(Bloomberg) -- Eurex Clearing AG plans to start clearing repo trades for hedge funds directly by the middle of the year, a key step toward improving liquidity in a market that has been constrained over the years by tighter financial regulation. 

The firm, one of the leading global clearinghouses, aims to have hedge funds up and running on their platform “by the summer,” executive board member Matthias Graulich said on the sidelines of the Derivatives Forum in Frankfurt on Thursday. The company declined to make public how many funds would be on-boarded by then. 

“We have a number of hedge funds who are very interested to pilot cleared repo, and we have two clearing agents who are in close discussion with these pilots,” Graulich said. Eurex couldn’t push ahead with the move as initially planned last year, because key participants would have been unable to settle trades under the new framework, he added.

Traditionally, hedge funds have conducted their repo transactions without interacting with clearing houses, with their banks instead acting as middle men. But lenders’ appetite for this service has been limited by rules that forced them to ration their balance sheets after the 2008 financial crisis. 

That’s given rise to an alternative approach, where the funds essentially plug into the central clearinghouse directly, with their brokers only acting as sponsors. RepoClear, part of LCH, which has a bigger footprint in the overall cleared repo market is making a similar push.

New Approach

Europe’s €11 trillion ($11.9 trillion) repo market is a crucial channel for circulating cash and collateral through the financial system. Hedge funds use it both to borrow cash — by placing securities as collateral with dealers — and to borrow securities from dealers by offering cash in return. It’s also a means for them to increase their leverage.

Until now, two groups — pensions funds, and governments and supranational agencies — have led demand on the buyside for direct access for cleared repo, Graulich said. Appetite has increased as quantitative tightening by central banks and declining excess liquidity have made it more profitable to place cash into the repo market.

Eurex’s buyside repo business has increased from less than €10 billion outstanding in Jan. 2022 to over €50 billion by Dec. 2023. The firm has “a good pipeline of further pension funds, insurance firms,” Graulich said. 

Financial Stability

Regulators are alert to the financial stability benefits of widespread central clearing in bond and repo markets. The Bank of England has previously said that during the March 2020 market turmoil it would have reduced the gilt repo exposures on UK dealers’ balance sheets by 40%, freeing up liquidity for clients who needed it. 

The US has already gone one step further: it’s adopted rules that make central clearing mandatory in the Treasury market, including repo transactions. The Securities and Exchange Commission said the incoming changes are designed to protect investors, reduce risk, and increase operational efficiency.

While it’s unlikely Europe will replicate that move, at least for now, speculation is mounting that regulators will introduce mandatory “haircuts” for repo collateral, a safety feature that values bonds posted as security at below the market price, which means more capital has to be set aside.

That could encourage skeptics who are minded to stick with the traditional repo model given the additional cost of central clearing, said Eurex’s Graulich.

“There are a number of regulatory discussions ongoing. One is that regulators discuss introducing haircuts on the bilateral repo business, which of course would increase the relative attractiveness of the cleared product,” he said.

--With assistance from Greg Ritchie.

(Add context on US regulation in the 10th paragraph.)

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