Q1. Do you agree with the assessment of the gilt repo market dynamics described in Section 2? Are there any further dynamics that you would highlight, beyond those identified above? Which of the issues described in Section 2 do you see as key risks to gilt repo market resilience, given current market structure?
25. This DP seeks views on the effectiveness of potential measures designed to mitigate the risks described in Section 2 and enhance the resilience of the gilt repo market. It is exploratory in nature and welcomes input on whether specific measures, or combinations of measures, could support market resilience and financial stability, without imposing undue costs on the market. The measures under discussion include greater central clearing of gilt repo, as well as minimum haircuts on non-centrally cleared gilt repo transactions, which are described in this section.
26. Central clearing is a process through which a CCP steps in between the original parties of a transaction. As a result, the CCP assumes the obligations of both sides, becoming the buyer to every seller and the seller to every buyer. This effectively eliminates counterparty credit risk between the original parties, as parties face the CCP rather than each other.
27. The presence of a CCP simplifies the complex web of transactions that exist between counterparties, as illustrated in Figure 2. This allows participants to ‘net’ their exposures across the CCP’s ecosystem, reducing their counterparty exposures, as well as providing operational efficiencies that come from streamlining and standardising settlement processes. Post-GFC, mandatory central clearing in many OTC derivatives markets has promoted financial stability in those markets by making derivatives markets simpler and safer.
28. To collateralise their exposures, CCPs require clearing members to post pre-funded resources. These mainly take the form of collateral to cover potential future exposures that could materialise due to adverse market moves in a scenario where the CCP has to close out the portfolio of a defaulted clearing member. At LCH Ltd., the only CCP currently offering central clearing of gilt repo through its RepoClear service, IM is recalibrated at least daily by the CCP based on members’ positions to withstand 99.7% of historical five-day market moves. In addition, the CCP can apply margin add-ons for factors like concentration and credit risk. Together, IM and margin add-ons act as a first line of defence against potential losses following a member’s default. In addition to margin, members are also required to contribute to a mutualised default fund, calibrated to withstand the simultaneous default of the two members to which the CCP has the largest exposures under extreme but plausible market conditions.
29. In addition to pre-funded resources, clearing members are also required to exchange VM on a daily basis to offset changes in market value of the contracts held at the CCP. The exchange of VM is common practice in both centrally cleared and non-centrally cleared transactions. In centrally cleared markets, VM is paid in cash and then the CCP pays it out to the relevant ‘in the money’ participant, returning the liquidity to the market quickly.
30. The adoption and use of central clearing in government bond repo markets varies considerably across jurisdictions due to differences in market structure, regulation, and trading and clearing infrastructure. In the US, by mid-2027 almost all UST repo transactions will be centrally cleared due to the SEC’s central clearing mandate, from approximately 20-30% in 2022. In Japan, over 60% of outstanding Japanese government bond repo is voluntarily centrally cleared at the Japan Securities Clearing Corporation. In the euro-area government bond repo market, over 60% of outstanding repo transactions are centrally cleared, with large variations across euro-area countries (eg, 72% in Italy, 27% in Sweden and zero in 12 other euro-area jurisdictions).
31. In the gilt repo market, 23% of gross outstanding transactions are currently voluntarily centrally cleared at LCH Ltd., which is authorised and supervised by the Bank, through its RepoClear service. CCPs in the UK are regulated in line with international standards: the Principles of Financial Markets Infrastructure, implemented via the UK Onshored European Markets Infrastructure Regulation, which holds CCPs to robust standards in terms of their financial and operational resilience. The Bank is currently consulting on its CCP rulebook, which looks to maintain the same high standards.
32. Currently, LCH Ltd.’s RepoClear service offers a direct clearing model, mainly for banks and securities dealers, and sponsored clearing models for a subset of non-bank counterparties. Under the RepoClear service’s sponsored clearing model, the non-bank counterparty becomes a sponsored member with the support of a sponsoring agent, ie a bank who is already a direct member of the CCP. This sponsoring agent facilitates the payment of margins from the non-bank to the CCP and contributes additional resources on behalf of its clients, including the client’s contribution to the default fund. In the case of guaranteed sponsored membership, the sponsoring bank is also required to guarantee to cover losses incurred beyond the non-bank’s prefunded resources in case of the non-bank’s default.
33. This section of the DP aims to explore the potential for greater central clearing to enhance the resilience of the gilt repo market. This DP does not make assumptions about the share of the market that would need to be centrally cleared to realise financial stability benefits, how long it would take to reach that level, which specific central clearing access model would be developed by one or more CCPs clearing gilt repo, or how greater central clearing would be achieved. However, the Bank is aware that there are interdependencies between the benefits and costs of central clearing, including from a financial stability perspective, and the way in which central clearing is implemented and used by market participants. We welcome views from market participants on how this could work in practice and what the costs and benefits would be.
34. The role of central clearing in enhancing dealer intermediation capacity has been widely noted by the academic literature and policymakers (eg, Duffie (2020) and the Inter-Agency Working Group on Treasury Market Surveillance (IAWG) 2021 report). Under central clearing, if a dealer transacts a repo with one counterparty and a reverse repo with another counterparty, it would substitute exposures to the CCP for the original separate (bilateral) counterparty exposures. Subject to conditions, the dealer could then net the repo (a liability) against the reverse repo (an asset) for regulatory and accounting purposes. This multilateral netting reduces the number and size of individual exposures, lowering the risk each dealer has to account for on their balance sheet. In turn, this means that dealers can hold less capital against these exposure profiles or make alternative use of the balance sheet that may be available against existing capital levels. While netting in the non-centrally cleared market serves the same purpose and is actively used by dealers, netting efficiencies are generally greater with central clearing, given the presence of one single counterparty (the CCP).
35. Recent literature has sought to quantify these potential benefits. Baranova et al (2023) find that comprehensive central clearing could have increased the stock of nettable gilt repo by £75 billion on an average trading day before the March 2020 ‘dash for cash,’ equivalent to 9% of all outstanding gilt repo at the time. This stock of nettable gilt repo would have risen to £81 billion on an average day during the ‘dash for cash.’ In terms of freeing up balance sheet, the move to comprehensive central clearing would have reduced the leverage ratio impact of gilt repo by 40% in aggregate for a sample of GEMMs.
36. In the cash US Treasury market, Fleming and Keane (2021) find that central clearing of all outright trades would have lowered dealers’ daily gross settlement obligations by roughly 60% in the weeks ahead of the ‘dash for cash,’ and by nearly 70% during the peak of the ‘dash for cash’ period. The authors also note that the estimated netting benefits of market-wide central clearing would be greater if repo transactions were taken into account. By contrast, Bowman et al (2024) examine the potential leverage ratio benefits of central clearing of both US Treasury cash and repo markets, finding that expanded central clearing would have a relatively limited impact (on the assumption of a partially cleared US Treasury repo market). This finding may reflect the fact that there is already greater adoption of central clearing by NBFIs and balance sheet netting by dealers in US markets compared to UK ones.
37. Central clearing seeks to reduce counterparty credit risk for market participants via several channels, with the extent of the benefits depending on the clearing model deployed and the CCP’s regulatory requirements. As outlined in paragraphs 27-28, multilateral netting reduces dealer banks’ counterparty exposures, while members’ prefunded resources and the predetermined CCP default process (the ‘default waterfall’) aim to absorb losses which may arise from the simultaneous default of the two clearing members to which the CCP has the largest exposures under extreme but plausible market conditions. This level of collateralisation and the default process aim to limit potential losses for the non-defaulting counterparty (relative to the level of protection offered by the current practice of zero or near-zero haircuts in non-centrally cleared markets) and the risk of contagion should one member default on its obligations. In the unlikely event that these prefunded resources are not sufficient, however, the CCP has access to other loss allocation or position balancing tools which could allocate any remaining losses among members.
38. These centralised default management processes reduce the risk of a disorderly unwind or transfer of defaulted members’ positions, potentially reducing the market impact of the default. Furthermore, the centralisation and transparency of default management within CCPs could mitigate uncertainty during periods of market stress and potentially reduce the first-mover advantage of dealers’ withdrawal from liquidity provision in expectation of further defaults. Therefore, central clearing allows repo dealers to reduce their counterparty credit risk and generate further headroom with respect to internal credit limits, with the additional capacity potentially deployable into further repo activity, including in stress.
39. As noted in Section 2, a significant share of collateral haircuts in the non-centrally cleared gilt repo market are currently zero or near-zero. This allows market participants to build-up highly leveraged, concentrated positions by borrowing in the repo market against government bond collateral, which, if not properly managed, could pose risks to financial stability. Therefore, and in line with the FSB’s recommendations on leverage in NBFI, there is merit in exploring the potential for central clearing to mitigate financial stability risks from leveraged, concentrated strategies which could trigger forced asset sales and amplify market dysfunction.
40. Greater central clearing may increase the price of high levels of leverage in the form of higher margin requirements, making it more costly for market participants to build and maintain highly leveraged positions. Broadly, two channels might contribute to this effect. First, if the cost of margin were to increase, this could decrease the profit of leveraged positions and therefore of arbitraging discrepancies in pricing between financial instruments. Second, margin costs, to the extent these are fully met by the NBFI client, could place a limit on the re-use of repo collateral and therefore limit the maximum degree of leverage achievable via repo (not accounting for other factors, such as liquidity requirements). It is likely, however, that the ceiling to the build-up of leverage created by CCP margin costs would be binding only for the most highly leveraged counterparties, or in other words those market participants with the greatest potential to undertake destabilising asset sales during stress.
41. In addition, CCPs can impose margin add-ons for concentrated positions (eg, if the collateral portfolio includes a significant market share of a specific instrument or a set of instruments) or credit risk. This would act as a further disincentive to the build-up of highly leveraged, concentrated positions, although this is dependent on whether the central clearing model grants the CCP visibility of NBFI clients’ positions. Finally, greater transparency and more robust default management processes at the CCP could also help mitigate financial stability risks from defaults of leveraged participants, as described earlier in this section.
42. Ultimately, we expect that the impact of CCP margin requirements on NBFI leverage would depend on the amount of margin that NBFIs are required to post to the CCP and the clearing model deployed by the CCP (for example, whether the clearing model requires the NBFI client to post margin or whether these costs can be met by the sponsoring bank).
43. Given that central clearing (or, as discussed later, minimum haircuts) could increase the price or decrease the availability of leverage, it may therefore also impact the cost of trading in both stable and stressed market conditions. For example, if margin levels were high or firms were highly leveraged, margin requirements might increase the cost of trading and therefore affect the profitability of some market participants’ trading strategies. Some of these strategies, such as RV trading, play a key role in the functioning of the gilt repo and cash gilt markets by providing liquidity and facilitating price discovery.
44. The consequences of higher repo trading costs on market participants’ behaviours are uncertain. For example, market participants engaged in cash-futures basis trading may require greater compensation to arbitrage differences in pricing between bonds and corresponding futures, resulting in wider spreads, but the impact may be smaller for participants with offsetting centrally cleared gilt repo and reverse repo (such as strategies that involve arbitraging between different bonds) where margins are likely to be lower due to netting. In general, we expect the impact may be largest for market participants with directional repo positions such as pension schemes and LDI funds, who take positions in longer-dated gilts to hedge long-dated liabilities for pensioners and therefore are likely to incur greater margin costs under central clearing. However, these participants are generally much less leveraged than, for instance, hedge funds pursuing RV strategies.
45. In addition, there are also costs that arise from setting up and maintaining the operational infrastructure required to centrally clear gilt repo. This may be particularly binding for smaller market participants and, if required to centrally clear, may lead them to consider economically equivalent alternatives to the gilt repo market to achieve their objectives.
46. At the same time, the impact of central clearing on market participation may be offset by some of the other benefits of central clearing discussed above. For example, expanded dealer intermediation capacity could be deployed in the gilt repo market, enhancing gilt repo and cash gilt market liquidity. Similarly, the reduction in operational frictions resulting from central clearing may enhance market liquidity, offsetting some of the potential impact of higher margin costs. As a result, the overall impact of greater central clearing on the cost of trading may be manageable in comparison to the benefits.
47. As noted in Section 2, greater central clearing may generate liquidity pressures on market participants, particularly during periods of stress.
48. Since the ‘dash for cash,’ there has been substantial international work on margining practices in both centrally cleared and non-centrally cleared markets, and a focus of these has been enhancing CCPs’ IM model transparency to enable market participants to better prepare for margin calls. Further work was also conducted by CPMI-IOSCO to highlight effective practices in streamlining processes for collecting cash VM in centrally cleared markets. In addition, the FSB has set out recommendations to enhance market participants’ ability to cope with sudden, sharp rises in liquidity demand from (both centrally cleared and non-centrally cleared) margin calls. The SWES showed that NBFIs were well-prepared to post more non-cash margin during the stress scenario. However, the possibility remains that greater central clearing in gilt repo could lead to an increase in liquidity pressures on market participants due to sharp increase in cash margin calls, which they would need to be prepared for.
49. The gilt repo market operates on a delivery vs. payment (DvP) basis, and so any increase in central clearing volumes would increase potential liquidity risks to CCPs operating in this space. CCPs need to ensure they hold sufficient liquid assets to manage these risks and may rely on members to contribute to the total liquid resources held at the CCP, and so this could potentially result in greater liquidity demands on the wider financial system. Greater reliance on CCPs in this market would also increase the importance of operational continuity at the CCPs as the risks associated with an outage would also increase.
50. However, the high regulatory standards to which the Bank supervises CCPs can act as mitigants to these risks. CCPs in the UK are required by regulations to have sufficient financial and liquid resources to ensure they can meet the obligations that would arise in extreme but plausible market conditions that led to the default of the two clearing members to which they had the highest aggregate exposures. These requirements aim to provide confidence in the continuity of critical clearing services in stress and would scale in line with the increased volumes cleared at the CCP. The Bank also expects CCPs to meet new expectations of their operational resilience and continues to work closely with other authorities to promote the operational resilience of the broader financial system to mitigate the risk of disruption in core markets.
51. The risks outlined above may evolve if new CCPs were to enter the gilt repo market, as is expected to be the case in the US Treasury market following the announcement of the SEC’s central clearing mandate. The presence of multiple CCPs could incentivise greater innovation in access models and encourage participation from a broader range of market participants. However, having multiple CCPs operating in the same market may result in the fragmentation of repo positions across CCPs, reducing some of the financial stability benefits of central clearing, such as those from balance sheet netting, the prudent management of concentration risks, and centralisation of default management procedures.
52. Some of these risks may also apply to sponsoring banks. For example, if only a small number of banks were to offer clearing services to clients, the default of one sponsoring clearing member means that a large number of gilt repo market participants, such as sponsored clearing members, may be temporarily impacted or unable to continue participating in the market.
53. While this DP makes no assumptions around specific central clearing models, we expect that many of the financial stability costs and benefits of greater central clearing are contingent on the design and set-up of the CCP clearing model. For example, a gilt repo clearing model which does not prescribe the extent to which NBFI clients pay margin to the CCP (as is currently the case in the US Fixed Income Clearing Corporation, where margining is negotiated bilaterally between clearing members and their clients) may limit some of the financial stability benefits, such as the potential reduction in highly leveraged, concentrated positions via higher margin costs. At the same time, flexibility on margin pass-through to NBFI clients may also mitigate some of the potential impact of central clearing on the cost of trading for NBFIs, and therefore on underlying market liquidity and pricing. As another example, under a direct clearing access model such as the existing sponsored access model available at LCH Ltd.’s RepoClear service, the CCP may have greater visibility of the build-up of concentrated, leveraged positions at both member and market level, allowing it to apply add-ons as warranted by the degree of risk; under other clearing models, where client positions are aggregated into a single ‘omnibus’ client account, this may not be possible. The design of the clearing model may also impact the banking regulatory treatment of cleared repo positions that banks facilitate, impacting balance sheet netting benefits. Furthermore, in a central clearing model where sponsoring banks guarantee the settlement of their clients’ trades, the reduction in counterparty credit risk is less significant compared to other models. This is because the sponsoring bank continues to bear credit exposure to its clients, even though the trades are centrally cleared.
54. Additionally, the choice of how greater central clearing is implemented, and the scale of central clearing achieved, will have a bearing on the ultimate financial stability implications. Greater central clearing could be achieved, for example, via a regulatory requirement to centrally clear all gilt repo trades (ie a ‘central clearing mandate’) or could be driven by market participants’ decisions to increase their portion of centrally cleared repo business in response to incentives. In the US, the SEC has mandated central clearing for most cash and repo US Treasury transactions by end-2026 and June 2027, respectively. In the case of the gilt repo market, even if a mandate were the right way forward, it may not be suitable for all types of market participants to be in scope. The costs and benefits for different sectors of the market would need to be assessed. For example, as mentioned above, in the UK, pension scheme arrangements are not in scope of the OTC derivatives clearing mandate as the call for evidence found that the liquidity buffers required to meet cash VM calls would reduce schemes’ ability to invest in productive assets and generate returns. At the same time, were pension schemes not prepared to meet large increases in cash VM in stress, this could exacerbate liquidity and selling pressures in the gilt market and increase the likelihood of financial instability. Finally, the FPC’s March 2023 resilience standard for LDI funds has already resulted in more prudent risk management of leverage in the sector, and the potential impact of greater central clearing on pension schemes should be assessed in this context.
55. Some jurisdictions have suggested that incentives may be a preferable way to achieve greater central clearing (for example, the ESRB report on its system-wide approach to macroprudential policy). Packages of incentives may help achieve greater central clearing of gilt repo without a mandate, achieving some of the benefits of central clearing while potentially helping to minimise costs. Some potential incentives that authorities might consider in this context include:
56. In the context of this DP, ‘minimum haircuts’ refers to the potential for a minimum requirement on the level of adjustment to the quoted value of securities collateral provided by market participants in a non-centrally cleared government bond repo transaction.
57. In both the policymaking community and the academic literature, there has been growing interest in exploring the merits of minimum haircuts to address vulnerabilities that may threaten financial stability. Most recently, the FSB recommended that authorities consider introducing activity-based measures such as minimum haircuts to mitigate risks from leverage in core markets. In a similar vein, staff work at the Federal Reserve and the ECB recently has explored the potential impact of minimum haircuts (in government bond and non-government bond repo, respectively) on hedge fund leverage; the former, for example, concluded that minimum haircuts on US Treasury repo would reduce effective leverage on RV trades, but may also have an impact on the size and volatility of spreads in related financial instruments, as well as liquidity conditions in relevant markets.
58. Previously, in 2015, the FSB set out a regulatory framework for minimum haircuts on non-government bond, non-centrally cleared securities financing transactions. This framework was part of a broader package of measures to mitigate financial stability risks from NBFI and was later transposed into bank capital standards by the Basel Committee on Banking Supervision (BCBS). Jurisdictions are continuing to explore the implementation of these standards, and in many cases, there have been delays, including due to data gaps preventing authorities from fully assessing securities financing markets.
59. The remainder of this section explores the extent to which minimum haircuts may mitigate vulnerabilities in the gilt repo market, including by reducing counterparty credit risk, limiting the risk of liquidity shocks from sharp increases in margins or haircuts, and by mitigating the build-up of highly leveraged positions. This section will also explore how minimum haircuts could potentially impact gilt market liquidity and pricing and covers initial considerations on implementation and design choices.
60. As in our exploration of the considerations around central clearing, we have not made any ex ante assumptions about the calibration or design of minimum haircuts. However, international precedents suggest they might be calibrated in a way that reflects the risk profile of the product or portfolio, including different repo terms, collateral maturities, and counterparty credit risk (as noted in, for example, work by the Federal Reserve on proportionate margining for repo transactions, or the FSB’s policy recommendations on addressing NBFI leverage in core financial markets).
61. In Section 2, we noted that the PRA’s Fixed Income Financing review found that, in the non-centrally cleared gilt repo market, margining practices tend to be driven by competitive pressures and market dynamics rather than prudent risk management. These findings were echoed by a recent US Treasury Market Practices Group (TMPG) white paper in the context of the non-centrally cleared US Treasury repo market.
62. Setting minimum haircuts may help address this instance of market failure, creating a baseline degree of counterparty risk protection on firms’ gilt repo exposures. In turn, this reduction in banks’ counterparty exposures may help bolster confidence during periods of stress and reduce the risk of concerns about counterparty credit risk and defaults crystallising into a reduction in liquidity supply, as occurred during the global financial crisis and was illustrated by the SWES (Sections 2 and 3.1). At the same time, minimum haircuts may result in the party giving collateral taking an unsecured credit exposure to the other party, at the margin resulting in additional counterparty credit risk.
63. Section 2 describes how haircuts in the non-centrally cleared gilt repo market rose in a sudden, sharp fashion during previous stresses and in the SWES. At the same time, there is generally greater flexibility in risk management practices in non-centrally cleared markets than in centrally cleared markets.
64. Minimum haircuts may help mitigate the sudden, sharp nature of these procyclical increases and reduce corresponding financial stability implications. By setting minimum haircut requirements, banks may be able to avoid sudden spikes in collateral calls, as they would be better collateralised against counterparty risk in the run-up to stresses. Evidence from the SWES corroborated this, finding that banks that came into the exercise with higher haircuts were less likely to raise them procyclically in the stress scenario.
65. In Section 3.1, this DP discussed how margin costs arising from central clearing might impact leveraged NBFI strategies: they could raise the cost of leverage, thereby potentially reducing the ex ante build-up of highly leveraged, concentrated positions. In a broad sense, minimum haircuts are expected to work in the same way: they could cap the level of leverage market participants could take via gilt repo while also affecting the profitability of individual trades by increasing the amount of equity capital needed to fund leveraged positions, particularly for those firms that are leverage constrained. As with greater central clearing, we expect this may bind in particular on the most highly leveraged market participants, reducing the risk that they propagate or amplify shocks.
66. As outlined in Section 3.1 on the potential impact of greater central clearing, an increase in the cost or decrease in the availability of leverage means that minimum haircuts may have an impact on the cost of trading and on market participants’ ability or willingness to arbitrage between financial instruments or take leveraged positions in the gilt market. This may result in an impact on gilt market participation and pricing. The increase in trading costs would be highly dependent on the calibration of minimum haircuts, but it would likely be larger for market participants who take directional positions or are more highly leveraged. A key distinction from central clearing is that minimum haircuts do not come with set-up and maintenance costs (such as contributions to a CCP default fund). Another is that minimum haircuts would not expand balance sheet capacity, reducing some of the potential countervailing benefits of the policy tool.
67. Minimum haircuts could be structured and designed in different ways: they could be calibrated according to different risk sensitivities or vary by maturity; they could apply only to certain subsets of the gilt repo market or to certain participant types (eg, only on dealer-to-client trades); they could be applied at the level of individual trades, or to portfolios as a whole.
68. As with central clearing, policy design and implementation choices would have an impact on the extent to which financial stability costs and benefits are realised. One key variable is the scope of potential minimum haircuts. For example, policymakers wishing principally to address risks from NBFI leverage via minimum haircuts may restrict those minima to the dealer-to-client segment and implement the policy via bank prudential rules.
69. Another key variable in any minimum haircut regime is calibration. Unlike in the case of central clearing, where risk management is conducted by the CCP (subject to regulators’ oversight), authorities would calibrate the level of minimum haircuts. Higher minima may have a greater impact on reducing the ex ante build-up of leverage and achieve a greater reduction in counterparty credit risk, thus bolstering the resilience of liquidity supply, but in turn may imply a greater impact on the cost of trading in normal times.
70. It is also conceivable that the optimal approach to enhancing the resilience of the gilt repo market lies in a combination of greater central clearing and the introduction of minimum haircuts on non-centrally cleared transactions. As outlined above, increased central clearing promotes more prudent collateralisation, which can serve as an effective mitigant against the build-up of excessive leverage, but only if margin requirements are fully met by clearing members’ NBFI clients. To ensure this outcome, a dual approach that integrates broader central clearing with minimum haircuts may offer the greatest benefits in enhancing the resilience of the gilt repo market.
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