Columnists

Repo market comeback a blessing that comes with big responsibility

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Nairobi Securities Exchange trading floor. FILE PHOTO | NMG

The repo market. which is basically borrowing backed by government securities as collateral, is coming back years after failing to take off. The pilot is planned for January 2023, and this is a blessing, especially for tier II and III banks, who will be the biggest beneficiaries.

During market distress, tier II and III banks have always found themselves cut off from accessing liquidity from tier I banks keen to avert the contagion risk, leaving them more vulnerable.

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So the comeback of the repo market, a liquidity tool, will not only bolster supply lines but will also provide the market with the needed stability during distress.

The liquidity discontinuity problem in the banking sector has been a shared concern for a long period.

Anyone would notice the discontinuity problem in the market from the cocktail variations of rates at the interbank on the same day.

The reason the repo market failed to take off when it was first introduced was that the law doesn’t allow for the surrender of ownership of the collateral, leaving all the risk to be taken by the lender in case of a default.

The new reforms will circumvent this constraint in law by moving the collateral digitally from the borrower to the lender’s registry on the central bank's CDS platform.

But going forward, there is a need to build greater confidence in the repo market in Kenya by enacting a statutory provision which recognises the absolute transfer of title in a repo transaction.

Just like those who pray for rain should be ready to deal with thunder, the repo market despite coming as a blessing is tagged with its own risks, which we should be ready for.

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Currently, the bond market already has a problem of rogue trading, and the repo market opens more space for such traders to take advantage of in the sell/buy-backs or buy/sell-backs transactions on the pretext of looking for liquidity.

And this will be a concern going forward.

Sell/buy-backs or vice versa are used for liquidity purposes but since it is not an outright sell or purchase, the far leg is priced lower to cater for the cost of ‘lending.’

This is likely to distort the price of the bank’s holding, especially when the securities are swapped repetitively for liquidity.

When the bank's portfolio fair value is affected, it consequently affects the bank's Available for Sell Reserve. So, impairment from the mispricing of the bonds by rogue traders has a systemic risk.

Therefore, the repo market comeback means that banks have to tighten their market risk teams to mitigate this related risk.

From a regulator's perspective, they will have to monitor the yield curve and watch out for rogue trading.

The regulator will also need to differentiate between repo and outright transactions on the yield curve.

Repo transactions shouldn’t affect the yield curve because the prices in sell/buy-backs are not a true reflection of the securities' fair value.

The writer is an economist.