Repo Spike Signals Wrong Kind of Volatility

A wild, mysterious ride in short-term funding markets isn’t good news for Wall Street trading desks. Big global investment banks have a love-hate relationship with volatility. With the right kind of price swings, or so-called good volatility, clients see opportunities and start making trades. That is helpful to banks with trading operations. But with the bad kind of volatility, clients retreat from trading out of fear.

For Wall Street banks, a key question now is whether recent events—including the oil market’s reaction to the Saudi attack, a rotation from growth to value stocks and a two-day surge in repurchase agreement, or repo, rates—represent the right or wrong kind of volatility. Wall Street’s typically opaque ways of making money make this hard to figure exactly. In stocks at least, this month’s sectoral rotation likely helped some trading desks. But in the much bigger fixed-income, commodities and currencies business, things look less rosy.

For one thing, it is clear that some clients somewhere are in trouble. The timing of the repo spike is noteworthy: When repo rates surge at the end of a quarter, it is often tied to banks trimming balance sheets for regulatory purposes. But this spike came two weeks before quarter-end. That suggests clients or dealers, not banks themselves, are driving the drama. Corporations and investors have either pulled cash out of the market, helping exacerbate the repo squeeze, or are scrambling for cash to cover immediate needs. That could be related to what happened in oil. In any case, these clients aren’t putting on new positions, and thus aren’t generating revenue for desks. Secondly, funding costs will likely rise for some desks. Banks have reduced their reliance on short-term funding since the financial crisis, but it is still a factor. In particular, broker dealers not affiliated with deposit-taking banks, including the U.S. operations of some European banks, are facing the prospect of having to fund positions at higher prices. With trading desks already holding lots of low-yielding paper, this puts further pressure on net interest margins. Net interest revenue in fixed-income trading at


the rare bank that gives detail on such results, was already down 4% from a year ago through the first half of the year. Unlike the last time there was a funding squeeze in the repo market during the financial crisis, banks aren’t in any fundamental danger. And increased volatility in currencies, Treasurys, and commodities markets in this quarter from a year ago can be positive indicators for trading desks. But some bank executives this month warned that clients remain anxious and said that September activity would determine the quarterly outcome on trading revenue. Events of the past two weeks won’t help make this picture any more appealing when banks report earnings next month. Write to Telis Demos at

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