The Bank of England has created a new short-term lending facility that allows banks to borrow cash in exchange for bonds they own, in its latest attempt to stop a fire sale of assets by pension funds from reigniting.
Here is a look at how the new “repo” facility works and what BoE officials hope to achieve.
What is the new programme?
The repurchase or repo market serves as a vital lubricant in the daily functioning of global finance, allowing investors to raise cash by taking out a short-term loan against the assets they hold.
The market is typically dominated by investment banks, who lend cash to asset managers, hedge funds and pension funds to finance their investments.
The investor offers high-quality assets — typically government bonds — in exchange. The loan is paid back a couple of days later. It is a sizeable market with around €300bn-€350bn of gilts changing hands every day as of June, according to trade body ICMA.
The BoE acts as the lender of last resort in the UK financial system, and it typically offers repo to banks, providing them with sufficient liquidity to continue serving customers even in times of stress.
The Temporary Expanded Collateral Repo Facility (TECRF) announced on Monday greatly widens the pool of assets the BoE will accept as collateral in its repo operations, allowing the banks more flexibility to accept a broader range of collateral from pension funds using LDI schemes.
Until November 10, banks can offer up any investment grade corporate bonds, or even some debt denominated in foreign currencies, in exchange for short-term cash loans.
What is the BoE trying to achieve?
The plan aims to ease the liquidity pressures facing pension funds in the wake of a crisis that forced the BoE to step in with a bond-buying programme worth up to £65bn two weeks ago.
So-called liability driven investment funds manage some £1.5tn worth of assets in the UK, according to the Investment Association. After the “mini” budget sent gilt yields soaring, LDIs have been trying to raise cash in order to meet margin calls on the vast derivatives bets they used to line up assets and liabilities. The BoE hopes that the expanded range of accepted collateral in the system will alleviate the pressure on pension funds to urgently sell their assets.
“This is about buying more time for pension funds to get their balance sheet and liquidity position in order,” said Antoine Bouvet, a rates strategist at ING.
Why is the BoE acting now?
The BoE’s bond-buying scheme — which halted a chaotic sell-off in gilts — is due to end on October 14, leaving the market facing what many analysts called a “cliff edge”. There were widespread fears that a renewed rise in gilt yields could accelerate once the BoE steps back, forcing leveraged LDI funds to once again rush for cash and dump government bonds, rekindling a self-reinforcing spiral of selling.
However, the BoE was anxious not to prolong its unplanned purchases of gilts. The central bank has been at pains to underline that the scheme is temporary and is not a monetary policy tool, instead falling firmly within its financial stability remit.
Having bought time with its initial intervention, the BoE is aiming to provide an additional window for pension funds to sell assets and raise cash without muddying its commitment to fighting high inflation with tighter monetary policy.
Will it work?
The repo scheme should be a helpful backstop for pension funds looking to urgently raise cash. However, LDI investors cannot access the facility directly. Its take-up is likely to be constrained by the appetite of the banks which can do so on behalf of their pension fund clients.
Using the repo market raises banks’ capital requirements. It also introduces a credit risk to the bank, which would ultimately take the loss if the LDI manager defaulted on repayment of the transaction.
Analysts at RBC in London said the high cost of using the new repo facility might temper enthusiasm for it, as terms on the open market were more competitive. Banks will be charged a flat rate of 0.15 percentage points above the BoE’s main interest rate, currently set at 2.25 per cent.
Lower quality bonds will be valued at a discount, or so-called haircut, to their market price, to protect the central bank in the event of a default. The haircuts range from 0.05 percentage points for the safest assets such as sovereign bonds up to 0.42 percentage points for certain portfolios of risker corporate bonds and commercial paper, a source of short-term funding for companies.
Moreover most pension funds hold gilts with maturities of up to 50 years rather than riskier assets.
“These measures are probably helpful on the margin, but will not stop what’s going on,” said an executive at one large pension fund.