account of the results of public consultation.
In the coming months, active discussion on the domestic data collection framework will take
place in Japan, mirroring developments at the global level. To facilitate the smooth
introduction of the framework, it is necessary to pay due attention to the burden on market
participants and implications for the market.
National authorities see the data collection project as marking significant progress toward
increasing transparency of the repo market as well as shadow banking activities. The project
should also help to contain financial stability risks. Active participation in it will contribute to
global financial stability. Furthermore, the project will enhance Japan's international
competitiveness by ensuring global trust in the nation's money markets. In cooperation with
stakeholders both at home and abroad, the Bank will continue to contribute actively to this
project.
B. Reforms to increase stability (implementation of appropriate risk
management)
The second key idea concerns the stability of the repo market. In this regard, "haircuts" are
intended to increase the safety of a transaction by reducing the market value of the collateral
in proportion to factors such as fluctuations in the collateral price. At the height of the
financial crisis, the prices of asset-backed securities (ABSs) plunged. These securities were
used as repo collateral, and the level of haircuts for them rose sharply. This led to a further
decline in prices and liquidity, destabilizing the entire repo market.
With these experiences in mind, the FSB is requesting regulatory authorities to apply two
measures to all the repo transactions that are not cleared by a central counterparty (CCP).
The first measure is numerical haircut floors (Chart 5). The thinking is that in good times
market participants tend to underestimate price volatility risk and set haircuts that are too
optimistic. By setting a floor, this measure aims to avoid "procyclicality": excessive buildup of
leverage in good times and rapid deleveraging in stressed market conditions due to a sudden
rise in haircuts.
Repos using government securities are exempted from the numerical haircut floors. This is
because price movements in government securities tend not to be procyclical, and haircuts
on government securities are zero or close to zero for most transactions. Unlike in the United
States, where a considerable amount of repos uses ABSs, government securities are mainly
used in Japan (Charts 6 and 7). For this reason, the implementation of numerical haircut
floors would have little impact on the repo market in Japan.
The second measure requested by the FSB concerns methodology standards. Regulatory
authorities are required to establish qualitative standards for the methodologies that market
participants use to calculate haircuts, incorporating stress scenarios.
As just mentioned, nearly all the repos in Japan use government securities, for which
haircuts are hardly applied. However, even the most creditworthy and liquid assets such as
government securities can entail a risk of price fluctuations. Therefore, to ensure repo market
stability, it is important to establish a common understanding among market participants on
what risk management, including methodology standards, should entail.
The FSB will establish a monitoring process to prevent market participants from avoiding
numerical haircut floors by booking transactions in different jurisdictions. Depending on the
results of this monitoring process, the FSB will consider reviewing the scope of the
application, which currently excludes repos using government securities, as well as the level
of haircut floors as necessary. The Bank deems it necessary to continue actively participating
in the international discussions regarding the framework for numerical haircut floors, while
making sure that these do not have unintended consequences for liquidity in the global repo
markets.
II. Reforms to increase efficiency (shortening of the JGB settlement cycle)
In parallel with the international discussions just mentioned, there is an ongoing initiative on
efficiency. In Japan, market participants are aiming to further shorten the settlement cycle for
outright transactions of JGBs from two business days (T+2) to one business day (T+1) after
the trade date.
This initiative was taken in response to the significant increase in settlement fails in the JGB
market at the height of the Lehman crisis. By compressing the unsettled transaction amount,
it intends to reduce settlement risks. In addition, shortening the settlement cycle would bring
drastic changes to the repo market, because the initiative is accompanied by the creation of
a new market-wide infrastructure.
The repo market complements the JGB market, because it accommodates the need to adjust
excesses or shortages of cash resulting from outright transactions. Therefore, it is essential
to introduce a T+0 settlement cycle for the general collateral (GC) repo market in conjunction
with achieving the T+1 settlement cycle for outright JGB transactions. To this end, much
greater speed and efficiency are required in processing repo transactions. This leads to the
third key idea: increasing efficiency. Japan's repo market is planning to introduce the
subsequent collateral allocation method for GC repo transactions. For this purpose, the
market will establish a new collateral management infrastructure with sufficient allocation
capacity.
Heightened efficiency in the repo market has the potential to bring considerable change to
the money market in Japan. More specifically, it could lead to the creation of a significantly
expanded T+0 funding market.
If all of the overnight GC repos currently settled on T+1 shift to T+0, the market size is
roughly expected to reach 20 to 30 trillion yen (Chart 8). On the other hand, the size of the
brokered and uncollateralized overnight call market is currently 2 to 3 trillion yen. This
suggests that there is a high probability that the size of the T+0 GC repo market will exceed
that of the call market and become the largest money market in Japan, offering same-day
liquidity.
As I mentioned, the size of Japan's repo market is expanding. From a broader perspective,
while unsecured funding has been diminishing globally after the financial crisis, secured
funding has been relatively robust. This result seems to reflect structural factors, such as the
increase in the awareness of credit risks of interbank transactions following the financial
crisis, as well as the introduction of financial regulations that discourage unsecured
shortterm funding.
On the basis of this broad trend, the establishment of the T+0 repo market has the potential
to not only affect the current call market but also bring structural change to the money
market, which is vital to the money market operations of the Bank. Currently, banks and
money market brokers are major cash borrowers in the call market, while in the GC repo
market securities firms are major cash borrowers (Chart 9). The T+0 repos may greatly
increase the depth of the T+0 funding market and the diversity of its participants. These
changes could help to further vitalize the money market as a whole.
With these possibilities in mind, the Bank will work closely with market participants and follow
the potential impact of these changes. Specifically, the Bank is greatly interested in the
potential impact on the size of call and repo market, the diversity of participants, and the
money flow. Changes in these factors might also affect the behavior of the money market
rates.
III. Reforms toward globalization (shifting to the new gensaki method)
Another important initiative is the unification of contract types for repos. Recently, market
participants agreed on the uniform adoption of the new gensaki method, a more globally
accepted form of a repurchase agreement. They are now working on the transition process,
such as amending the master agreement. This leads to the fourth key idea: globalization.
In Japan, loan-type repos (called gentan repos) have been widespread in the market. This is
because the securities transaction tax - although now abolished - used to be levied on the
purchase and sale of securities. Thus, there have been three types of repo contracts in
Japan (gentan, new gensaki, and old gensaki), with correspondingly diverse market
conventions (Chart 10). This is considered to be one factor that impedes efforts to improve
efficiency and automation in the processing of repo transactions.
In addition, it is often said that the loan-type repos cause difficulties in communication among
domestic participants, and overseas authorities and participants, because the loan-type
repos have the same legal characterization as securities lending in major overseas markets.
Consequently, the unification of repos to the new gensaki contracts will contribute to the
further globalization of Japan's money market and lead to the vitalization of Japan's repo
market, including transactions with foreign investors who are present here today. Market
participants are expected to improve their IT systems, change market conventions, and seek
clients' involvement. The Bank is committed to offering support to achieve these goals.
Concluding remarks
Today, I have talked about the four key ideas regarding the reform of Japan's repo market:
transparency, stability, efficiency, and globalization. In the creation of a market-wide
infrastructure, these four ideas are important for not only the repo market but also the
financial markets as a whole.
The share of JGB holdings by foreign investors is expected to expand over the medium and
longer term, reflecting changes in domestic savings and investment. Developing a safe and
attractive repo market for investors both at home and abroad would contribute to boosting
liquidity in the JGB market. This would also increase trust in Japan's financial markets.
Reforms in the repo market, which were initiated by the failure of the Lehman Brothers, are
expected to reach their final stage in two to three years. In this regard, we are at a critical
moment for fulfilling the reforms. The Bank judges that it is extremely important for the repo
market, the epicenter of Japan's money market, to become more transparent, stable,
efficient, and easily accessible for foreign investors.
The Bank will hold a Repo Market Forum on May 14, and will exchange opinions with major
repo market participants on the four key ideas behind the reform. The Bank aims, together
with market participants, to contribute further to the development of the repo market and to
the Tokyo financial market.
Thank you very much for your attention.
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