Traders Stockpiling Bonds Are Causing a Great Collateral Squeeze

(Bloomberg) -- Dealers and investors in Europe and the U.S. are rushing to stockpile the safest assets as collateral -- gumming up the financial plumbing of the biggest bond markets with echoes of disruptions wrought by the 2020 pandemic.

As Russia's invasion of Ukraine spurred a disruptive flight-to-quality, Treasury traders failed to follow through with their so-called repurchase agreements by the most in almost two years.

On the other side of the Atlantic, U.K. market participants have been forced to use a safeguard repo facility repeatedly as liquidity in short-dated gilts dries up. Bund investors, meanwhile, have been paying highest premium since the eurozone sovereign debt crisis to own cash bonds over equivalent swaps.

While there's no funding crisis, these are all liquidity-sapping market dislocations that threaten to clog up the flow of money for trades across assets -- especially in Europe -- as the hunt for high-quality collateral rages. The repo market, where big market players swap securities for cash, is a crucial component of global bond liquidity and helps ensure the wheels of finance turn smoothly.

“As soon as things get choppy and bid/offer spreads widen, finding paper to cover trades via the repo market is both more expensive and more challenging,” said Marc Ostwald, global strategist at ADM Investor Services. “The fact that central banks have absorbed so much of the ‘free float' in markets via quantitative easing clearly also plays a role.”

Developed-market government bonds are used as collateral to underpin repurchase agreements -- short-term secured loans -- thanks to their liquidity and creditworthiness. The likes of hedge funds engage in repo activity to fund their leveraged trades and to borrow securities in order to take short positions.

Now, as geopolitical stress spurs risk aversion and trading in Russian assets freezes, many market participants have been facing exorbitant costs to get hold of the most sought-after financial instruments -- especially in Europe.

The so-called asset-swap spread of benchmark German bonds is the largest since the 2011 eurozone crisis, while the premium to own cash bonds in the U.S. is less elevated as haven demand stateside proves more modest.

In the U.S., the rate on overnight general collateral repurchase agreements has been trading above the Federal Reserve's offering yield on its reverse repo facility -- currently 0.05% -- an indication the funding markets are continuing to function despite the geopolitical turmoil.

Haven Demand

It's a somewhat different story in the U.K. Dealers have flocked to a standing facility -- whereby the Debt Management Office lends out a specific gilt for repo purposes -- at the fastest rate since the early days of the pandemic.

Much of the logjam in the collateral supply-chain is centered around particularly scarce bonds. A gilt maturing in 2023 has proved troublesome for gilt traders to source. The moves in special rates versus general collateral rates in markets such as Germany implies “there is an increased scarcity of certain collaterals in the market,” said Kate Karimson, an executive director at fixed-income trading platform BrokerTec.

The collateral shortage, a long-standing gripe among investors, might ease if central banks downsize asset holdings, though the outlook for policy tightening looks less certain due to the Ukraine fallout.

READ: Stress in Money Market Seen Avoiding Crisis Level on Russia Risk

In the view of many participants, the sudden rush to own the safest assets after this year's big bond selloff is exacerbating the liquidity challenges. Investors have been betting against bonds on the prospect of monetary tightening, leaving some securities prone to a short-squeeze.

There has been “increased pressure on specific bond levels, potentially due to short positioning from the market looking to take directional risk,” said John Edwards, a colleague of Karimson at BrokerTec.