An Analysis of the Electronic Repo Market in the Euro-Zone

THE ELECTRONIC REPO MARKET 2006 − 3RD EDITION −

THE ELECTRONIC REPO MARKET 2006 − 3RD EDITION −

AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

TABLE OF CONTENTS

1INTRODUCTION 1 1.1 Objective 1 1.2 What is New in this Survey 1 1.3 About BearingPoint 1

2EXECUTIVE SUMMARY 3

3MARKET OVERVIEW − TRENDS AND LATEST DEVELOPMENTS 4

4THE REPO MARKET 9 4.1 Definition 9 4.1.1 Advantages of Repo Transactions 11 4.1.2 Participants 11 4.2 Development 12 4.3 Moving Toward an Electronic Market 13 4.4 Description of Transaction Types: The Repo Value Chain 14 4.4.1 Direct Trading and Voice Brokered Repo 16 4.4.2 Tri-Party Repo Systems 18 4.4.3 Electronic Repo Trading Platforms 19

5ATS - ELECTRONIC REPO TRADING: COMPETITIVE ANALYSIS 21 5.1 Success Factors and Business Drivers 21 5.2 Competitor Analysis 23 5.2.1 BrokerTec − An ICAP Electronic Trading Platform 23 5.2.2 Eurex Repo 26 5.2.3 MTS Group 31

BEARINGPOINT I THE ELECTRONIC REPO MARKET 2006

TABLE OF CONTENTS (CONTINUED)

5.3 Clearing and Settlement Issues 34 5.3.1 Clearing and Settlement Process Description 34 5.3.2 Summary − Eurex Clearing AG versus LCH.Clearnet Limited 36 5.3.3 Settlement Barriers and Current Situation 37 5.4 Identified Strengths and Challenges of Competitors 38

6THE SECURITIES LENDING MARKET − A PRIMER 39 6.1 Definition 39 6.1.1 Business Motivation 39 6.1.2 Repo versus Securities Lending 41 6.2 Electronic Securities Lending Trading − Competitor Profiles 41 6.2.1 EquiLend 43 6.2.2 Eurex SecLend 44 6.2.3 SecFinex 44

7INTEGRATION OF REPO TRANSACTIONS 45 7.1 Best Practise Core Elements 45 7.2 Current Situation 47 7.3 Manual Processes of Small and Medium Sized Banks 50

8OUTLOOK 54

APPENDIX I: LIST OF PARTICIPATING INSTITUTIONS V

APPENDIX II: REFERENCES VII

APPENDIX III: GLOSSARY IX

APPENDIX IV: NOTES XII

II BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

INDEX OF EXHIBITS

Exhibit 1 The Repo Process 10

Exhibit 2 GC and Special Repos 10

Exhibit 3 Development of Daily Outstanding Repo Transactions in Europe 12

Exhibit 4 Counterparty Analysis of Repo Trading Methods 13

Exhibit 5 Development of Repo Markets 15

Exhibit 6 Advantages and Disadvantages of Repo Transaction Types 16

Exhibit 7 Brokered Repo Process 17

Exhibit 8 Tri-Party Repo Process 18

Exhibit 9 Estimated Daily Assets in International Tri-Party 19

Exhibit 10 Electronic Repo Transaction with CCP 21

Exhibit 11 Matrix of Success Factors and Business Drivers 22

Exhibit 12 Process Flow of Euro GC Pooling Transaction 29

Exhibit 13 Structure of MTS Segments 32

Exhibit 14 Summary of Repo Transaction Flow 35

Exhibit 15 Identified Strengths and Challenges of Repo Platform Providers 38

Exhibit 16 Characteristics of Repo versus Securities Lending 42

Exhibit 17 Best Practise Trading − High-Level Model 46

Exhibit 18 Best Practise Back Office − High-Level Model 47

Exhibit 19 Best Practise Trading − Examples 48

Exhibit 20 Best Practise Back Office − Examples 49

Exhibit 21 Manual Process Flow of Repo Transactions 52

BEARINGPOINT III THE ELECTRONIC REPO MARKET 2006

TABLE OF ABREVIATIONS

ATS Automatic/Alternative Trading Systems GC General Collateral

ABS Asset Backed Securities GMSLA Global Master Securities Lending BAFin Bundesanstalt für Finanzdienst- Agreement leistungsaufsicht GMRA Global Master Repurchase Agreement

BAMBL Bond Advanced Management for (I)CSD (International) Central Securities Borrowing and Lending Depository

BIS Bank of International Settlements ICMA International Capital Market BO Back Office Association (formerly ISMA)

CAD Capital Adequacy Directive ISLA International Securities Lending Association CBF/CBL Clearstream Banking Frankfurt / Clearstream Banking Luxemburg LCH London Clearing House

CCP Central Counterparty NGSM New German Settlement Model

CDS Credit Default Swaps MMF Money Market Facility

CHF Swiss Francs OSLA Overseas Securities Lenders` Agreement

DBV Delivery by Value OTC Over-the-Counter

DVP Delivery versus Payment PSA Public Securities Association

ECB European Central Bank PPS Protected Payments System

EMA Euro Master Agreement RBM Risked Based Margining

EOC EuroClear REPO Repurchase Agreement

EONIA Euro Overnight Index Average SIS SegaInterSettle

ERC European Repo Council SIC Swiss Interbank Clearing

EUREPO Benchmark Rate of the SMT Swiss Market Index Euro Repo Market SNB Swiss National Bank

EURIBOR Euro Interbank Offered Rate STP Straight-Through-Processing ETP Exchange Traded Products

FO Front Office

FED The Federal Reserve Bank of the U.S.

IV BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

sed in Appendix I. We hope you will agree that their 1. INTRODUCTION thoughts and ideas make this survey an interesting reading. 1.1 OBJECTIVE 1.2 WHAT IS NEW IN THIS SURVEY Following the 2002 and 2004 editions, this third edi- This survey expands on previous editions of the tion of BearingPoint's "Electronic Repo Market Survey" BearingPoint Electronic Repo Market Survey. The new focuses on the latest market developments in the elec- topics in this edition are outlined below: tronic repo market. We provide an update on the current market positions of the key competitors, as well as New Topics Overview: their competitive strengths and weaknesses. The survey Updated figures on market volumes and transaction also addresses new issues, such as the introduction of types. new products in the secured market (e.g. Euro GC Pooling of Eurex Repo). In addition, we compare and Updated figures regarding liquidity on major plat- contrast repo and securities lending transactions and forms, new products and service implementations as briefly provide an overview of electronic platforms for well as strategic evaluation of competitors. securities lending. Finally, we identify the current mar- Introduction to securities lending. ket entry barriers for small and medium sized banks in Profile description of electronic securities lending the elec-tronic repo markets by outlining the manual platform providers. intensive processes these banks follow in order to be able to participate in collateral trading. This edition, Updated strategic evaluation of clearing services of therefore, provides a comprehensive overview of the major European central counterparties (CCPs) and European electronic repo trading market, covering tra- settlement environment. 1 ding, clear-ing and settlement. Market entry barriers for small and medium sized banks and process description for trading and clear- Irrespective of previous project experience that ing of repo and securities lending transactions. BearingPoint has had with any of the survey participants, this research paper aims to provide an indepen- Updated outlook on the repo market. dent perspective. 1.3 ABOUT BEARINGPOINT This survey would not have been possible without the support of the members of the security financing/repo BearingPoint, Inc. (NYSE:BE) is one of the world's lar- industry. The results presented in this edition draw on gest Management and Technology Consulting firms more than 25 in-depth interviews with industry practi- serving Global 2000 companies, medium-sized busines- tioners conducted in late 2005 and early 2006. We are ses, government agencies and other organisations. We grateful to them for their help in creating the question- provide business and technology strategy, systems naire, taking the time to participate in the survey, and design, architecture, applications implementation, net- helping us analyse and review the results. The interview- work and systems integration, and managed services. ees will not be quoted directly in this report, and the Our service offerings are designed to help our clients names of institutions they represent will only be disclo- generate revenue, reduce costs and access the informa-

BEARINGPOINT 1 THE ELECTRONIC REPO MARKET 2006

tion necessary to operate their business on a timely basis. BearingPoint's global headquarters is in McLean, Virginia, United States.

The Repo Services Team of the BearingPoint Competence Group Capital Markets compiled this report. As part of the Financial Services practise, the Repo Services Team was founded in 2000 in both Germany and Switzerland. The team's primary focus is on the repo and securities lending market. Its main task is to consult European second-tier banks on participating in the repo market. BearingPoint shows great interest in following the developments of this market and is a leading partner in collateral management issues. Relevant project experience includes:

Supporting the launch of automatic/alternative trading systems (ATS) in Europe.

Several business process re-engineering projects in front- and back offices at major European banks.

Conducting software selection and implementation for money market, fixed-income and treasury departments.

Defining functional requirements and specifications for secured money market products.

Strategic advice for the German banking sector on the more efficient use of repo and securities lending transactions and new covered bonds issuance models.

Advising financial institutions on integrating electronic repo and tri-party repo transactions into their front- and back offices.

Educating the repo community by providing studies and articles and presenting material at major con- ferences.

For more information, please visit our web site at www.bearingpoint.de or www.bearingpoint.com.

2BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

coming standardised and electronically traded. This 2. EXECUTIVE SUMMARY can be seen in the increasing use of the credit asset class as well as the diversification of ECB-eligible This third edition of the BearingPoint electronic repo assets for repo transactions. market survey, which builds on the previous 2002 and 2004 editions, provides an update on the key competi- In the B2C segment, new market models are ena- tors’ current market positions, product offerings, com- bling additional players to efficiently participate in petitive strengths and weaknesses and their clearing and the repo market (e.g. Bloomberg's request for quote settlement architecture. In addition, we compare and model). contrast the repo and securities lending transactions and So far, term business and more structured products briefly provide an overview of electronic platforms for remain the dominant business area for voice brokers. securities lending. We also present an outlook of their However, the average duration of transactions on value proposition for the future. Furthermore, we out- ATS is increasing beyond 3-6 days. line the manual processes that small to medium sized The development of the European electronic repo German banks follow for trading and clearing of repo platforms remains dynamic and likely to see some transactions. This study is based on in-depth interviews challenges to the current business models of brokers, held with more than 25 market experts in late 2005 and tri-party agents and ATS. early 2006, as well as of BearingPoint's latest project experience and independent research. Major findings Still, only top market players are currently realising are summarised below: the benefits of ATS trading in terms of straight- through processing (STP). Outstanding repo volumes in the European market have risen to more than EUR 5,300 billion. This There is a trend within banks to concentrate all fun- means that the European repo market is now as big ding activities (cash and collateralised funding) and as the U.S. repo market. liquidity control.

The trend toward greater use of electronic repo plat- Equity financing is likely to develop along a similar forms with the use of central counterparty continues path as fixed income did over the last 10 years in (average growth rate of 54 percent of ATS market terms of standardisation.

share since 2002). Efforts to liberalise the European clearing and settle-

The trend toward greater use of ATS coincides with ment landscape are showing some results. Most inef- developments of the other three transaction types: ficiency still lies in settlement processes, although direct over-the-counter (OTC), voice brokered and some cross-border settlement issues have been re- tri-party repo. solved between the major ICSDs.

Increasing importance of collateral solutions with Changes to the regulatory environment (e.g. Basle intelligent clearing and collateral management func- II, Capital Adequacy Directive or to some extent the tionalities (e.g. the introduction of Euro GC lifting of the state guarantee to German Sparkassen Pooling, a new secured money market product on and Landesbanken) significantly impacts the repo Eurex Repo). market. As a consequence, banks need to be able to better net their balance sheets. Through increased product innovation (e.g. greater use of tradable asset classes) more products are be-

BEARINGPOINT 3 THE ELECTRONIC REPO MARKET 2006

EUR 4,561 billion in June 2004 and EUR 3,305 3. MARKET OVERVIEW - TRENDS AND LATEST billion in June 2002)2. The results showed healthy DEVELOPMENTS year-on-year growth of between 16 percent and 19 percent, despite generally lacklustre conditions in In recent years, improvements in the standardisation of the fixed income market in Europe. This makes that the repo market have led to the rise of electronic repo the European repo market is now of comparable size trading. In our first study, we described the trend as the U.S. repo market. towards full electronic trading. The second survey focused on the latest development in this market, thereby All participants involved in our study reported an analysing the three major electronic platform providers: increase in their overall securities financing activi- BrokerTec, a London-based interdealer-wholesale plat- ties. Some of them even reported significant volume form; Eurex Repo, an interdealer platform that is part of increases (30-45 percent). Eurex Frankfurt AG; and the MTS Group, recently Electronic trading is gaining momentum through acquired from Euronext and Borsa Italiana, offering an standardisation as well as system and interface interdealer repo market over its electronic system. In improvements. Despite a perceived high barrier of addition, we defined a best practise approach for inte- entry, participation on ATS with CCP is increasing. grating electronic repo transactions as well as over-the- Banks are thus benefiting from risk reduction and counter (OTC) transactions in the front- and back-offi- netting. For the moment, however, the share of elec- ce systems and processes. tronic trading has stabilised at 21.2 percent of repor- With this third edition we provide an update on the key ted business (compared to 23.8 percent in June competitors’ current market positions, as well as their 2004 and 18.0 percent in June 2003). Anonymous competitive strengths and weaknesses. The survey also electronic trading has fallen in relative terms to 10.4 addresses new issues, such as the introduction of new percent. This may reflect the delay in the introduc- products in the secured market (e.g. Euro GC Pooling tion of new services by one of the main CCPs in 3 of Eurex Repo). In addition, we compare and contrast Europe. repo and securities lending transactions and briefly pro- In our study, the top players surveyed conduct more vide an overview of electronic platforms for securities than 70 percent (compared to 60 percent in 2004) lending. Finally, we identify the current market entry of their transactions in the interdealer market over barriers for small and medium sized banks in the elec- ATS. 4 Second- and third-tier banks are reporting tronic repo markets by outlining the manual intensive their share of electronic trading at 30 to 40 percent processes these banks follow in order to be able to par- of their entire transaction count (compared to 25-30 ticipate in collateral trading. percent in 2004).

The trend continues toward electronic repo platforms. The following chart demonstrates the growth in the

The June 2005 ICMA survey continues to demon- overall European repo market and the development of strate the significant size and uninterrupted growth volumes in different transaction types: of the European repo market by fixing the lower boundary of that market at EUR 5,319 billion in terms of outstanding contracts (compared with

4BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

Tri-party repo has continued its upward trend. 6,000 Despite relatively low market penetration, an in- 5,000 creasing demand for collateral management has 4,000 helped tri-party agents to gain momentum. This is 3,000

Billion EUR Billion due to their ability to handle different asset classes 2,000 and to reduce back-office costs. Currently tri-party 1,000

0 agents hold 10.4 percent of the European market June 2001 Dec 2001 June 2002 Dec 2002 June 2003 Dec 2003 June 2004 Dec 2004 June 2005 share, which is below its peak of 11.2 percent in December 2003 but well up on the 6.2 percent reported in June 2003.5 In contrast, due to a diffe- 50 46.7 45.5 45.1 43.9 45 41.0 40.5 rent market structure, tri-party agents have gained 40 34.4 35 30.7 30 about 50 percent of the U.S. repo market. High 24.824.6 23.8 25 21.2 20 18.0 transaction costs, difficulties in integrating tri-party 15 12.7 10.910.4 8.1 transactions into banks' infrastructures as well as the 10 5.5 6.3 6.2 5 Market Share in Percent in Share Market 0 inability of re-hypothecation of securities within tri- Direct Voice Broker ATS Tri-Party party arrangements are factors contributing to their June 2001 June 2002 June 2003 June 2004 June 2005 relatively low penetration so far in Europe. To coun- teract this, Euroclear has announced the introduc- Source: ICMA Surveys 2001-2005 tion of a re-use functionality for tri-party transac- The trend toward ATS coincides with developments of tions later in 2006. Clearstream also has plans the other three transaction types. underway to implement this functionality this year. We expect a further increase of volumes in this seg- Direct: In the future, the so-called direct OTC repo market will concentrate most of its liquidity in ment. As soon as the re-use functionality has been structured products that require highly personalised made available and standardised collateral basket services, justifying the increased cost compared with have been introduced in tri-party, the increase of more automated trading channels. We expect that volumes will become even more significant. the direct market share will stay at current levels in There is an increasing importance of collateral solu- the medium term. tions with intelligent clearing and collateral manage- Voice brokered: To a greater extent, brokers are ment functionalities. look-ing to partner with electronic trading system According to the ICMA and the latest European providers. Increasing cost pressure will bring bro- Central Bank (ECB) money market survey, the kerage fees down. This will force brokers to consoli- importance of secured financing is increasing.6 date or investigate alternative ways to generate pro- Regulations, such as Basle II, will ensure this trend fits in the repo market. The development of continues. In particular, trading of baskets (e.g. ECB BrokerTec emphasises this trend. We expect brokers eligible baskets) of securities as collateral, rather than might look for new strategies to cooperate more individual securities, will spread. closely with ATS, using the existing infrastructure for clearing and settlement of trades. The launch in March 2005 of the Euro GC Pooling by Eurex Repo was a significant move in the general

BEARINGPOINT 5 THE ELECTRONIC REPO MARKET 2006

collateral market. This secured money market pro- transacted via tri-party agents. However, the duct is attractive to both repo as well as money mar- European Repo Council (ERC) is currently discus- ket traders for short-term business. All interviewees sing whether credit derivatives, such as Credit reported this as the major development in the Default Swaps (CDS), should be acceptable as colla- European repo market since 2004. Liquidity in this teral. In addition, it will be interesting to see how segment on Eurex Repo reached more than EUR 10 decisions to include bank loans as collateral affect billion outstanding volume until the end of 2005. the market. Credit repos are, therefore, still in their infancy and it remains to be seen whether the indus- There is demand for electronic secured financing. A try will develop in this area. key success factor for Euro GC Pooling will now be attracting major international customers as well as BrokerTec was one of the first ATS to introduce a expanding its securities range to non-German secu- credit repo segment in 2005. So far, however, there rities.7 is only limited liquidity in this segment. More structured products are still generally only seen in bilate- There is increased product innovation (e.g. greater use ral trading or with voice brokers. This is likely to of tradable asset classes) and more products are beco- remain the case for these transaction types. ming standardised and electronically traded. In the B2C segment, new market models will allow Generally the range of assets used as collateral conti- additional players to efficiently participate in the repo nues to widen by expanding beyond the traditional market. government and covered bonds categories. The share of electronic repo and securities lending Although collateral management is gaining impor- platforms without CCP functionalities is likely to tance, collateral management systems within banks increase. For example, Bloomberg has recently are often still quite fragmented across asset classes. launched a free request for quote service for cash- Through increased innovation, more products are providing banks and is attracting a strong client becoming standardised and electronically traded. base. Furthermore, EquiLend, a major provider in More benchmarks are becoming established in the electronic securities lending market is automa- liquid markets. ting the processing of securities lending and borro-

High yield corporate bonds, emerging markets wing on its platform. In addition, Eurex SecLend bonds and sub-investment grade securities are has recently started its electronic lending and borro- growth areas of fixed income financing and provide wing operations using Eurex Repo technology. new revenue streams. UK interviewees reported that the number of coun- In addition, equity financing is likely to develop terparties has increased since the beginning of 2004. along a similar path as fixed income did over the last The main increase is in hedge funds and insurance 10 years in terms of standardisation. companies. German interviewees did not report a

The credit asset class is growing, thereby diversifying major increase in counterparties so far. This is pro- the scope for repo transactions. This growth is main- bably due to structural differences between the ly driven by hedge funds making strong use of asset/ German and the UK markets and regulatory envi- mortgage backed securities (ABS/MBS), which are ronments. However, bigger Sparkassen banks in

6BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

Germany are seeing the benefits of the repo business been as successful at penetrating the Italian market. and are becoming more interested in using this mar- This is despite the attempt to acquire MTS Group ket more intensively. (the dominant player in this market) in 2005. BrokerTec has, however, also implemented a clea- Term business and more structured products remain ring link to Monte Titoli, as a further step into the the dominant business area for voice brokers. Italian market. BrokerTec's main strengths, as iden- There has been a slight shift of term business from tified by our interviewees, are: high liquidity in most voice broker to ATS with CCP. Two ATS stated that of the European markets, narrow spreads in govern- the average term duration on their platform rose ment segments, high transparency, superior trading from 3-6 days to 9-10 days. In comparison, other technology and functionality, and outstanding bilateral electronic markets report longer durations customer service. However, BrokerTec suffers from a (e.g. average term transactions have increased to 56 dependency on the performance and capabilities of days). its clearing provider, LCH.Clearnet. Many inter-

Generally longer terms will remain the main busi- viewees reported serious concerns regarding ness of the brokers. Nevertheless, some banks LCH.Clearnet's delay in delivery of a new inte- reported to frequently transact repo with up to 6 grated platform.

months (sometimes up to one year) on ATS. Eurex Repo, is part of the world's largest derivatives exchange, Eurex. It has positioned itself as an inter- The development of the European electronic repo dealer platform as part of its overall fixed-income platforms remains dynamic and might see some chal- strategy. In contrast to its competitors, in an effort lenges to the current business models of voice brokers, to attract second- and third-tier banks, Eurex Repo tri-party agents and ATS. offers its participants lower connection fees to its BrokerTec has focused its marketing efforts on platform. Currently more than 170 financial institu- major players in the fixed-income business. The ori- tions are trading on Eurex Repo in both the Euro ginal 14 shareholders and other important European and Swiss France repo markets. In particular, Eurex players are providing BrokerTec with a steady stream Repo has also successfully introduced its cash-driven of liquidity. The change of its governance structure secured money market solution, Euro GC Pooling, in 2003, from a mutual structure towards a corpora- in March 2005. Since our 2004 survey, Eurex Repo te structure owned by one of the world's largest has significantly increased its market share and voice brokers, led the way to a hybrid model that shows the highest growth rate among the European brought together the flexibility of a voice broker and ATS in both the GC and the special repo market. the speed and efficiency of an electronic broker. Nevertheless, Eurex Repo remains behind its com- Even though the hybrid model has earned criticism petitors in the special repo market for German in the repo community, support for BrokerTec's government bonds. Its volumes have risen in the platform still remains solid. BrokerTec is clearly the Swiss Franc repo market. This has not only been due market leader in most European government bonds to Eurex Repo's strong ties with the Swiss National segments (e.g. Germany, France and the UK gilt Bank (SNB). Furthermore, the launch of a securities market). Almost 70 banks are actively trading in its lending and borrowing market, based on the repo anonymous markets. However, BrokerTec has not platform, in November 2005 demonstrates Eurex

BEARINGPOINT 7 THE ELECTRONIC REPO MARKET 2006

Repo's highly recognized product innovation capa- ed gateways, are already implemented or in imple- bility. In addition, Eurex Repo's openshop design, mentation by top market players. These systems major improvements in Eurex Clearing's CCP func- enable the traders to view and access different elec- tionalities, increasing international customer base tronic markets in order to up- and download posi- and recent developments in the settlement process tions (best price execution) through a single trading make it a strong competitor for other platform pro- screen (e.g. ION Trading, icubic). After the deal is viders, according to the interviewees. concluded over an ATS, all information is routed to the front-office system via an electronic link. The The MTS Group offers an interdealer repo market information is then automatically processed and for more than 190 participants, focusing its market transferred to the back-office system, which moni- strategy on a pan-European fixed-income market. tors clearing and settlement. Settlement netting of Over the last two years, MTS has been able to CCP transactions is done automatically without any defend and expand its prominent position in the manual intervention, thereby realising vital cost Italian government repo market. The change in reductions. Given the path to further realising STP, governance after the acquisition through Euronext most banks have implemented integrated real-time and Borsa Italiana in 2005 has not affected its busi- collateral management systems for individual asset ness model so far. In an effort to become a truly classes (e.g. ANVIL, Algorithmics). European platform, MTS Group has added other countries to its network (e.g. including accession Smaller banks face several disadvantages, including countries such as Poland). A major step for MTS in higher setup costs. Even if minor players signup 2005 was the launch of its new Money Market with ATS providers, platform connections are most- Functionality (MMF), which creates a single liquid- ly manual. Consequently, they do not enjoy the ity pool across all products and markets. The major- same operational benefits of larger participants and, ity of its repo volumes still remain concentrated in for this reason, are less likely to participate as effi- the Italian market, where MTS is protected by ciently in markets dominated by electronic trading. national regulations. Interviewees mentioned that its main strengths are dominant position in the There is a trend within banks to concentrate all fun- Italian market, broad range of instruments, impro- ding activities (cash and collateralised funding) and vements in customer service, high domestic market liquidity control.

penetration through integration of central banks, We currently observe a development at various and loyalty of major players. banks to concentrate all securities financing and liquidity control activities in one place within the Still, only top market players are currently realising organisation. the benefits of ATS trading in terms of straight- through processing. This means secured and unsecured business, whether it is fixed income or equity financing, is moving Currently, only first-tier banks benefit from the closer together. This is driven by a need to integrate advantages that electronic repo trading offers over a collateral management across current asset class cate- CCP. They can price their positions and automati- gories. cally upload them into an electronic trading system. Quote machines and multi-market systems, so-call-

8BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

Efforts in the European clearing and settlement lands- The future trend in the repo market is one of increased cape are showing some results. standardisation. This will cause some liquidity to move from the unsecured market to the secured market. Also, Fragmented settlement structure, lack of regulatory changes to the regulatory environment (e.g. Basle II, conformity and domestic developments in various Capital Adequacy Directive, lifting of the state guaran- European markets are still preventing the creation of tee to German Sparkassen and Landesbanken) will sig- a true pan-European repo market. Even though the nificantly impact volumes in the repo market. This is three major platform providers have increased their especially true as more balance sheet netting is required. market shares, market segregation still exists. The If market conditions develop as expected, market share result is a market in which banks must signup for of electronically traded repos could grow by more than more than one platform. This situation excludes 40 percent. Market players still need to find better ways smaller banks that are often not able to afford the to consolidate their business or seek communication costs that arise from participating in each individual and common market standards to reduce their setup market. costs Until recently, cross-border settlement was still an issue. Some improvements, however, have been achieved (e.g. the fully automated day-time bridge 4. THE REPO MARKET for cross-border settlement between Euroclear and Clearstream Banking Luxembourg implemented in 4.1 DEFINITION 2004). A sale and repurchase agreement, or repo, is the sale of In various efforts, the European Repo Council, the securities by one party (the seller of securities or cash European Central Bank and the major settlement taker) to another (the buyer of securities or cash provi- institutions discussed possible solutions to improve der) with the added condition that those securities, or cross-border settlement. In January 2006, those similar to it, will be returned at a given price at a Clearstream waived its intraday borrowing fees for specified future date.8 A reverse repurchase agreement, all borrowers of German securities in Clearstream or reverse repo, is the exact same transaction from the Luxembourg's fails lending system. This now allows perspective of the cash provider. Clearstream's customers to deal with banks in UK Maturities of repo transactions normally range between (Euroclear customers) without being penalized for one-day and one-year agreements. Generally, the legal failed deliveries due to delays in overnight proces- title of the securities is wholly transferred to the cash sing. Clearstream's decision should thus increase the provider as collateral, thus giving the cash provider the level of liquidity available to its customers and option of selling the collateral in the case of a default on improve interoperability between the domestic and the side of the cash taker. international markets. Euroclear has subsequently waived its intraday borrowing fee from January 30, The exhibit below provides a graphic representation of 2006. According to our interviewees, full interope- a repo from the perspectives of both the cash provider rability between the major ICSDs has been achie- and the cash taker. ved. It remains to be seen, how market perception will develop in the coming months.

BEARINGPOINT 9 THE ELECTRONIC REPO MARKET 2006

EXHIBIT 1. THE REPO PROCESS

Bank A Repo Reverse Repo Bank B

Cash Taker / Cash Provider / Security Lender Security Borrower

Sale Purchase Cash

Securities

Period: Intraday ~ 1 Year

Cash Plus Repo Interest

Repurchase Sale

Two Possible Uses for Repos: General Collateral Repo: Financing Medium Special Repo: Hedging Instrument

Source: BearingPoint

EXHIBIT 2. GC AND SPECIAL REPOS

General Collateral Repo (GC): Special Repo: Basket Trading Single Security Trading

Cover an existing Financing or re-financing Rational future short position

Agree on the quality A specific class of of the securities (basket) Delivery security

Money market Origin Bond trading

High: Term structure, Low: Term structure quality of the security, Standardization not pre-defined baskets

Instrument for central Instrument for bond banks, electronic markets Market and future trading

Source: BearingPoint

10 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

There are two main types of repos that need to be dif- 4. Efficient Use of Capital. The European Community ferentiated: general collateral (GC) repos and special Capital Adequacy Directive (CAD) − and, in the near repos. A GC repo is a repo transaction that "is primari- future, Basle II − will have a great impact on the capital ly to be considered as a form of financing or refinan- requirements that money market participants must cing."9 The cash provider in this case "only has to agree abide by. Due to collateralisation, the participant in on the quality (creditworthiness of an issuer) of the repo transactions requires almost no capital resources. securities and not the individual class of securities."10 A This means that the repo is a much more capital-effi- special repo is generally "used to cover an existing or cient instrument that enables participants to leverage future short position in a specific class of securities."11 their capital more effectively. Exhibit 2 diagrams the differences between the GC and 4.1.2 PARTICIPANTS special repo instruments. Participants in the repo market can be grouped into 4.1.1 ADVANTAGES OF REPO TRANSACTIONS four general categories13: Repurchase agreements provide participants with a Investors - Repos enable investors to earn a return number of significant advantages when compared with above the risk-free rate on government securities similar instruments, such as traditional money market without sacrificing liquidity. Investors such as instruments. There are four primary advantages for the money market investors or bond portfolio managers use of repos12: can gain significant benefits in the repo market. 1. Security. In the case that a counterparty defaults, col- Money market investors will benefit from the pre- lateralisation provides the cash provider with a higher viously mentioned advantages: security, flexibility, level of security. This offers the cash provider the possi- liquidity, diverse credit/yield availability and the bility of liquidating the collateral to offset a default. The efficient use of capital. Bond portfolio managers will selling of the collateral is only possible where legal trans- be able to increase their portfolio yield via the spe- fer of that collateral from the cash taker to the cash pro- cials market.14 vider is accepted. Dealers - Historically, dealers have tended to be net borrowers in the repo market. In some instances, 2. Flexibility. A liquid repo market exists in most major however, dealers have been net lenders of repo currencies for maturities ranging from one day to one funds, due to the shorting of securities that were year. This allows the investor to trade with unique purchased through a repo. maturities and investment amounts. The only other alternative that could give such flexibility is the un- Leveraged Customers - This category includes all secured deposit market. institutions (with the exception of central banks) that use repos for financing positions. The repo mar- 3. Diverse and Competitive Yield Structure. Through ket provides these institutions with a "large and the prudent assessment of the creditworthiness of a liquid alternative to borrowing cash via unsecured counterparty and the quality of the collateral and deli- bank deposits."15 very mechanism, investors are able to find the investment vehicle that exactly matches their needs. Central Banks - Central banks have typically used the repo market as a venue for financing open mar-

BEARINGPOINT 11 THE ELECTRONIC REPO MARKET 2006

ket operations. The U.S. Federal Reserve has been time, repos were primarily used by financial institutions active in the U.S. repo market since as early as 1917, to cover short positions. It was not until 1996 that the when it was used to provide temporary funds to repo gained wider acceptance as a financing instrument member institutions.16 In addition, the central bank in Europe and started to experienced rapid growth. One can send signals regarding the bank's target levels for of the major characteristics of the repo, leading to its short-term rates with its repo transactions.17 increase in popularity, was the simultaneous lending of money and reception of collateral. This made the repo 4.2 DEVELOPMENT an attractive instrument to administrate liquidity. This expansion led to the developments that we see in the The history of the repo dates back as far as 1917 with repo market today. One of these trends in particular is the U.S. Federal Reserve executing trades in order to that of moving away from the voice-brokered services lend funds within the Federal Reserve System. While toward fully integrated electronic platforms.19 repos have existed in the United States for quite some time, it was not until 1949 that they were used on a With the growing importance of the repo market insti- regular basis. Today, the U.S. repo market is considered tutions, central banks and repo market participants to have matured and is currently the most liquid and have taken steps to advance the state of the market. technologically advanced market in the world, with a Although these events and actions have generally taken daily outstanding volume of more than USD 5 trillion place on the national level, they have nevertheless in 2005.18 shaped both the European and U.S. repo markets (please see exhibit below). The European repo market, however, developed around 10 years ago out of the security lending market. At the

EXHIBIT 3. DEVELOPMENT OF DAILY OUTSTANDING REPO TRANSACTIONS IN EUROPE

6,000

5,000

4,000

3,000 Billion EUR Billion 2,000

1,000

0 June 2001 Dec 2001 June 2002 Dec 2002 June 2003 Dec 2003 June 2004 Dec 2004 June 2005

Source: ISMA Surveys no. 1-8 ICMA Survey no. 9

12 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

These various national events show very clearly that plicity and technological advancements, major develop- while the European market as a whole has shown tre- ments in recent years have been made to close the gap. mendous growth, it remains fragmented. An example of In June 2005, the ICMA conducted its 9th Repo this is the north-south split in the European repo mar- Market Survey. The ICMA survey was the first to give a ket. The northern European market is largely a classic general statistical overview of the European repo mar- repo market, whereas the southern market, primarily ket. In the latest survey, 81 financial groups helped cha- due to its lack of standardisation, is largely that of a racterise the current outstanding volume by supplying buy/sell-back market. demographics and methods with which they transact On a final note, current events such as the downgrading repos in the European market. The latest ICMA survey of European banks by the rating agencies and regulato- continues to demonstrate the significant size of the ry changes have encouraged banks to shift more to the European repo market by fixing the lower boundary of secured money market. Banks are starting to realise that that market at EUR 5,319 billion in terms of outstan- the unsecured money market will be insufficient to raise ding contract (compared with EUR 4,561 billion in the funding necessary to overcome a short squeeze in June 2004). It again revealed healthy year-on-year the markets. Thus, we will see further developments in growth of between 16 percent and 19 percent, despite the repo market, which will be supported by further generally lack-lustre conditions in the fixed income standardisation and automation of the electronic provi- market in Europe.20 der, as well as of the clearing and settlement institutions. The EUR 5,319 billion outstanding volume was distri- buted among four different methods of transacting 4.3 MOVING TOWARD AN ELECTRONIC repos: direct, voice-brokered, tri-party and ATSs, as MARKET shown in exhibit 4. Even though the European repo market has historically lagged behind the U.S. market in terms of its size, sim-

EXHIBIT 4. COUNTERPARTY ANALYSIS OF REPO TRADING METHODS

50 46.7 45.5 45.1 43.9 45 41.0 40.5 40 34.4 35 30.7 30 24.824.6 23.8 25 21.2 20 18.0 15 12.7 10.910.4 8.1 10 5.5 6.3 6.2 5 Market Share in Percent in Share Market 0 Direct Voice Broker ATS Tri-Party

June 2001 June 2002 June 2003 June 2004 June 2005

Source: ISMA Surveys no. 1-8 ICMA Survey no. 9

BEARINGPOINT 13 THE ELECTRONIC REPO MARKET 2006

Major findings regarding counterparty analysis include: As the ICMA report and our survey show, there is a trend in Europe to move toward electronic trading plat- The share of electronic trading has stabilised for the forms. The reasons for this increase in electronic trading moment at 21.2 percent of reported business, but are the benefits ATS have for banks, such as reduced risk anonymous electronic trading has fallen in relative and lower back-office costs. Also, trends toward stand- terms to 10.4 percent . This may reflect the delay in ardisation and widespread acceptance of repos as financ- the introduction of new services by the one of the ing tools will presumably lead to additional liquidity in main CCPs in Europe.21 the repo market. Tri-party repo has resumed its upward trend, reaching 10.4 percent. It remains below its peak of 11.2 4.4 DESCRIPTION OF TRANSACTION percent in December 2003 but is well up on the 6.2 TYPES: THE REPO VALUE CHAIN percent reported in June 2003. According to the Bond Market Association, there are The share of government bonds in collateral issued five types of systems in the fixed-income trading mar- in the EU fell back to a record low 85.7 percent, ket: auction, cross-matching, single-dealer, multidealer probably reflecting the growing role of credit repo in and interdealer. All three players in the European elec- Europe.22 tronic repo trading market-BrokerTec, Eurex Repo and the MTS Group-fall into the interdealer category. An The ICMA survey pointed out that not only is the mar- interdealer system is one that allows "dealers to execute ket moving more and more from unsecured to secured transactions electronically with other dealers through transactions, but also that the current market situation the fully anonymous services of brokers' brokers." In is changing from an OTC-driven market toward a fully contrast to the interdealer system, a multidealer system electronic integrated market. The development that has can be described as a system that provides "customers taken place since 2001 shows that the volume of elec- with consolidated orders from two or more dealers and tronically traded repos over ATSs has more than dou- provides customers with the ability to execute from bled. The percentage of repo trades conducted through among multiple quotes." In later sections, we will take voice brokers dropped to 24.6 percent in June 2005, an in-depth look at these three platform providers in the from 45.5 percent in June 2001, showing a clear trend European electronic repo trading market. toward electronic trading.23

According to statements the major market players made during our interviews, in average more than 70 percent of their transactions (count, not volume) in the interdealer market are now traded over ATS. Only , leaving only term business and the more complex products are transacted in the OTC markets. However, second- and third-tier banks are reporting their share of electronic trading at only around 30 to 40 percent of their entire transaction count.

14 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

EXHIBIT 5. DEVELOPMENT OF REPO MARKETS

Country Description24 History U.S. Classic/Fully A string of defaults by a number of active repo participants in the early 1980s Developed – helped to shape the American market's current regulatory framework. Due to Est. Market these bankruptcies factors such as counterparty risk were given closer attention Vol. ~ USD and legislation regarding collateral management and ownership was drafted in 5,000 Billion order further to distinguish the repo transaction from other instruments and ensure transaction credibility throughout the market.25 These measures as well as the length of time over which the U.S. market had developed (almost 50 years), are major reasons explaining the current status of the U.S. market with relation to its counterparts. Germany Classic - Before 1997, there was a minimum reserve requirement set by the Deutsche Frankfurt and Bundesbank for repo transactions. This was later rescinded, as much of the London DM repo business fled to London, where the spreads were more attractive and Driven Est. costs were lower. The exemption of repos with maturities of up to one year Market Vol. ~ from the German minimum reserve, effective on January 1, 1997, was aimed EUR 900 to boost the German repo market at the expense of London. In fact, this action Billion led to a disappearance of a spread between general collateral in Frankfurt and in London.26 The first six months following the lifting of the minimum reserve on repos saw changes, with primary German market players shifting some of their DM-repos from Londen back to Frankfurt. Italy Buy/Sell-Back Italy's government bond market is currently the second largest in Europe.27 In –Domestic spite of this fact, the lira repo market was considered one of Europe's least Est. Market efficient due to its lack of standardisation in the market. Because of this, the Vol. ~ EUR Italian market has extremely high transaction costs, one of the larger 650 Billion disadvantages for repo markets.28 UK Classic - The UK market has developed rapidly, despite the late start of the gilt repo Domestic market in January 1996. It has since become one of the most important Est. Market markets for the national and international repo business. The Bank of England Vol. ~ EUR supported the domestic market by using gilt repos for its daily money market 400 Billion operations since November 1996.29 Source: BearingPoint

This section will analyse the different methods of how repos are currently transacted. After looking at the different transaction types, we will discuss the advantages and disadvantages of each of the methods. (Exhibit 6 summarises our findings, which are described in detail later in this chapter).

BEARINGPOINT 15 THE ELECTRONIC REPO MARKET 2006

EXHIBIT 6. ADVANTAGES AND DISADVANTAGES OF REPO TRANSACTION TYPES

Transaction Examples Advantages Disadvantages Type Voice Brokered Cantor • Best suited to handle • High operating and Fitzgerald structured products counterparty risk GFI • Personalised service • High back-office cost Prebon • Preferred means during • No standardised agreements Garban market pressures because of in Europe ICAP the above • No central counterparty Tri-Party Repo Clearstream • Suited to handle • Moderate risk Systems Euroclear structured products • Moderate back-office cost JPMorgan Chase • Personalised service • No standardised agreements in SegaInterSettle • Good in times of market Europe (CHF) pressures • No central counterparty • Partial clearing and settlement outsourcing • Automatic margining ATS – BrokerTec • Standardised agreements • Less suited to handle structured Bilateral Model Eurex Repo • Standardised trading products (CHF) • Lower back-office cost • Personalised service MTS Group • Moderate operating and • Counterparty risk eSpeed counterparty risk • Set up cost for the ATS Senaf • Automatic margining provider (front- and back office) ATS – BrokerTec • Standardised agreements • Less suited to handle structured CCP Model Eurex Repo • Standardised and products (EUR) anonymous trading • Personalised service MTS Group • Automatic margining • Set up cost for the ATS eSpeed • Lowest back-office cost provider and clearing institution Senaf • Lowest counterparty risk (front- and back office) • Netting possibilities within clearing house

Source: BearingPoint

4.4.1 DIRECT TRADING AND VOICE BROKERED REPO

The OTC market can be described as a non-centralised marketplace for financial products. A repo transaction takes place whenever a buyer and a seller agree to a price. More than 66 percent of the outstanding volume in the repo market is still traded either directly between the market participants or by means of a brokerage service (compared to 75 percent in 2003).30 The high percentage of repos traded in the OTC market is a result of its liquidity and ability to structure products to the needs of the participants on a personalised basis. The exhibit below illustrates the transaction process.

16 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

EXHIBIT 7. BROKERED REPO PROCESS

Bank A Bank B

Negotiation and acceptance Trade data & of repo trade Trade data & trade trade confirmation confirmation Broker

Trade data & Trade data & trade trade confirmation Clearing Clearing confirmation house house

Trade Back-office Back-office Trade data Bank A Bank B data

Cash Settlement Settlement house house Collateral

Source: BearingPoint On the other hand, the lack of an exchange and of analogous to variation margin in the exchange-traded standardised contracts has created many disadvantages markets. Thus, for a bank to participate actively in the for the OTC traded repo. One of these disadvantages is OTC repo market, an infrastructure would have to be a higher credit risk. "Consequently, unlike the exchan- set up to accommodate all these requirements. ge-traded markets where one neither knows nor cares Banks that are not in the first tier are generally not able who is your counterpart, in the OTC market it is usu- to take advantage of the OTC repo market. This is due ally very important to know who is on the other side. to either their lower credit rating or to the higher ope- Creditworthiness can be one of the most important rational costs, which diminish the benefits of the repo considerations in the trade."31Banks have established product. For example, active collateral management various mechanisms to control these potential credit requires banks to change their information technology problems and are now only establishing contracts with infrastructure, risk procedures and accounting rules counterparties rather than a major entity with a sound and, most importantly, increases the settlement and cle- credit rating. In addition, some institutions require aring cost. their counterparty to post collateral immediately after the transaction is completed. This collateral serves These changes cannot currently be justified for smaller much the same purpose as an initial margin in the futu- financial institutions because the spreads to the un- res and options market. Finally, some institutions re- secured market are too narrow to encourage the use of serve the right to call for additional collateral from their the repo product. Moreover, legal and settlement infra- counterparties if the market moves against them. This is structure barriers make the OTC market difficult to

BEARINGPOINT 17 THE ELECTRONIC REPO MARKET 2006

enter. The market is currently on the verge of moving mark-to-market, monitoring margins and income col- away from the OTC business, which carries a substanti- lection are all handled by the agent.32 The exhibit 8 al amount of risk and back-office costs for participating demonstrates the tri-party repo process. banks. Alternative methods of settling and trading repos Despite the advantages that tri-party repo services pro- are rapidly emerging to penetrate the market that is cur- vide banks with, they were unable to capture a higher rently dominated by either brokers or direct selling par- market share compared with other transaction types ties. Two of these alternatives, tri-party repo services and (10.4 percent in 2005 and 6.2 percent in 2002 accor- ATSs, will be discussed in the following sections. ding to the ICMA surveys). This is mainly because tri- 4.4.2 TRI-PARY REPO SYSTEMS party services have not been able to overcome regulatory barriers, the effects of a fragmented settlement infra- Tri-party repo services are collateral management servi- structure in Europe and difficult integration with inter- ces, which act as an agent to free both parties of the nal bank systems. Asynchronous processes between the transaction from administrative and operational bur- major clearing and settlement institutions hinder the dens. They provide the safekeeping and monitoring of quick mobilisation of collateral throughout Europe and securities held as collateral. In addition, tri-party agents therefore diminish the value of such a service. control and monitor the credit exposures for their participants. Thus, the tri-party repo service can be seen as Clearstream introduced the first tri-party repo service to a way to reduce the operational costs and administra- the European market in September 1992. Today, there tive burdens of the repo product. Operational burdens are two leading players in the European fixed-income such as delivery versus payment (DVP), the verification repo market, Clearstream and Euroclear. Recent deve- of the eligibility and sufficiency of collateral, daily lopments in clearing and settlement markets, such as

EXHIBIT 8. TRI-PARTY REPO PROCESS

Negotiation and acceptance of repo trade

Bank A Bank B Information to clearer Back-office Back-office outsourcing outsourcing of settlement of settlement and admin- CashInformation & Information & Collateral and administration reporting reporting istration

Tri-Party service including clearing and settlement

Cash Tri-Party account Tri-Party account Bank A Bank B Collateral

Source: BearingPoint

18 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

the setup of a real-time settlement link between reaching a level of sophistication already achieved in the Clearstream and Euroclear and other initiatives under- U.S. and Swiss Franc repo markets. Tri-party agents way, could provide tri-party services with a new surge in play central roles in managing collateral and reducing volume, as shown in the exhibit below. operational costs to a minimum. One observation during our interviews was that major Swiss banks could The growth rate can be partially explained by looking at handle more than 500 transactions daily with only one the development of the repo market, which has grown front- and back-office resource. Compared with this, a at a similar rate. Moreover, the trend toward outsour- fully STP-driven bank in Europe would need approxi- cing back-office processes to agents has become increas- mately four front office and six to eight back-office em- ingly accepted, thereby promoting the rise of tri-party ployees to handle the same amount of trades. This repos. Finally, the down-grading of major European shows how highly efficient link-ups between tri-party bank assets has forced banks to refinance in the secured services and ATS providers are, as well as the benefits of money market, using the flexibility of tri-party agents to a consolidated settlement infrastructure. manage their collateral more effectively. With banks realising the benefits tri-party agents offer, volume 4.4.3 ELECTRONIC REPO TRADING PLATFORMS growth is expected to continue in the future.33 The fol- In the last four years, the ATS electronic repo trading lowing exhibit shows the estimated market share of the platform has been one of the latest developments in the major tri-party agents and the increasing importance of repo market. ATSs are transforming the OTC-driven this transaction type. market toward a fully integrated electronic value chain. However, European tri-party agents' technical, settle- Trades are entered and executed over a central trading ment and legal limitations are preventing them from platform of the ATS system provider and are then pro-

EXHIBIT 9. ESTIMATED DAILY ASSETS IN INTERNATIONAL TRI-PARTY

200 178* 180 2002 160 143 2003 2004 140 135*** 120 125**** 2005 120 111** 100 100 86 80 80 65 60 60 50 Euro (in billions) (in Euro 38 40 35 27 20 14***** 20 12 10 10 5 9 8 0 0 3 2 2 0 Euroclear Clearstream Bank of JP Morgan Deutsche BNP Paribas Citibank New York Chase GSS

* Euroclear claims another USD 222 billion a day handled by the CREST delivery-by-value (DBV) system ** Clearstream claims another USD 90 billion in Germany via Clearstream Banking Frankfurt (CBF)

*** Includes tri-party securities lending. In the U.S., Bank of New York has overnight outstandings of around USD 830 billion **** Includes tri-party securities lending ***** As of Q1 2003 Source: Global Custodian Survey, Spring 2003, and Tri-Party Securities Financing Survey, Spring 2005

BEARINGPOINT 19 THE ELECTRONIC REPO MARKET 2006

cessed by a clearinghouse, which assumes either the role enjoy the benefits of the repo market by being able to of a tri-party repo agent (bilateral) or of a CCP. In the outsource most of their operational risks to SIS, which case of a CCP, the clearinghouse takes the role of a is currently the only real-time settlement system in buyer to a seller and a seller to the buyer, thus creating Europe. Margin calls are automatically executed on two new contracts that replace the original single con- behalf of customers via SIS. tract. Despite all benefits offered by Eurex Repo to its custo- The main advantages of a CCP are: mers, banks still face the difficult task of managing cre-

Risk reduction due to central management of coun- dit risk. On the other hand, the ATS bilateral model's terparty risk and delivery management. uniform trading interface, which is easy to use and inexpensive to install, offers increased market and price Anonymity among participants. transparency. For example, in the Swiss Franc repo mar- Cost reduction due to netting and cross-margining. ket, the majority of all repo trades are transacted via the Eurex Repo trading platform, thereby providing a con- Currently three fully integrated electronic repo trading centration of liquidity on one system. Moreover, the platforms (BrokerTec, Eurex Repo, MTS Group) are Swiss model shows how the repo market can work effi- trying to gain market share in the Euro market and ciently by using an ATS system. more are on the verge of joining the estimated EUR 5,300 billion European market.34 In addition to the 4.4.3.2 CCP Model three trading platforms there are also numerous electro- "The primary force behind the creation of CCPs is the nic marketplaces, which are offered over a third party, economic interest of capital market participants in such as eSpeed or GFI. In the following section, we will lowering the market side risk and cost of post-trade pro- examine the two different business models: the bilateral cessing."35 By replacing the original counterparties in a model and the CCP model. trade, the CCP assumes all the credit risk. Other advan- 4.4.3.1 Bilateral Model tages of the CCP are multilateral netting of exposures enabling regulatory capital savings and balance sheet In this model, traders execute their trades via the tra- expansion and settlement netting, which can reduce ding platform provider, which then forwards the infor- back-office costs. The advantages on the clearing side mation to the domestic settlement organisation. For are obvious, since a CCP is estimated to reduce the sett- example, Eurex Repo is currently operating without a lement cost by about a third of an equivalent OTC CCP in the Swiss Franc market. Its clearing and settle- trade.36 Finally, the CCP enables market participants to ment is executed via SegaInterSettle (SIS). The Swiss trade anonymously, thereby concealing market inten- Franc repo market is one of the most developed in tion while at the same time reducing counterparty risk, Europe and, therefore, provides a good example of how since the clearinghouse steps in when a bank defaults. an ATS can operate without utilising the services of a The exhibit below illustrates the repo transaction with CCP. The unique success factor of the Eurex Repo plat- CCP. form lies in the fact that the SNB controls its money supply via the repo market with the use of the Eurex The benefits of a CCP are especially evident in Europe, Repo system. More than 100 Swiss and European banks where banks trade more frequently on a cross-border are currently connected to the Eurex Repo system. They basis. Having to deal with multiple jurisdictions and

20 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

EXHIBIT 10. ELECTRONIC REPO TRANSACTION WITH CCP

Bank A Bank B Lift/hit of Quote quote Trade Confirm- Confirm- ation ation Electronic Trading System

Trade data & Clears (and nets) confirmation Clears (and nets) contract between contract between CCP and Bank A Clearinghouse CCP and Bank A CCP

Trade data Trade data

ICSD(I)CSD / CSD (I)CSD

Settles cash and collateral (in-house or cross-border)

Source: BearingPoint regulatory environments, banks look for a means to ers and of how those players have positioned themsel- mitigate their credit risk and, therefore, favour the use ves. We also describe the current positioning of the ATS of a CCP. The ATS platforms − BrokerTec, Eurex Repo providers compared with the situation described in our (EUR) and, to some extent, the MTS Group − under- second survey in 2004. We then look at the advantages stood this trend and are offering their services in con- and disadvan-tages of individual platform providers as nection with a CCP. The following sections will discuss identified in the interviews. In conclusion, we summa- how each of the respective platforms has adopted this rise the most important findings by providing a strate- strategy differently from one another. gic evaluation of all the market participants.

5.1 SUCCESS FACTORS AND BUSINESS 5. ATS-ELECTRONIC REPO TRADING: DRIVERS COMPETITIVE ANALYSIS Any analysis of the different market participants and This section analyses in detail the European electronic their competitive advantages must first identify the key repo market.37 We first look at the critical success factors success factors for a platform provider. In the course of of the different platform providers that have been iden- our interviews with the different market participants, it tified through our interviews with the business commu- was possible to narrow these success factors down to nity and through internal research by BearingPoint, as four distinct categories: liquidity, technology, efficiency well as through BearingPoint's project experience with- and legislation. Whereas the platform providers can in banks. This discussion of critical success factors leads directly influence the first three, legislation is an exter- into a detailed examination of the current market play- nal factor and will be discussed in a later section.

BEARINGPOINT 21 THE ELECTRONIC REPO MARKET 2006

Exhibit 11 summarises our findings from interviews ket. To attract liquidity onto a platform, providers have conducted with market participants. These findings will to gain market share quickly from the top domes-tic be addressed in detail through an analysis of the indivi- and international players. In this process, the platform dual platform providers. providers will often face the liquidity dilemma in attracting new participants. Limited participation on the Of the four success factors, liquidity clearly stands out platform will discourage new market participants from as the primary key to success for any trading platform. joining, thus creating a chicken and egg situation for Liquidity triggers narrower spreads, greater price trans- the platform provider. Moreover, acquiring the necessa- parency and, therefore, increases acceptance in the mar-

EXHIBIT 11. MATRIX OF SUCCESS FACTORS AND BUSINESS DRIVERS

Success Factors Business Drivers Liquidity • Price transparency including market depth and anonymity • Narrow spreads • Broad and committed member base that includes top market players • Initial capital investments by participants will spur liquidity • High quality customer service (e.g. responsiveness) • Broad and integrated product portfolio in accordance with customer needs • High flexibility such as the adoption of market trends and of customer needs • Close customer relationships • Support and loyalty of financial and regulatory authorities • Involvement of a central bank Technology • User-friendly and customisable system • Fully reliable, capable and scaleable integrated trading, clearing & settlement system • Free choice of (pan-European) CCP and of (I)CSD through multiple links direct to clearinghouses, between clearinghouses as well as CSDs and among CSDs • High system flexibility in order to react quickly to individual customer needs • Expansion of IT competence, especially with regards to Internet technology Efficiency • STP with the integration of services and market, CCP functionality including settlement netting and cross-margining. • Lean corporate structure and cost-efficient system architecture allowing low system installation and running costs for participants (e.g. access via internet) • Integrated collateral management service • Consolidation and harmonization among clearing and settlement houses • Harmonization of clearing & settlement rules and processes • Service and market integration (e.g. OTC clearing, tri-party-repo, pooling models) • Reduction of overhead costs Legislation • Legal and regulatory harmonization (e.g. master agreements) • Overcome national market boundaries • Change of ECB policy regarding the advantageous conditions for extensive unsecured lending • Re-use and substitution of securities • Balance sheet netting and close-out netting

Source: BearingPoint

22 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

ry support from the business community requires a by providing fast, reliable, cost-effective execution and European platform provider to have a system that is easy STP services to the world's fixed-income trading com- to use, efficient and consolidates the settlement process munity.40 in Europe. A combination of these factors will be used In 1999, a consortium of 14 international banks in the competitive analysis by referring to these factors announced the foundation of BrokerTec as a competi- as benchmarks for the success of the ATS platform pro- tor to the European exchanges, whose consolidation viders. process was considered by the banks to be too slow. The business model, which was at first seen only as a means 5.2 COMPETITOR ANALYSIS of exerting pressure on the European exchanges to con- The European electronic repo market currently consists solidate the market, began its commercial operations in of three major providers: BrokerTec, Eurex Repo and June 2000 by trading in U.S. and Euro Government the MTS Group. In this section, we will analyse these bonds.41 In December 2000, it expanded its operations providers in detail. to the repo platform. Finally, in 2003, BrokerTec mer- ged with ICAP, bringing together one of the leading In addition, there are other market contenders working electronic platform providers for fixed-income products to penetrate the European repo market (notably eSpeed, with the world's largest voice brokers. Today, it is seen GFI and Senaf). However, we will not look in detail nor as a market leader in most European government repo compare them directly with the providers outlined markets. below due to their limited liquidity or market penetration in the European electronic repo market. Further- 5.2.1.1 Structure more, through our analysis and through the consensus For three years, 14 international banks held shares in of the interviewees, we have established that eSpeed, BrokerTec: ABN Amro, Banco Santander, Barclays GFI and Senaf are still not seen as direct competitors to Capital, Credit Suisse First Boston, Deutsche Bank, the other three platforms.38 Dresdner Bank, Goldman Sachs, Greenwich Capital In analysing the three main providers, we will take an Markets, JP Morgan Chase & Co., Lehman Brothers, in-depth look at each of the three key success factors Merrill Lynch, Morgan Stanley, Salomon Smith Barney (liquidity, technology and efficiency). We will detail our and UBS Warburg.42 BrokerTec's governance structure findings by looking at the platform's structure, its pro- provided it with a competitive advantage of having duct range and its participants. Having characterised attracted the most active players in the market onto one the provider's profile, we will give an overview of the platform. Moreover, this co-ownership ensured partici- advantages and disadvantages of ATS platform provi- pants that they were able to control and influence the ders. direction that BrokerTec was taking.

5.2.1 BROKERTEC − AN ICAP ELECTRONIC BrokerTec was acquired by ICAP in 2003 for GBP 181 TRADING PLATFORM million.43 This led the way for a hybrid model, which brings together the flexibility of a voice broker with the BrokerTec is a fully integrated electronic interdealer speed and efficiency of electronic brokering. Since then, platform for fixed-income securities in Europe. Its mis- ICAP's customers can transact deals via a voice broker sion is "Bringing together multiple marketplaces and and, at the same time, use BrokerTec's straight-through multiple products on one global electronic platform"39

BEARINGPOINT 23 THE ELECTRONIC REPO MARKET 2006

BrokerTec (Repo): As of December 2005

Founded: 1999 HQ: London Shareholder: An ICAP Electronic Trading Platform since 2003. Originally 14 international investment banks. Start of Operations: Bonds June 2000, EUR Repo December 2000. Products: EU government and major agency bonds, mainly major GC government bonds, credit repos. Current Participants No: ~ 70 (incl. major first-tier banks). Liquidity: Overall approx. EUR 150 billion average daily transaction volume (nominal volumes, single count, incl. UK gilt). Biggest gov. bond markets: Germany, France, UK. Market leader in most European government bonds segments. CCP: LCH.Clearnet Limited. Others: Launch of credit repo segment supported by open repo functionality and full access from the ICAP Voice Brokers in 2005. functionalities to process the deal. Parallel to that, the last couple of years to connect almost all major BrokerTec's customers can still use the existing electro- benchmark issues over its CCP. BrokerTec, as a major nic interface to execute as well as transact their business liquidity provider for LCH's Repoclear system, is able directly over the electronic platform. Thus, BrokerTec to leverage LCH.Clearnet's product offering with its offers its customers a highly flexible and cost-efficient successful penetration of most of the European markets. method to execute their trades. Although BrokerTec does not operate under any exclu- sive arrangement with LCH.Clearnet in the current set On the trading side, ICAP Electronic Broking’s model up this means that BrokerTec does suffer from a depen- provides an integrated and broad product range that dency on the performance and capabilities of its main consists of OTC derivatives, fixed income, money mar- clearing provider, LCH.Clearnet. Many interviewees kets, foreign exchange, energy, credit and equity deriva- reported serious concerns regarding LCH.Clearnet's tives of which commodities and fixed-income products delay in delivery of new integrated platform. Indeed are traded mostly over the BrokerTec plattform.44 BrokerTec has recently requested access to Eurex The trading system, originally developed by OM Clearing and is looking for other opportunities to Technology, supplies order matching through a pro- expand its clearing options further. prietary, highly efficient network utilising a front end BrokerTec is in the final stages of testing with the Italian that was co-designed by traders to address their special CCP (CC&G) and also Clearnet SA to offer a central needs. Furthermore, because the system is easy to scale counterparty for Italian Repo and is scheduled to go live and configure to individual needs and wishes, it offers in April/May 2006. Italian Repo has been available on high flexibility combined with an open architecture in BrokerTec since its launch in 2000 but from December order to interface easily with networks. Again, all survey 2005 BrokerTec became a clearing member of Monte participants cited BrokerTec's technological achieve- Titoli, and subsequently all Italian Repo trades executed ments as the superior electronic platform.45 on the system are sent as matched transactions direct to Another of BrokerTec's success factors is its clearing Monte Titoli and the Express 2 clearing system. Trades structure, especially the use of LCH.Clearnet's CCP on Btec are now settled identically to those traded on functionalities. LCH.Clearnet has been very active over MTS.

24 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

5.2.1.2 Product Offering trying to actively penetrate the Italian market. It has done so by attempting to acquire MTS Group in 2005 BrokerTec's rapid development can be attributed to its and implementing it’s clearing link to Monte Titoli. ability to attract major participants to its platform by providing superior technological infrastructure and With growth potential in its key markets, such as on the customer service. Focusing on the repo sector, term side of the repo business, there should be a steady BrokerTec Europe has offered a repo trading facility and assured supply of liquidity. This is being compli- since December 2000.46 BrokerTec offers all EU govern- mented by the merger with ICAP, a process that may ment bonds as well as the majority of supranational, well contribute to the growth of this market segment. sovereign and agency bonds such as Pfandbriefe, Letras, 5.2.1.3 Participants Cades, KfW, EIB etc.47 BrokerTec has been particulary successful in the German, French, Dutch, Belgian, Approximately 70 participants are currently participa- Greek, Finnish, Spanish, Portuguese, Irish, Austrian ting on BrokerTec's repo segment, with more in the and U.K. gilt repo markets. The three largest markets process of connecting (compared with approximately Germany, France and the UK have shown significant 60 in January 2004). These participants represent the growth over 2005 on both nominal and term adjusted vast majority of the European top market players whose volumes, with increased depth of market and tightening liquidity is unmatched by their competitors in their bid offer spreads. BrokerTec executes more than EUR respective markets. In its first three years BrokerTec’s 275 billion (single count − term-adjusted volume −) strategy was to focus exclusively on the top market play- daily and is averaging EUR 150 billion nominal daily ers. volume (single count) as of December 2005.48 In parti- However the extension of liquidity and customer reach cular, UK gilt term repos have more than doubled in of BrokerTec’s platform is now well placed, provided Q3/Q4 2005 against the previous period. In addition, participants are able to conform to the standard settle- BrokerTec is the first ATS which expanded its product ment procedures set forth by the clearing agents. portfolio to credit repos supported by it’s new open repo LCH.Clearnet in turn has lifted its clearing regulation functionality and with full access from the ICAP voice in 2003 by offering a non-clearing member (NCM) sta- brokers. This compliments BrokerTec's other electronic tus. Here the participants can connect to a Third-Party offerings in CDS and Eurobond cash. With more than Clearer such as Dresdner Bank to participate and trans- 5,000 trades executed per day, BrokerTec is the most act their repo business over BrokerTec. This setup offers active platform among the major European repo ATSs.49 second-tier banks the chance to participate in One reason for BrokerTec being able to gain market BrokerTec's markets without any upfront financial con- share in the German, U.K. gilt, French, Belgian and tribution. At the same time, BrokerTec benefits from Dutch markets is its clearing and settlement setup. Its the increased liquidity, which these participants bring to key markets favour this setup, clearing over its platform. LCH.Clearnet and settling their repo business over Euroclear or the respective CSD. In the Italian market, BrokerTec faces stiff competition from MTS Group. This market also has high barriers entry and favours a different clearing and settlement setup. BrokerTec is

BEARINGPOINT 25 THE ELECTRONIC REPO MARKET 2006

5.2.1.4 Evaluation of Current Positioning A high amount of short-term liquidity is concentrated on BrokerTec's state of the art electronic plat- Since the launch of its repo facility in December 2000, form. BrokerTec has attained a strong market position in the European repo market. Some of the reasons for this suc- It is the market leader in most European govern- cess are high shareholder commitment, CCP functiona- ment markets. lity and high-quality customer support. As previously Current liquidity encourages participation, thereby discussed, the LCH.Clearnet CCP service has helped taking advantage of the Third-Party Clearer setup BrokerTec become widely accepted in the trading com- for smaller market players.51 munity. Moreover, BrokerTec offers banks good func- The 14 original shareholders have committed them- tionalities packaged with an easy-to-use interface. Inter- selves to provide a certain amount of liquidity to viewees often mentioned BrokerTec's demonstration of BrokerTec's platform at least until 2006. flexibility in modifying the system quickly in accordance with the requirements and demands of its partici- 5.2.2 EUREX REPO pants. Recently, software delivery issues at LCH. Clearnet has affected trading activities on BrokerTec to Eurex Repo GmbH, a subsidiary of Eurex Frankfurt some extent. It is no surprise, therefore, that BrokerTec AG, is the trading entity of an integrated clearing and is the market leader of the electronic platform providers. settlement environment for sale and repurchase agree- This is also reflected in its outstanding volume, of ments. Its mission is to be the "leading provider of inte- which BrokerTec currently accounts for more than grated electronic trading for the international secured EUR 275 billion (term-adjusted volumes) in the funding business. The markets on Eurex Repo are inter- European repo market.50 dealer and open to all financial institutions. As a centre of competence, Eurex Repo plays an active role in edu- As stated, the new hybrid structure has brought up con- cation and consultancy of electronic trading, clearing cerns by participants. One concern, which again was and settlement in collateralised funding."52 mentioned during our interviews, was that the connection of a voice broker onto an anonymous interdealer This multi-market and multi-currency trading platform trading platform would create a conflict of interest. currently focuses on two markets: the Swiss Franc repo market (since June 1999) and the Euro market (since The broker will be able to access the information posted July 2001). By the end of 2005 the overall daily out- on the trading platform and use this information to its standing volume in the two markets, including the SNB advantage, thereby defeating the purpose of an anony- open market operations counted EUR 95 billion (com- mous trading platform, which is one of the primary suc- pared to EUR 60 billion by the end of 2004). However, cess factors of BrokerTec. It has taken steps to prevent the average growth rate in the Euro repo market since this situation from happening by implementing certain its introduction in 2001 is approx. 105 percent per measures, such as the physical separation of the two annum. As this study focuses on the Euro repo market, entities. the detailed company profile of Eurex Repo will concentrate on the Euro repo segment of Eurex Repo.54 During our interviews, respondents noted that However, in order to provide a complete overview of the BrokerTec will further expand its liquidity even with a Eurex Repo platform, we will briefly discuss the Swiss reduced/limited growth rate for the following reasons: Franc repo market.

26 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

Eurex Repo: As of December 2005

Founded: 2001 (Eurex Repo GmbH) HQ: Frankfurt Shareholder: Eurex Frankfurt / Eurex Zurich Start of Operations: July 2001 (EUR market); 1999 (CHF market; Eurex Zurich) Products: German Government Bonds, KfW-Länderanleihen, Jumbo Pfandbriefe. In addition since 2005 Agency, Austrian and Euro Covered Bonds GC baskets and specials; ECB basket for Euro GC Pooling segment as well as CHF baskets. Current Participants No: Overall > 170 (first-tier and second-tier banks; Increasing international client base). Participation of German Finance Agency. Liquidity: > EUR 95 billion daily average outstanding volume (single count; incl. CHF market). Significant growth in GC and special repo segment in 2005. CCP: CCP by Eurex Clearing in EUR market / bilateral trading in CHF markets (SIS). Others: Successfull introduction of Euro GC Pooling in March 2005. Operations of Eurex SecLand started in September 2005.

In the Swiss Franc repo market, the list of collateral ran- In general, strong central bank support in Switzerland ges from Swiss Austrian and German government bonds of the secured money market as a way of controlling to German Pfandbriefe, as well as a selection of Swiss liquidity should be seen as a model for other countries Franc equities in the form of Swiss Market Index (SMI) to follow. The fact that the Swiss banking system relies shares. Liquidity in EUR, USD and GBP can also be on the repo market clearly puts them at an advantage in managed from intraday up to 12 months with the the event of a liquidity crisis. During a squeeze of short- General Collateral baskets available in the Swiss Franc term liquidity, banks with little capital are able to refi- segment. In addition to the inter-bank repo market, nance themselves without paying the enormous spreads Eurex Repo also includes an auction module, which can necessary to secure their money supply. After the suc- be used for various purposes. The SNB, for example, cessful introduction of the repo business model in the makes use of this auction functionality to fulfil its Swiss Franc repo market, plans were made to roll out monetary Swiss Franc liquidity needs.55 The module is the system to cover the entire European repo market.58 also used for auctions of new issues in Swiss government 5.2.2.1 Structure bonds and "money market claims". Eurex Repo GmbH was founded in February 2001 as a Almost CHF 65 billion (EUR 43 billion) of average subsidiary of Eurex Frankfurt and started its operations daily outstanding volume is currently transacted by in July 2001. The front end of the system was adopted more than 130 participants over the Eurex Repo plat- from the Swiss model, but the clearing and settlement form, a volume increase of about 54 percent p.a. since operations were changed entirely. While repos in the its introduction in 1999. Approximately 40 percent of Swiss Franc repo market are settled through volumes is due to open market operations of the SNB SegaInterSettle (SIS)/Swiss Interbank Clearing (SIC), and 60 percent is due to the inter-bank market.56 The the clearing and settlement concept in the Euro market SNB has introduced its Lombard credit facility in 2005. is completely different. Eurex Clearing AG acts as the Through the Lombard credit facility, banks can take CCP for buyers and sellers and thus guarantees both the advantage of financing themselves on short notice settlement and anonymity of all transactions executed through Eurex Repo to bridge an unexpected liquidity via the system. Automated links to the settlement loca- squeeze.57

BEARINGPOINT 27 THE ELECTRONIC REPO MARKET 2006

tions, Clearstream and Euroclear, allow cross-border platform. In spring 2005 additional international secu- settlement.59 A significant characteristic that differenti- rities for GC and special repos were introduced e.g. ates the Eurex Repo platform is that it is specialised in Agency, Austrian and European Covered Bonds. Today, repos, whereas its competitors offer a wide scope of the German government bond special repo market, fixed-income products that can be transacted using the which is one of the most liquid repo market in Europe, same interface. is primarily traded electronically over the BrokerTec platform. By now, Eurex Repo significantly increased its Eurex Repo is also integrated within the Deutsche stake in German government bonds in the GC and the Boerse Group network (part of the Eurex family). This special repo segment. From the very first beginning network covers the entire value chain of exchange-tra- Eurex Repo was able to create the highest liquidity in ded products. The integrated structure enables the deci- the Pfandbrief segment traded electronically, a market sion-making process to become more homogeneous and which is mainly driven by its domestic players. The rea- therefore helps Eurex Repo to utilise synergies through son for this division is historical. The German govern- its parent. For example, the Euro GC Pooling product ment market has been one of the most open and liquid of Eurex Repo was developed in a close cooperation of markets in Europe and has therefore attracted larger the involved clearing and settlement units within the international players based out of London. When Deutsche Boerse Group network. This project impacts BrokerTec started its operation in 2000 it had won the entire value chain of trading, clearing and settle- those players as shareholders for its operation. Bro- ment and is an achievement unmatched by its competi- kerTec's clearing and settlement structure has given it a tors to date. In addition, the vertical structure is open in competitive advantage in the German government mar- settlement to other (I)CSDs such as EuroClear and SIS. ket. This structure is in contrast to the horizontal approach followed by both BrokerTec and MTS, where the trad- With the introduction of Euro GC Pooling in March ing platform providers, the CCP, and clearing and set- 2005, Eurex Repo took advantage of the integrated tlement parties are to a large extent separate entities value chain with Eurex Clearing and Clearstream looking to optimise profits. Banking. Euro GC Pooling enables banks to use their free collateral efficiently in short-term repo transactions Finally, Eurex Repo's business model differs from that by integrating an automated and centralised collateral of its main competitor, BrokerTec, in that it uses management system. With this new product, a truly Internet technology, which can be downloaded directly cash-driven secured money market with more than to the personal computer. This is in strong contrast to 8,000 ECB-eligible securities accessible via the existing BrokerTec, which requires the user to install a worksta- Eurex Repo platform was created for domestic and tion, creating additional overhead. Moreover, connec- international banks. In addition, the re-use of GC tion to the Eurex platform is relatively inexpensive com- Pooling collateral for collateral requirements out of the pared with its competitors. ECB/Bundesbank tender is available for the GC 5.2.2.2 Product Offering Pooling participants of the tender. With regard to the adopted GC Pooling clearing and settlement cycles to Eurex Repo currently offers German government the ECB/Bundesbank Tender, the GC Pooling partici- bonds, KFW/Länder and German Pfandbriefe with pants are enabled to utilize their surplus liquidity resul- ratings of AA or better as collateral over its European

28 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

ting from the Bundesbank Tender in an efficient man- Automated securities allocation replaces manual ner. As of today, Clearstream is developing further sett- trade completion by the trader. lement access to GC Pooling eligible collateral held in Automated securities substitution. custody at Clearstream Banking Luxembourg. Settlement netting via Eurex Clearings CCP. By the end of 2005, daily outstanding volumes reached Automated transfer of settlement instructions and more than 20 percent of its overall GC volume. This is efficient use of collateral management system a remarkable share, given the time period covered. The Xemac. largest single transaction size to date has been more than EUR 9 billion. This shows the opportunities within this Re-use of collateral received (e.g. for further re-use segment to increase the secured financing volumes and within Euro GC Pooling or pledging to Bundes- simultaneously reducing the number of transactions.60 bank).

Key characteristics of Euro GC Pooling can be summa- The process of Eurex GC Pooling transactions can be rised as follows: described as follows (see Exhibit 12).

Electronic trading of secured cash-driven General On the domestic side, being based in Germany and Collateral (GC) segment. offering banks an easy way to access the secured money market provides Eurex Repo with a competitive advan- Basket comprises approximately 8,000 ECB/Bun- desbank eligible securities. tage in the German marketplace. Bundesrepublik Deutschland Finanzagentur GmbH, which manages Overnight, TomNext, SpotNext, Spot Term and the German government budget, has early recognised OneWeek Tender harmonized with ECB Tender.

EXHIBIT 12. PROCESS FLOW OF EURO GC POOLING TRANSACTION

Bank A Bank B Process Description: 1 2 1. Bank A quotes „Collateral Type GC Pooling“ Quote Quote (cash size and basket ISIN required) 2. Bank B accepts (hit quote) 3 3. A trade is generated. Eurex Clearing now becomes counterparty

Eurex Repo 6 4. Eurex Repo transmits trading data to Eurex 5 GmbH Clearing 6 5. Eurex Clearing sends a confirmation to Eurex Repo and clearing reports to involved banks 4 5 6. Eurex Repo sends a confirmation to the participants Eurex Clearing AG 7. Eurex Clearing transmits settlement information to Clearstream Banking 8 Settlement in 7 8. Eligibility check, evaluation and allocation of Xemac central bank money securities in Xemac 9. Settlement of securities in CASCADE Central Clearstream 8 Bank Banking AG CASCADE Source: Deutsche Boerse www.eurexrepo.com/euro/gcpooling.html

BEARINGPOINT 29 THE ELECTRONIC REPO MARKET 2006

this advantage and has therefore been trading repos over London, Barclays, BNP Paribas, Citigroup and J.P. the Eurex Repo platform since 2002 and is now one of Morgan are now frequently trading some of their volu- the major participants on Eurex Repo. me over the Eurex Repo platform. It still has a lot of cat- ching up to do to attract as much liquidity as BrokerTec This development in the liquid short-term money mar- has in the German government bond segment. ket is highly recognised by the European repo commu- However, key for its further success especially for Euro nity and will differentiate Eurex Repo even more from GC Pooling will be the participation of non-German BrokerTec. banks, thereby being able to enhance Euro GC Pooling securities to a international range of ECB eligible 5.2.2.1 Participants basket, therefore using Clearstream Banking Luxem- Initially, eight financial institutions primarily started bourg. trading German government bonds and German Pfandbriefe. (Bayerische Landesbank, Commerzbank, 5.2.2.4 Evaluation of Current Positioning Credit Suisse First Boston, Deutsche Bank, Dresdner Since its launch in July 2001, Eurex Repo has had diffi- Bank, DZ Bank, HypoVereinsbank and Westdeutsche culties to attract liquidity in the German government Landesbank). Today, more than 36 domestic and inter- bond market onto its platform. Starting at the peek of national participants are active in the Eurex Repo Euro an economic down cycle can be considered partly market, with more in the process of signing up.61 As pre- responsible for its unsatisfactory launch. During this viously noted, the strategy of Eurex Repo was to apply period, banks were not inclined to invest in new tech- the successful business model of the Swiss Franc repo to nology and, due to this, the eight participants could not the German market. By connecting to Eurex Clearing, create enough liquidity to attract new members to the where most German banks already held clearing mem- platform. The limited liquidity on the Eurex Repo plat- ber status, the groundwork for the business model was form provided BrokerTec, which had already been oper- already laid out. Because Eurex Repo had the second ating successfully in the German government bond mover disadvantage to BrokerTec, however, the accep- market for more than six months, with a competitive tance of the Eurex system has, at first, been limited. advantage. However, with Eurex Repo increasing its Marketing efforts were made to attract both, domestic marketing efforts, extending its participant base to and international participants and have shown to be international key market players, adjusting its market successful over the last three years. For example, smaller model and system to the European market, introducing domestic players have shown interest in refi-nancing new products e.g. Euro GC Pooling, as well as con- themselves over the repo market, thereby look-ing for stantly improving its functionalities, it was able to sig- cost-effective solutions, which Eurex Repo could offer nificantly increase its liquidity (with the peak of more to them. The Bundesrepublik Deutschland than EUR 50 billion daily outstanding volume in the Finanzagentur GmbH assisted this effort by demons- Euro market as of November 2005). Since German trating its strong support for the Eurex Repo platform. banks have voiced their support for the Eurex Repo After the number of participants had increased, Eurex platform, it is to be expected that this market share will Repo has seen the highest volume increase among the grow further in the near future.62 European ATS since 2004 thereby attracting larger Nevertheless, Eurex Repo does not control as much international players. These banks such as UBS

30 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

liquidity with its trading platform as BrokerTec. To gain European trading platform. Since 1999, a series of MTS substantial market share in the special German govern- domestic markets modelled on MTS Italy were launch- ment segment, Eurex Repo needs to attract additional ed, expanding the network and turnover of the MTS major international players, convince domestic players Group. The mission of the MTS Group is: to make further use of the repo market as refinancing "to enable institutional trading of European bonds electro- instrument, and statements by the monetary authorities nically through a common trading platform, with the pri- to support the development of the secured lending mar- mary objective of enhancing the liquidity, transparency and ket. efficiency of the European bond markets while minimising Eurex Repo has a major stake in the GC segment. By the cost of trading." 63 introducing the Euro GC Pooling segment, it is the first Today, the MTS system, commonly referred to as market entrant in the secured money market. This has "Telematico", is a market leader in the European bond major benefits to electronic trading and collateral market. management. In this respect, Eurex Repo has been able to take advantage of the Deutsche Boerse Group's inte- In September 2005, Euronext and Borsa Italiana for- grated value chain. After the successful launch in March med a joint venture to acquire a stake in the MTS 2005 with more than 20 percent share of its GC vol- Group. With effect from January 2006, MBE Holding, umes by the end of 2005, this is an advantage over its the joint venture company, became the principal share- competitors. It will be interesting to see how rapidly holder in MTS S.p.A. with an interest of 60.37 per- major UK banks can be attracted by Euro GC Pooling cent.64 In addition, twenty-seven international banks and how volumes will develop. now own shares in MTS S.p.A (39.63 percent) (seven banks chose to further increase their respective share- 5.2.3 MTS GROUP holdings, while three banks became investors for the Founded in 1988, MTS S.p.A, with its operations in first time through the purchase of shares).65 Italy, was the first electronic market for the trading of bonds in Europe. In 1999, MTS and a group of financial intermediaries launched EuroMTS as the first pan-

MTS Group (Repo): As of December 2005

Founded: 1988 HQ: Italy Shareholder: MTS S.p.A – MBE Holding (60.37 percent) and 27 international banks (39.63 percent); MBE Holding is a joint venture between Euronext (51 percent) & Borsa Italiana (49 percent) – Closing of acquisition in November 2005; EuroMTS is wholly owned by MTS S.p.A. Start of Operations: Bonds 1988, Repos (across European markets) October 1999. Products: EU government and major agency bonds. Market leader in Italian repo segment. Current Participants No: More than 190 (mainly Italian banks) are connected to MMF. Liquidity: Approx. EUR 53 billion average daily turnover (single count). CCP: LCH.Clearnet; parallel bilateral transactions without CCP possible. Others: Introduction of new Money Market Facility (MMF) in 2005.

BEARINGPOINT 31 THE ELECTRONIC REPO MARKET 2006

5.2.3.1 Structure

The extensive network of the MTS, which operates in all the Euro-zone countries, allows for the trading of cash, repo, buy/sell backs, basis and spread. The MTS Group operations include the following markets:

EXHIBIT 13. STRUCTURE OF MTS SEGMENTS

Market MTS Segment Government • MTS Amsterdam • EuroMTS Bond Markets • MTS Austrian Market • EuroMTS Linkers Market • MTS Belgium • Eurobenchmark Treasury Bills Market • MTS Denmark • NewEuroMTS (a segment for the • MTS Deutschland benchmark bonds of EU Accession States) • MTS España • Euro GlobalMTS (the market for Euro- • MTS Finland denominated sovereign bonds of non-EU • MTS France countries). • MTS Greece Market • MTS Ireland • MTS Italy • MTS Israel • MTS Poland • MTS Portugal Quasi – • MTS Quasi-Government Market Government Bonds Covered Bonds • MTS Cedulas Market • EuroCredit MTS Source: www.mtsspa.it/content/markets/

Since the last survey, the MTS Group has expanded into as the management and supervision of each market is several new markets. In addition, the MTS Group owns concerned.67 BondVision, a regulated Internet-based multidealer-to- In September 2005, MTS launched the new Money client platform, and MTSNext, the company managing Market Facility (MMF) using its latest TradeImpact the first real time independent pan-European govern- technology. This technology replaces the former repo ment bond indices, the EuroMTS Index.66 market system with a more flexible system to expand its The MTS network connects members of the network to current product offering. The MMF repo platform sup- one interface and order book, allowing them to trade plies modular and configurable architecture granting European debt instruments on one common platform. the simplification of former repo features. It takes The system allows for each of the domestic MTS mar- advantages of a user-friendly and highly configurable kets to adopt their preferred trading specifications as far trading system interface. In addition, the request for

32 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

quote functionality allows anonymous and transparent favour the bilateral trading model offered over the MTS bilateral negotiation with individual counterparties on network. either special or general collateral instruments. Compared with our 2004 Survey, use of the 5.2.3.2 Product Offering LCH.Clearnet/CC&G combined CCP functionality for the Italian government bond market has grown con- The MMF supports special and general collateral repos siderably. At the end of 2005 CCP volumes accounted trading and buy/sell backs of European government for 30 percent of all volumes transacted on the repo bonds, Jumbo Pfand-briefe and Quasi-Government market and this has since passed 50 percent in the first bonds. In addition to the classic repos, MTS supports quarter of 2006. The smaller Italian banks may still pre- buy & sell back contracts, which are commonly traded fer to remain outside the CCP because of the initial in the Italian and Portuguese government markets.68 investments involved to modify their existing infrastructure however the hybrid model of the MMF repo According to MTS, the average daily turnover of the market is able to accommodate both their preference MTS repo platform is approximately EUR 53 billion and that of the larger members of the CCP. (single count; term adjusted basis reached peaks of EUR 175 billion in the first quarter of 2006). About 85 per- This growth in CCP membership and fully anonymous cent of this volume is generated in the Italian repo mar- trading has been reflected in a growth in volumes and ket through MTS Italy.69 Participants state that the trades of longer maturity. depth of the Italian repo market is greater at times than On the other hand, the expansive MTS network places that of the German Bund repo market traded over the MTS Group in a strong position to penetrate the BrokerTec. According to MTS, non Italian repo volu- European market further and while most of its initiati- mes increased by 31 percent and CCP transactions ves to date have focused on the cash government bond increased over 35 percent compared to 2004. trading side, where the MTS network is considered the Another unique functionality of the MMF is that it cre- leading platform in the European markets, the launch ates a hybrid marketplace where both CCP members of the MMF gives MTS the platform to expand its mar- and those members who can only trade bilaterally coe- ket share as well as its participant base outside the xist in a single order book for maximum transparency Italian market. Previous attempts to capture the and depth. This allows for both fully automated anony- Belgian, French and Spanish repo markets on the old mous trading and transparent bilateral trades in a single platform made only little progress because of technical market. restrictions and competition from BrokerTec and Senaf. However, the changes in the corporate structure and 5.2.3.3 Participants strategy of EuroMTS/MTS combined with its launch of To date, the entire MTS network has attracted more the MMF will lead to new developments in the non- than 1,000 members to its fixed-income platform. Of Italian repo markets. the 400 MTS members, more than 190 are connected 5.2.3.4 Evaluation of Current Positioning to the new money market facility. Approximately 100 participants trade repos on a frequent basis. A large per- The MTS Group, having been the first-to-market with centage of these participants are Italian banks, which its pan-European fixed-income platform (EuroMTS) in

BEARINGPOINT 33 THE ELECTRONIC REPO MARKET 2006

1999, is now operating with more than 190 participants tion costs due to decreasing margins in the repo busi- connected to the MMF. Adopting a market model of ness, which should encourage the formation of such a bilateral as well as CCP services over the platform has platform. Market entries of multidealer providers such brought it limited success in the northern European as Trade Web, the U.S.-based retail platform, have been markets. Its primary focus on the fixed-income business planned for the repo market but have not reached the has nevertheless differentiated it from its competitors. European market space to date. During the course of The MTS system has been able to offer cash, basis, our interviews, participants said that with the current spread and repos and buy/sell backs. The cost of unit number of electronic trading platforms already out trading is similar to its competitors. In addition, being there, a consolidation of the ATS, clearing and settle- known to offer narrow spreads over its platform makes ment providers would have to take place before the it one of the leading platforms in the European fixed- retail segment can be automated. income market. The Telematico system, which was introduced in 1988, drew criticism in our 2004 survey 5.3 CLEARING AND SETTLEMENT ISSUES as users felt there system had some disadvantages when A description of the different ATS providers was given compared with the more recently developed BrokerTec in the previous sections. This section will focus on fur- and Eurex Repo systems. The new TradeImpact tech- ther details regarding the clearing and settlement struc- nology and the Money Market Facility have addressed tures of the individual ATS and their corresponding these concerns. Some interviewees were very impressed CCPs. The comparison is based on an overview of the with this new development. MTS should be enable to different CCPs through an illustration of their functio- react quickly to market changes as well as streamline the nalities and how CCPs complement the ATS's trading current trading environment. model. Today, the MTS Group plays a leading role in both the 5.3.1 CLEARING AND SETTLEMENT PROCESS second largest repo market in Europe and second largest DESCRIPTION government bond market in the world. The fact that it is physically connected to the entire European inter- Once a trade has been executed anonymously over an dealer market makes it an alternative to its competitors. ATS, the CCP takes over as the central counterparty to Nevertheless, MTS has to find ways to make its repo that trade. In general, the flow of a repo transaction platform more attractive to its participants outside the after trade execution can be broken down into four Italian markets. One possibility could be to use the net- steps: work of the MTS Group to expand its product offering 1. Registration of trade. outside the interdealer into multidealer-to-client plat- 2. Risk management procedure (risk management form space. This is a step that MTS has already taken in during the course of the trade). the sovereign debt, agency debt, and covered and cor- 3. Determination of net positions and communication porate bond markets with the introduction of of net result to members (settlement netting). BondVision. However, larger banks have to agree to 4. Transaction settlement (instructions issued to post their trading volume onto such a platform since (I)CSDs as well as fails and partials processes). they would make this market more transparent and thus reduce the margins of the market overall. Nevertheless, banks are looking for new ways to reduce their transac-

34 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

EXHIBIT 14. SUMMARY OF REPO TRANSACTION FLOW

Steps in transaction CCP Eurex Clearing AG CCP LCH.Clearnet Limited flow Products • Product offering: German government • Product offering: Austrian, Belgian, Dutch, eligible in bonds, European government bonds e.g. German, Irish, Finnish, Portuguese and UK Instruments Austria, German Pfandbriefe, European government bond as well as German Jumbo covered bonds, Agencies, Euro GC Pfandbriefe and international bonds. Pooling. 1. • All Eurex Repo trades are transferred to • All transactions eligible to clear over the Registration Eurex Clearing/CCP-system. LCH.Clearnet are transferred to of Trade • Eurex Clearing steps in immediately as a LCH.Clearnet Limited either over an ATS or central counterparty as soon as the trade is through a separate matching system executed (open offer). ETCMS.70 • Limited CCP LCH.Clearnet Limited becomes involved in the contractual agreement either by open offer (ATS) or novation (ETCMS). 2. • Pending trades are received from the • Based on the netted positions, LCH.Clearnet Risk trading locations and are transformed in Limited carries out the margin calculation Management net risk positions. Afterwards they are using the SPAN method.71 Procedure considered for risk-based margining. • Margin calls are sent by LCH.Clearnet Eurex Clearing calculates the Current Limited to clearing members’ Protected Liquidating Margin (CLM) and the Payments System (PPS) banks (together with Additional Margin (AM) using the RBM all netted cash positions and any relevant method. coupon payments). • Eurex Clearing calls the margins from the • As margin cannot currently offset all member’s accounts held at Central Banks positions from all markets, cross margining is (Deutsche Bundesbank or SNB) on a not possible. daily basis (together with all netted cash positions and any relevant coupon payments). • Intra-day margining takes place every 15 minutes. • Cross margining with different product types is automatically provided. • Usage of a collateral pool for all products and markets (cross collateralisation). 3. • Since 2005 (Fixed Income CCP 3.0) • LCH.Clearnet Limited will net all delivery Determinati Eurex Clearing offers settlement netting obligations (i.e. start leg, end leg and on of Net facility to their repo customers (incl. substitutions) due for settlement the next Positions Gross Delivery Management) business day. and • In addition combined netting with Eurex • Position (cash and securities) will be netted Communi- Bonds trades is possible. around accounts and instruments (ISIN) and cation of Net • Position (cash and securities) will be shaped into nominal position of up to EUR Result to netted around accounts and instruments 50 million in Europe, EUR 200 million in Members (ISIN) and shaped into nominal position Belgium and GBP 50 million in Sterling. (Settlement of up to EUR 50 million and up to EUR • Cross product netting is not possible. Netting) 250 million for Euro GC Pooling • Balance sheet netting and close-out netting trades.72 possible. • Improved reporting functionalities with CCP 3.0 (e.g. end-of-day and intraday reporting on single trade and net basis). • Balance sheet netting and close-out netting possible. 4. • Eurex Clearing will send its delivery • LCH.Clearnet Limited instructs depositories Transaction instructions on behalf of members to the on behalf of members or, if the depository Settlement individual (I)CSD. Power of Attorney for does not recognise a Power of Attorney both ICSDs. structure LCH.Clearnet Limited will send its • Cash amount/cash management is done side of the transaction to the member’s automatically over the Deutsche depository e.g. in Crest). Bundesbank, Clearstream Banking Lux. • Cash amount/cash management is done or Euroclear automatically over the PPS. • Real-time settlement of overnight Repo is offered. Source: BearingPoint

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Exhibit 14 summarises the transaction flows of the dif- Deutsche Boerse Group has long been keen to win ferent CCPs and explains the differences of the two cle- more repo business. On several occasions during our aring models. interviews, repo traders have complained about the late LCH.Clearnet software delivery issue. Also, members of 5.3.2 SUMMARY − EUREX CLEARING AG VERSUS the European repo council have indicated in the finan- LCH.CLEARNET LIMITED cial press that their willingness to listen to further pro- Compared to our 2004 survey, most of the interviewees mises from LCH.Clearnet is ebbing fast.73 recognised that Eurex Clearing had achieved major Despite all this, LCH.Clearnet has formal plans in place improvements in their clearing services. In our last sur- to launch two new General Collateral products in 2006. vey, the settlement netting and reporting functionality was mentioned as a major disadvantage compared to These new product initiatives will extend the existing LCH.Clearnet's CCP. The launch of Eurex Clearing's repoclear service: Fixed Income CCP, in 2005, met these market demands Delivery-by-Value (DBV) product for the UK gilts for additional functionality. Our current interviewees market. DBV is a mechanism used by CREST, regard Eurex Clearing as a very reliable clearing provi- whereby a member may borrow or lend cash versus der. In particular, its functionalities across its product overnight collateral. The system automatically lines and its low barriers of entry were mentioned selects and delivers securities and retrieves them the during our interviews. In addition, Eurex Clearing has following day over the term of the transaction. DBV introduced corporate as well as other European govern- for gilts is a cash-led market, which is used as a fund- ment bonds in 2005. ing and collateral management tool by major banks In addition, integration into the Deutsche Boerse and investment institutions. Most DBV business is Group has enabled Eurex Clearing to work closely with done short-term and therefore DBV is strongly link- its partners, such as Eurex Repo and Clearstream. This ed to the Sterling money market. DBV is used has supported the development of new functionalities, rather than GC for trades of up to two weeks term. such as Euro GC Pooling. Euro GC product. The Euro GC product is an LCH.Clearnet has been re-organising its fixed-income extension of the DBV for gilts product that could business in an attempt to see off the growing competi- utilise the auto-allocation tools provided by the tion from its rival Eurex Clearing. LCH.Clearnet major tri-party agents. announced its planned delivery of a new clearing plat- According to LCH.Clearnet the launch of DBV for UK form in 2005. During our interviews, major banks gilts is planned for June/July 2006. Both products are reported serious concerns as this delivery is late. The being launched on the existing Repoclear service on a functionalities expected after the merger between LCH non-mandatory basis.74 With this approach LCH.Clear- and the Paris-based Clearnet are not in place, system net focuses on the same UK gilts market segment as improvements have not been delivered and the benefits Eurex Repo does with Euro GC Pooling in the Euro- they were led to expect have not yet been realised. Zone. Whilst these are different currency segments, Eurex Clearing is currently positioning itself to be an there are clearly similarities between both offerings. The attractive alternative to the clearinghouse in London. key difference is that the Eurex Repo offering allows

36 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

participants to manage their central bank money within an (mainly German banks) have found it difficult to the same collateral pool as their inter-bank repo activi- trade with trading departments which are Euroclear ties. clients. This is due to a potential risk of late delivery of collateral. Future developments in this space are awaited with great anticipation. In various efforts, the European Repo Council, the European Central Bank and the major settlement insti- 5.3.3 SETTLEMENT BARRIERS AND CURRENT tutions discussed possible solutions to improve cross- SITUATION border settlement. In January 2006, Clearstream waived Fragmented settlement structure, lack of regulatory its intraday borrowing fees for all borrowers of German conformity and domestic developments in various securities in Clearstream Luxembourg's fails lending European markets are still preventing the creation of a system. This now allows Clearstream's customers to true pan-European repo market. Even though the three deal with banks in UK (Euroclear customers) without major platform providers have increased their market being penalized for failed deliveries due to delays in shares, a market segregation still exists. The result is a overnight processing. Clearstream's decision should market in which banks must sign up for more than one thus increase the level of liquidity available to its custo- platform. This situation excludes smaller banks that are mers and improve interoperability between the domes- often not able to afford the costs that arise in participa- tic and international markets. Euroclear has subse- ting in each individual market. quently waived its intraday borrowing fee from January 30, 2006. According to our interviewees, full inter- Improvements have been achieved in the last couple of operability between the major ICSDs has now been years, e.g. the fully automated day-time bridge for cross- achieved. It remains to be seen, how market perception border settlement between Euroclear and Clearstream will develop in the coming months. Banking Luxembourg implemented in 2004. Until recently, cross-border settlement was still an issue bet- In addition, competition from brokers and client ween the both ICSDs. Banks and dealers trading demand has forced Clearstream to find alternative lend- German government bond repos can settle their trades ing routes. In October 2005, Clearstream launched in three different locations: the domestic CSD or one of ASLplus. Automated Securities Lending is the ICSD's the two ICSDs. Due to the difference in settlement fails lending programme. ASLplus is a parallel system cycles, the custodians cannot always settle overnight. As whereby that pool of securities can also be loaned out in a consequence, the banks sometimes have to borrow the the wholesale market by Clearstream's two chosen con- securities from the ICSDs fails lending program. This tributors: UBS and Citigroup. generates additional costs to the transaction through These two banks were chosen following a lengthy selec- intraday borrowing fees and hampers market develop- tion process, which took almost two years to complete. ment. Furthermore, Clearstream also launched its quad-party The problem was particularly acute for German securi- service. Operated with Citigroup and Barclays Capital, ties because the German government debt (Bunds) is the service enables easier financing of international and the most traded instrument in Europe. Until recently, domestic assets by extending tri-party repo to include trading departments with Clearstream as their custodi- the local agent bank appointed by the cash taker.75

BEARINGPOINT 37 THE ELECTRONIC REPO MARKET 2006

In contrast, Euroclear is planning to launch a single individual strengths and challenges of each of the parti- platform to support securities financing across all mar- cipants. kets of the Euroclear group. Exhibit 15, which is a result of the interviews conducted, displays the views of the participants in order of 5.4 IDENTIFIED STRENGTHS AND importance. This highlights the competitive strengths WEAKNESSES OF COMPETITORS and weaknesses of the three main platform providers, In the previous section, we analysed the individual mar- with the major differences in strengths and weaknesses ket participants in terms of their structure, products and compared to our 2004 survey are highlighted in bold. participants. A summary of these findings produces EXHIBIT 15. IDENTIFIED STRENGTHS AND CHALLENGES OF REPO PLATFORM PROVIDERS

Top Identified Strengths from the Top Identified Challenges from the ATS Interviews Interviews BrokerTec • Market leader in Government bonds • High barriers to entry due to initial high segments (especially German, French investments and UK securities) • Cross-selling becomes difficult because of • High liquidity and narrow spreads minimal liquidity in cash products • State-of-the-art trading technology and • Delay of LCH.Clearnet’s software functionality delivery for new CCP release (originally • User friendly system interface and high planned for end of 2005) hinders further quality of sales and marketing staff product development • Outstanding customer service Eurex Repo • Significant increase of volumes in • Low volume in the Bund segment 2005; market leader in German • Limited number of major international Jumbo-Pfandbrief segment players esp. in Euro GC Pooling segment • Most innovative business and product strategy: Pioneer in secured money market segment with Euro GC Pooling • Low barriers of entry and open-shop design and independent governance structure set prerequisites for high participant base with small to medium- sized banks • Major improvements of CCP functionality (Eurex Clearing) e.g. settlement netting • Participation of German Finance Agency (Bundesrepublik Deutschland Finanzagentur GmbH) MTS Group • Dominant position in Italian • So far, limited use of CCP government bonds segment • Important role in repo segment only in • Broad range of instruments Italian market • High domestic market penetration through integration of central banks and loyalty of major players • Each clearing and settlement procedure in accordance to domestic standards • Compared to 2004, customer service improvements have been made

Source: BearingPoint

38 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

purpose of influencing a shareholder vote is not 6. THE SECURITIES LENDING MARKET - regarded as acceptable market practice.76 A PRIMER Loaned securities on a unsecured basis are rare. Most securities loans are collateralised - either with other 6.1 DEFINITION securities or with cash deposits. Where lenders take Securities lending describes the market practice by securities as collateral, they are paid a fee by the borrow- which, for a fee, securities are transferred temporarily er. By contrast, where they are given cash as collateral, from one party (the lender) to another (the borrower), they pay the borrower interest but a rate (the rebate and where the borrower is obliged to return them either rate) that is lower than market rates. This allows them on demand or at the end of any greed term. The bor- to reinvest the cash and make a return. Pricing is nego- rower will collateralise the transaction with cash or tiated between the parties and would typically take into other securities of equal or greater value than the loan- account factors such as supply and demand for the pared securities, in order to protect the lender against ticular securities, collateral type and flexibility, the size counterparty credit risk. Some important consequences of any manufactured dividend and the likelihood of the arise from the nature of securities lending transactions: lender recalling the securities early.

Absolute title over both loaned and collateral securi- 6.1.1 BUSINESS MOTIVATION ties passes between the parties, therefore these securities can be sold outright and "on loan". Both prac- 6.1.1.1 The Lending Motivation tices are commonplace and an intrinsic part of the functioning market. The supply of securities into the lending market comes mainly from the portfolios of beneficial owners, such as Once securities have been acquired, the new owner pension and investment funds, insurance companies, of them has certain rights. For example, it has the custodian banks, tri-party agency lenders. Underlying right to sell or lend them on to another buyer and demand to borrow securities depends largely on the tra- vote in AGMs. ding activities of dealers and hedge funds.

The borrower is entitled to the economic benefits of The importance of intermediaries in the market partly owning the loaned securities (e.g. dividends) but the reflects the fact that securities lending is a secondary agreement with the lender will oblige it to make activity for many of the beneficial owners and underly- ("manufacture") equivalent payments back to the ing borrowers. Intermediaries provide valuable services, lender. such as credit enhancement and the provision of liqui-

A lender of equities no longer owns them and has no dity, by being willing to borrow securities at call while entitlement in vote. But it is still exposed to price lending them for term. They also benefit from econo- movements on them since the borrower can return mies of scale, including the significant investment in them at a pre-agreed price. Lenders typically reserve technology required to run a modern operation. the right to recall equivalent securities from the bor- Intermediaries include custodian banks and asset mana- rower and will exercise this option if they wish to gers who lend securities as agents on behalf of benefici- vote. However, borrowing securities for the specific al owners, alongside the other services provided to these

BEARINGPOINT 39 THE ELECTRONIC REPO MARKET 2006

clients. Some specialist securities lending agents have index arbitrage play a significant role in the market, also emerged. Agents agree to split securities lending along with the financing requirements out of active revenues with lenders and may offer indemnities against market making activities of the stock. This financing certain risks, such as borrower default. drives many transactions - the lender is seeking to borrow cash against the loaned securities, whether using Another category of intermediary is dealers trading as repo or cash-collateralised securities lending. Another principals. Dealers intermediate between lenders and large class of transactions not involving a short compri- borrowers, but they also use the market to finance their ses those motivated by lending in order to transfer own wider securities trading activities. They may seek ownership temporarily, an arrangement which can work returns by taking collateral, counterpart credit or liqui- to the advantage of both lender and borrower. dity risk, for example, by lending securities to a client for a period while borrowing them on an open basis 6.1.1.3 Trading & Settlement with a risk of early recall by the lender. Through their The securities lending market is a hybrid between a rela- prime brokerage operations, they also meet the needs of tionship-based market, and an open, traded market. hedge funds where the borrowing of securities to finan- Historically, transactions were negotiated by phone but ce positions has grown rapidly. For beneficial owners, increasingly securities are broadcast as available at parti- there are a number of different possible routes into the cular rates using email or even electronic platforms such market. These include: using an agent (custodian bank, as EquiLend or Eurex SecLend. Loans may be either for asset manager or specialist) to manage a lending pro- a specified term, or more commonly, open to recall, gramme; auctioning a portfolio to borrowers directly; because lenders typically wish to preserve the flexibility selecting one principal borrower; establishing an "infor fund managers to be able to sell at any time. house" operation and lending directly; or some combi- Settlement occurs on a shorter time frame than outright nation of these strategies. transaction, so that securities can be borrowed to cover 6.1.1.2 The Borrowing Motivation a sale. In most settlement systems securities loans are settled as Historically, settlement coverage (fail-driven lending) "free of payment" deliveries (in contrast to delivery-ver- has played a significant part in the development of the sus-payment in case of repo) and the collateral taken is securities lending market. Particularly for less liquid settled quite separately, possibly in a different payment securities (e.g. corporate bonds and equities with a or settlement system, and maybe a different country limited free float) settlement coverage remains a large and time zone. This can give rise to "daylight exposure", part of the demand to borrow. a period in which the loaned securities have been deli- The so-called naked shorting of securities is a high-risk vered but the collateral securities have not yet been business reason for borrowing. The number of funds received. To avoid this exposure some lenders insist on relying on naked shorting is relatively small and there- pre-collateralisation, so transferring the exposure to the fore probably a declining business stream for borrow- borrower.77 Settlement of securities lending includes the ing. The range of arbitrary positioning such as pairs handling of corporate actions, dividends and interest trading/relative value arbitrage, convertible bond arbi- claims as the major part of the securities maintenance as trage, tax and dividend reinvestment plan arbitrage or well as netting and collateral substitution transactions.

40 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

6.1.1.4 Risk Management against cash - although this distinction is not always clear cut. Another main difference in these markets is Financial risk of lending transactions to be handled by the universe of securities to be exchanged. Securities the lender are primarily managed through the use of lending includes almost every tradeable equity or fixed collateral and netting. Balancing collateral value by income product, whereas repos focuses primarily on adopting haircuts requires daily mark-to-market of the highly rated government bonds. Reinvestment of cash security and corresponding systems to be in place. collateral has been an integral part of securities lending When taking cash as collateral: A lender taking cash as business for many years, particularly in the U.S.. collateral pays rebate interest to the securities borrower. Reinvestment opportunities have often driven the So the cash must be reinvested at a higher rate in order underlying securities lending transactions.78 to make any net return on the collateral aspect of the In some ways, repo and securities lending are similar transaction. Expected returns can be increased by rein- products. They differ in terms of level of standardisa- vesting in assets with more credit risk or longer maturi- tion, underlying collateral and legal agreements as well ty in relation to the likely term of the loan, with a risk as in terms of different treatment for accounting, finan- of loss if market interest rates rise. Many of the large cial reporting and risk management. securities lending losses over the years have been associ- ated with reinvestment of cash collateral. The following table describes the characteristics and differences of repo and securities lending transactions (see Transaction collateralised with other securities: Added to Exhibit 16).79 the risk of errors, system failures and fraud that are always present in many markets, problems can arise 6.2 ELECTRONIC SECURITIES LENDING from the default of a borrower. Following a default the TRADING - COMPETITOR PROFILES lender must sell its collateral in the market in order to raise the funds to replace the loaned securities. It will As of January 25, 2006, according to the Securities lose money if the value of the collateral securities falls Lending Performance survey of performanceexplorerTM, relative to that of the loaned securities. Generally, the the value of securities available for lending totals USD risk of loss is greater if it takes longer to close out these 7,592 billion. Approximately USD 3,185 billion of this positions, if the collateral or loaned securities are is in the form of government and corporate bonds; wrongly valued, if the markets for these securities are whilst USD 4,407 billion is in the form of U.S., illiquid or if the market prices of the lent and collateral European and Asian equities as well as Depository securities do not tend to move together. Receipts and Exchange Traded Funds.80

6.1.2 REPO VERSUS SECURITIES LENDING Most of today's securities lending transactions are agreed by phone. The use of electronic trading platforms is In contrast to securities lending transactions, repo trans- increasing slowly. This is because trading over an elec- actions are used for the temporary transfer of securities tronic platform requires a minimum degree of standar- against cash. Originally, securities lending was more dization. As a consequence, following a rather difficult motivated by the desire to borrow specific equity or start, electronic securities lending platforms are gaining fixed income securities. Repo is driven by the desire to more acceptance. borrow cash (GC market) or securities (special market)

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EXHIBIT 16. CHARACTERISTICS OF REPO VERSUS SECURITIES LENDING

Characteristics Repo Securities Lending Formal Method • Sale and repurchase under terms of • Sale with agreement to make subsequent of Exchange master agreement reacquisition of equivalent securities Legal • TBMA/ISMA Global Master • GMSLA Documentation Repurchase Agreement (GMRA) • Bilaterally adjusted agreements • EMA (European Master Agreement) Form of • Securities versus cash • Securities versus cash collateral Exchange (delivery versus payment) • Securities versus securities collateral • Cash versus general collateral (sometimes free of payment or delivery securities versus delivery) Motivation • GC market: Financing (cash-driven) • Security specific (securities driven) • Special market: Security specific (securities driven) Typical Type of • General Collateral (mainly • All asset classes possible (e.g. equities, Underlying government bonds and Jumbo- government bonds, corporate bonds, Pfandbriefe; equities or corporate mortgage bonds, letters of credit, DBVs, bonds possible) or acceptable CDs, ETFs) collateral as defined by buyer Maturity • Mostly term traded • Mostly on open basis Collateral • Yes in case of GC repos (determined • Yes (determined by the borrower) Substitution by the original seller) • Not possible for special repos Payment • At Maturity • Monthly P/L • Quoted as repo rate, paid as interest • Quoted as lending fee; in case of cash Return Payable on the cash collateral rebate interest (i.e. return paid on cash: lower than comparable cash market interest rates) Dividends & • Paid to the original seller • Manufactured to the lender Coupons Effects on • Always effects liquidity and balance • If free-of payment transactions no effects Liquidity/ sheet on liquidity, but always effects on balance Balance Sheet • Cash flow: Effect like simple sheet unsecured funding • Cash Flow: Effect like simple unsecured funding Risk Securities provider/cash taker Lender Management • Issuer risk • Issuer risk • Market risk of collateral • Market risk of collateral • Counterparty risk • Counterparty risk Securities taker/cash provider Borrower • Counterparty risk • Counterparty risk Source: BearingPoint and ISLA (www.ISLA.org)

42 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

There are a number of securities lending platforms avai- this platform: The Abbey National Group, ABN lable to banks. The following section outlines the func- AMRO, Mellon, Bank of New York, Barclays Global tionality and product coverage of the three platforms Investors, Bear Stearns, BNP Paribas, Credit Suisse First most frequently mentioned by interviewees: EquiLend, Boston, Deutsche Bank, Fortis Bank, Goldman Sachs, Eurex SecLend and SecFinex.81 In addition, there are Insight Investment Management, JPMorgan, KAS various successful third party lending programs such as Bank, Lehman Brothers, Merrill Lynch, Morgan agency and principal lending for clients available in the Stanley, Nomura, Northern Trust, Robeco, Société market (e.g. State Street and Dresdner Kleinwort Général Asset Management, State Street, Timber Hill Wasserstein offer agency lending business for its and UBS.84 clients).82 Such third party programs are not discussed The platform is message-based, allowing borrowers here.83 looking for specific securities to contact lenders directly 6.2.1 EQUILEND to try and fulfil their trades. If the first lender contacted does not have the stock, the request will go automati- EquiLend was founded in 2001 by a group of 10 finan- cally to the next lender on the list until it is closed. For cial institutions. Its platform has been operational since high volume and simple transactions the deal can be 2002. Today, EquiLend Holdings LLC is made up of completed automatically. The platform allows point-to- two subsidiaries: EquiLend LLC and EquiLend Europe point connections between counterparties to transact Limited. EquiLend's mission is "to optimize efficiency in with each other through a secure "hub". In addition, the securities finance industry by developing a standardized EquiLend has been working with vendors to develop and centralized global platform for trading and operations means for clients to more easily access its platform's services". liquidity. EquiLend's platform was designed to process equity Since its launch in June 2002, new services have been securities transactions between borrowing and lending added or upgraded. Such as the new billing delivery ser- institutions. Expansion into the fixed income segment vice, which allows EquiLend clients to send monthly started in 2005. electronic bills to each of their counterparties, elimina- Thereby, the platform increased efficiency by standard- ting the need to print and mail hard-copy statements. ising, centralising and automating front- and back- Due to customer demands, trading activity was expand- office processes. ed in 2005, so that participants are now able to trade U.S. Treasury and agency securities. In addition, in EquiLend was initially perceived by the industry as only March 2005 a new service called "AuctionPort", was viable for large firms. Use of the platform was initially launched. This functionality provides an alternative too expensive for many banks. However, EquiLend has method for distributing a securities portfolio at more subsequently changed its model. Now buyers do not attractive terms than those obtained through bilateral have to buy the whole package, making it more accessi- agreements with principals.85 Furthermore, "Auto ble to smaller players. Especially in 2005, EquiLend has Borrow" provides automatic borrowing capability to seen growth in Europe. Since its launch, EquiLend has firms with lower trading volumes. more than doubled its client base and strengthened its market position in the global securities finance community. Currently 23 financial institutions are trading on

BEARINGPOINT 43 THE ELECTRONIC REPO MARKET 2006

6.2.2 EUREX SECLEND including high-speed cross-border settlement. In addition to the SIS settlement process, market participants Eurex SecLend is an electronic market place for the may use their existing bilateral process flow and collate- lending and borrowing of equities and fixed-income ral baskets in place. products. Eurex Zurich AG launched Eurex SecLend with a "Lenders Day" on 10 November 2005. Around 6.2.3 SECFINEX 11 banks placed securities on the market for securities SecFinex was established in 2000 by a group of industry lending via Eurex SecLend, with a volume of USD 195 professionals with the aim of bringing electronic solu- billion. Securities from G7 countries, as well as from the tions to increase market liquidity, transparency and effi- key European countries and supra-nationals were pro- ciency, while maintaining impartiality. More recently vided to the market for lending. The ratio of equity and Fortis and Société Générale Corporate & Investment debt securities for lending was around 2:1. The range of Banking have taken a stake in SecFinex. Currently more 86 products covered both GC as well as specials business. than 40 financial institutions participate in SecFinex's Currently 18 international banks use this new platform, internet platform, including a cross-section of lenders, providing USD 50-80 billion available securities daily. borrowers and intermediaries, including some of the

87 Subsequently, the product portfolio spans the spectrum major securities finance players in Europe. of fixed income and equity securities, including ETFs SecFinex provides an efficient and impartial trading from all major industrialized nations as well as emerging platform for securities financing professionals to meet markets. Standardized securities baskets, such as the G7 and execute trades worldwide in Dutch, French, government bond basket, contribute significantly to the German, Irish, Italian, Japanese, Spanish, Swedish, development of this market segment, in particular via Swiss and UK equity markets. the acceleration of the entire trading, settlement, and The SecFinex system offers traders access to three diffe- collateral value chain. rent markets:

The system includes fast two-way quotation, order The Order Market is a revolutionary new way to books and standardized interfaces for easy position conduct securities finance. All information on the upload and integration into banks in-house systems. Order Market is presented anonymously. Names are Eurex Repo participants can use their existing infra- only exchanged to the counterparties after a trade is structure for securities lending via Eurex SecLend. agreed. Thus, no further IT investment is involved. In this way, The Private Market provides an easy and efficient Eurex supports the entry of small and medium-sized way for lenders and borrowers to put their current banks to this highly profitable securities lending and business online. A borrower can easily search the borrowing business. availability of a particular stock across the entire Beyond direct access to this electronic securities lending lender base. Searches show not just who has the and collateral trading market, Eurex SecLend offers stock, but if an agreement is in place, the dividend financial institutions fully integrated trading, settle- they require and the price at which the lender is will- ment, and collateral management in collaboration with ing to lend the position. SIS SegaInterSettle. SIS SegaInterSettle provides a wide selection of settlement and loan management services,

44 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

The Auction Market allows a firm with a long posi- 7.1 BEST PRACTISE CORE ELEMENTS tion to create its own auction determining the start- On the basis of discussions carried out with market ing time of the auction, the amount to be auctioned, experts, BearingPoint derived a "best practise approach" the acceptable collateral, the required dividend rate, for the trading, clearing and settlement of repo transac- a reserve price and the start and end (if applicable) tions involving latest developments and technologies. dates, as well as inviting its counterparties to bid. This approach was based essentially on the best systems In Summary and processes of key market participants in Germany, England and Switzerland. Consequently, it allowed for EquiLend and SecFinex are more messaging systems to the bank-specific characteristics of each country. The facilitate securities lending processes, whereas Eurex approach for the front office could be as shown in the SecLend is an advanced electronic trading platform. All exhibit below. are solutions developed to meet the needs of their origi- For ATS trades, there is complete STP available: nal respective U.S. and European home markets and automated upload of priced positions into the ATS compliment each other. It will be very interesting to see through the front-office systems or special message how EquiLend will function in the fixed income arena broker. After the trade has been executed, the trade and how Eurex SecLend will continue to develop. It gets automatically transferred to the front-office remains to be seen how SecFinex will continue to deve- system for later processing. lop its business. OTC transactions must still be entered manually

7. INTEGRATION OF REPO TRANSACTIONS into the front-office system. Before a transaction takes place, the trader checks the counterparties' credit lines and the respective legal framework in the In earlier sections of this survey, we pointed out the trading system. (In the case of ATS transactions, increase of ATS transactions since our last survey. In only limits to CCPs are checked. The respective particular, electronic trading systems employing CCPs CCP assumes certain failure risks and makes limit have gained widespread acceptance in the repo commu- surveillance easier.) After trade execution, the front- nity. Banks can take advantage of minimising the coun- office system takes over and uses data from the terparty risk by employing CCPs together with the master system and pre-deal check. By means of greatest possible STP through an ATS. Another trend intelligent default mechanisms, trades can be enter- developing in the European marketplace, which we ed within a very short time. When a trade has been highlight in our study, is an increase in the acceptance entered, inventory is automatically updated. of tri-party agents. Tri-party agents enable banks to refi- Tri-party services are used intensively. On a daily nance themselves more effectively and alleviate some of basis, trading supplies tri-party agents with a colla- the operational burdens of settling a repo transaction. teral pool. The tri-party agent trades the collateral However, through our discussions about these develop- on behalf of the client. When a transaction has been ments we have so far not mentioned how leading banks concluded, inventory is automatically updated via have integrated these technologies into their front- and Swift. The agent carries out all other clearing and back-office infrastructure. settlement. As a result, there is an outsourcing effect in the front- and back office.

BEARINGPOINT 45 THE ELECTRONIC REPO MARKET 2006

EXHIBIT 17. BEST PRACTISE TRADING - HIGH-LEVEL MODEL

Automatic/Alternative Trading Systems (ATS) Information Systems BrokerTec Eurex Repo MTS Voice Broker eSpeed Reuters Garban

Bloomberg FO system position / Quotes GFI

ICAP Pre-deal check Best Practice Description Automatic up- and downloads to ATS systems Real-time overview and evaluation of inventory FO system Trader OTC/Direct Automatic publication in info systems entry Up-to-date price information from info Autom. systems FO system Bank A credit check Automated pre-deal checks Junior/ ATS trades taken over per download into the Support Bank B front-office system and send to back-office Autom. transaction system per STP without further checks entry Bank C OTC deals checked by trader support FO system deal check

automatic flow manual flow

Manual Automat. Tri-Party Repo Person Process Process FO-BO-Interface

Source: BearingPoint

Once the front-office system has processed the trade, Automated confirmation check: Due to short-term the middle-office or, for many banks, the back office transaction maturities and short clearing and settle- takes over. The process could be as shown in the exhibit ment cycles, manual confirmation check only takes 18 below. place in case of forward repos or free-of-payment transactions. Main transaction checks take place The back-office system initiates all necessary boo- during settlement matching (value date -1). The kings and automatically processes transactions to the automated confirmation check is done with the use clearing agent. What remains to be checked is set- of ATS reports. tlement only (employees concentrate on dealing

with exceptions and non-standard transactions). In Online settlement checks in the back-office system the back-office system, automated technical support are done by means of feedback from the clearer. of standard processes - such as pair-offs, CCP clea- Only those transactions that have not settled are ring and settlement matching proposals, and colla- called up. In an attempt to solve the problem, the teral substitution - are guaranteed. respective employee informs the counterparty. Other transactions are not in need of manual repro- There is a dedicated depository management. cessing. Certain persons or teams act exclusively and in a proactive manner to optimise position-keeping at the depositories.

46 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

EXHIBIT 18. BEST PRACTISE BACK OFFICE - HIGH-LEVEL MODEL

CHF Tri-Party repo Eurex ATS FO-BO interface transactions Repo Best Practice Description OTC transactions Two-way interface There is a two-way interface between front-office and back- Cash office systems for real-time booking matching of inventory Back-office system There are interfaces to all Reporting relevant clearing institutions and system/reports CSDs/ICSDs Most of the reporting is done via Swift standard Collateral Check of counterparty management confirmations only for forward repos; ATS reports and CCP settlement matching only Manual actions only in case of Eurex LCH.Clearnet exceptions or fails Clearing All ATS transactions via STP CHF Tri-Party Tri-party repo leads to maximization of ticket numbers SIS with low volumes and narrow spreads as well as reduction of back-office resources CSD/ICSD

Other CBF/CBL EOC domestic External Internal Interface system system

Source: BearingPoint

7.2 CURRENT SITUATION highest degree of automation, and German-based banks. One key differentiation is the way German The described core elements of best practise processes banks have integrated tri-party services. In the course of illustrate in a simplified manner how a bank can imple- our analysis we have seen that most banks still have pro- ment repo transactions in its particular infrastructure. blems with fully automated trade processing of tri-party This best practise approach is a combination of diffe- trades. When using a tri-party agent, it is important to rent front- and back-office practises sampled during the take advantage of the outsourcing effects in the back course of our survey. Each bank has its variation of the office, which German banks have so far not been able to best practise processes. For example, some banks have realise to their full extent. One important factor is implemented a middle-office, some have not. In some German accounting regulations, which is difficult to banks the front-office system can carry out the upload apply for this transaction type. Banks have to adjust and download functionalities into the ATS, whereas their accounting infrastructure and systems to fully uti- other banks have an intermediary system transferring lise the advantages of tri-party agents. the trade in and out of the ATS. All leading banks, however, share the level of automation to some extent. Another major difference we see is the use of ATS by the The following exhibit 19 summarises the situation in market leaders and second-tier banks, such as Landes- the different repo front offices. banken and other more domestic players. Currently, benchmark players process more than 60 percent of This table reveals that a distinction needs to be made their repo transaction count via electronic trading plat- between London-based banks, which have reached the

BEARINGPOINT 47 THE ELECTRONIC REPO MARKET 2006

EXHIBIT 19. BEST PRACTISE TRADING - EXAMPLES

Best Practice Trading - Examples

Element Market Leaders London Market Leaders Germany

Counterparty More than 70 percent of all Up to 60 percent of all transactions transactions (count) are done via ATS (count) are done via ATS with existing with existing interfaces to FO and BO interfaces to FO and BO systems as systems as Straight-Through- Straight-Through-Processing. Processing. Uploads/downloads Automatic upload of real-time priced Automatic upload of real-time priced positions in the FO system into the positions in the FO system into the ATS ATS system, afterwards automatic system, afterwards automatic download download into FO- and BO systems. into FO- and BO systems. Tri-Party agents Intensive use of Tri-Party agents for Increasing use of Tri-Party agents: Due trades with lower trading volumes and to more time and efforts necessary for smaller spreads. Fully automated generating bookings, banks cannot clearing and settlement. benefit from positive outsourcing results. Business driver/business Repo predominantly used for profit Repo predominantly used for profit motivation maximisation. Strong orientation contribution and balance sheet control. towards corporate bonds. Increasing demand for credit repo. Interfaces FO-BO Fully automated interfaces Most banks have or are implementing system fully automated interfaces; quote machines implemented or in progress to be implemented.

Source: BearingPoint forms by using CCPs.88 In the medium term, according banks' structures and sizes). However, for banks that to the head traders of the leading players, they are have not realised the STP capabilities, the ticket count expecting to execute more than 75 percent of their is closer to 40 to 50 tickets a day for the same transac- transaction count (not volume) over an ATS.89 In the tion type. case of second-tier banks, the number of ATS tickets lies Banks benefit from the advantages that electronic repo between approximately 30-40 percent. The reason for trading offers over a CCP as they can price their posi- this discrepancy lies in the fact that these banks have not tions and automatically upload them into an electronic yet established automatic links to the ATS, therefore not trading system. Quote machines and multi-market realising the STP capabilities of entering a ticket elec- systems, so-called gateways, are already implemented or tronically in the bank's front- and back-office systems. in implementation by top market players. These For the key players in the market, the number of traded systems enable the traders to view and access different tickets (standard transactions) per trader per day is be- electronic markets in order to up- and download posi- tween 100 and 150 (taking into account differences in

48 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

tions (best price execution) through a single trading securities lending transactions without manual inter- screen (e.g. ION Trading, icubic). After the deal is con- ventions (e.g. cross-currency repos, index-linked repos, cluded over an ATS, all information will be routed to floating repos, convertible repos). Trading and clearing, the front-office system via an electronic link. The infor- pricing, haircuts and margining for repos all still pose mation is then automatically processed and transferred challenges in emerging markets, such as Poland, Turkey, to the back-office system, which monitors clearing and Hungary. settlement. Settlement netting of CCP transactions is The level of automation of London- versus German- done automatically without any manual intervention, based banks, as well as the difference in size, is further thereby realising vital cost reductions. Given the path to noticeable within the back-office processes. The exhibit further realising STP, most banks have implemented below summarises the main differences in the back offi- integrated real-time collateral management systems for ce. individual asset classes (e.g. ANVIL, Algorithmics). Here again, market leaders in both countries have Major banks are able to transact various types of repo or reached a high level of STP processing in their back of-

EXHIBIT 20. BEST PRACTISE BACK OFFICE - EXAMPLES

Best Practice Back Office – Examples

Element Market Leaders London Market Leaders Germany

Structure of back No separate repo settlement; instead No separate repo settlement; instead office integration in the fixed-income area. integration in the fixed-income area. Depositories Special teams deal exclusively with Special teams deal exclusively with management depositories. Claim Management is depositories. Claim Management is organised outside of clearing and organised outside of clearing and settlement in a special Claim settlement in a special Claim Management department. Management department. Netting Can take full advantage of netting Manual steps still necessary, therefore capabilities thereby saving 5 percent of little cost reduction. the settlement cost. Work organization Entry check Entry check (only in case of OTC-trades), (only in case of OTC-trades), matching check and processing of matching check and processing of settlement fails. settlement fails. Verification of No verification of counter Verification of counter confirmations counter confirmation in case of standard only done in certain cases confirmation transactions. In all other cases, trade (OTC > = SN/1 week, forward verification takes place via settlement repos and free-of-payments). Otherwise, matching. trade verification takes place via settlement matching or via automated ATS reports.

Source: BearingPoint

BEARINGPOINT 49 THE ELECTRONIC REPO MARKET 2006

fice. The front-office system automatically forwards repo business (see also the discussion of tri-party transactions to its back-office system. It is no longer agents), thereby putting German banks at a disadvan- necessary to duplicate entries. All ATS transactions, tage to their foreign counterparts. apart from "exceptions" that require a manual process, Finally, smaller banks that cannot justify the expenses and all steps in the back office right up to matching and necessary to fully integrate repo trades in their infra- settlement are done in a fully automated way. In this structure have to deal with additional operational bur- process, the back office mainly has a control function dens. For example, by not realising the full STP capabi- only. Since some of the workload is taken off the back lities of the ATS, banks have to check the trade infor- office, open capacities can be used for optimising pro- mation between the internal and external systems cesses, such as dedicated depositories management. manually. According to a survey conducted by With key players in the market, repo clearing and set- BrokerTec, the estimated cost reduction realised tlement is integrated in the fixed-income back-office through the savings in internal processing by linking to area. As a general rule, there exists no separate an ATS are about 60 percent. Up until now, smaller repo/securities lending back office. To guarantee effi- banks were not able to realise these cost reductions. For cient depositories management, leading players have set this reason, BearingPoint has established a competence up special teams that deal exclusively with portfolio centre to assist banks in tackling these problems optimisation at the respective depositories. Claim without having to invest heavily in new infrastructures management takes place outside of clearing and settle- while enabling them to administer repo trades in their ment in a special claim management department. The back office. We assist banks in integrating an ATS, find back office checks trade entries only in the event of cost-effective ways to realise the benefits of settlement OTC transactions. Within the trade confirmation pro- netting, and look at current processes and regulations to cess, however, we noticed a key difference between optimise their trade processing. London- and German-based banks. London banks have With these solutions, we can help second-tier banks agreed to check their trading information through the compete with the market leaders in the business. settlement matching process because of cost-cutting measures. Conversely, German banks, which are requi- 7.3 MANUAL PROCESSES OF SMALL AND red by law to check every OTC transaction with a MEDIUM SIZED BANKS maturity greater than T+2, are not able to realise these cost savings. In fact, German banks have problems con- Electronic repo and securities lending trading offers forming to the regulations set forth by regulatory autho- banks the potential to reduce costs through extensive rities, such as the Bundesanstalt für Finanzdienstleis- process automation and reduction of manual interven- tungsaufsicht (BAFin), since foreign banks (especially tions. Many small and medium sized banks, however, London-based banks) often do not confirm the trade cannot and do not manage the necessary collateral anymore. This has made the trade confirmation process required. These banks tend to enter the repo market but often an unnecessary step in transacting a repo. the majority of transactions is done on an unsecured basis. Most of them will continue to do so until they are In addition to the previously mentioned regulatory forced to collateralising their exposure. requirements, there are accounting and other regulations, which are not fine-tuned to the specifics of the

50 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

As a consequence, small-to-medium sized financial for only approximately 1 percent of institutional refi- institutions cannot easily gain the full benefits of elec- nancing volumes. The reason for this limited use is due tronic trading. They lack the critical mass to justify the to lack of significant effects from the removal of the considerable investments in IT infrastructure and pro- state guarantee and the Anstaltslast since July 2005. cesses. The daily average number of executed repo trans- The instruments for unsecured refinancing have so far actions for many of these institutions is in single digits. been sufficient to cover the current liquidity demand. As described in the Best Practice Approach, and based So far only a few Sparkassen und Volks- und Raiffeisen- on BearingPoint's previous project experience, signifi- banken have made use of the potential of unsecured cant investments are only made after more than 20 securities lending to generate additional revenue. tickets per day. Credit risk has not played a significant role between This context explains why many small-to-medium sized institutions in the Sparkassen-Finanzgruppe. However, financial institutions do not see the relevance of the Best external refinancing in the money and capital markets is Practice Approach to their business. It is more impor- requiring increased secured transactions. This has impli- tant for them to ensure that all necessary manual steps cations for the refinancing of e.g. Landesbanken and are aligned. This section is particularly relevant for subsequently for the entire liquidity of the Sparkassen- banks, which only make limited use of the repo and Finanzgruppe. The provision of liquidity through se- securities lending market or who are new to this market cured transactions is therefore increasing in importance segment. for all parts of the Sparkassen-Finanzgruppe. The exhibit below outlines all the necessary steps for Despite the current arrangements for liquidity provision trading and settling repos and secured securities lending within the Sparkassen-Finanzgruppe, the cost of short- transactions. These transactions are different from the to-medium term refinancing for Sparkassen could beco- unsecured securities lending transactions (without cash me more expensive in the future. Compared to un- collateral), which are executed to generate additional secured transactions, secured money market transac- revenues (basis points) for the collateral provider tions have spread advantages given their risk reduction through the loan of depot A securities. The liquidity and securing of liquidity, especially as credit risk is argument, in contrast to repo or secured securities lend- minimised and additional requirements are always ing transactions, is more relevant to this business. The covered with securities. key difference lies in the valuation of the underlying securities during the term of the transaction, the margining. Mark-to-market only applies to repo and securities lending transactions. See Exhibit 21 for a more detailed overview of these differences.

In the case of many small-to-medium sized German banks (e.g. Sparkassen und Volks- und Raiffeisenbanken) the processes outlined below are all carried out manually. Interviews have found that repos, tender and securities lending in the Depot A area for Sparkassen account

BEARINGPOINT 51 THE ELECTRONIC REPO MARKET 2006

EXHIBIT 21. MANUAL PROCESS FLOW OF REPO TRANSACTION

Manual Process Flow of Securities Lending Transactions Involved Departments Front Office Back Office Risk Controlling Phase Process Description Regulatory Reporting / Accounting Obtain market data & price information Calculate required liquidity Initiation Monitor available collateral portfolio

Check contract with counterparty Pre-Deal- Check Check counterparty limit

Conclusion of transaction & money disposition Entry of transaction data (e.g. selection of security, nominal value, maturity, interest rate, counterparty, delivery instructions)

Deal Entry P/L Analysis Update position keeping Review liquidity management Forward ticket data to back office

Plausibility check & check of completeness Trade In case of inconsistencies consultation with front office and if necessary correction or cancel of trade Validation Trade entry in back office system

Fair value verification (depending on GC or special trade) Monitoring Send confirmation to counterparty Check incoming confirmation of counterparty

Charge on counterparty limit Transfer security & purchase price Create delivery instructions (free of payment/delivery vs. payment instructions) Preparation of regulatory reporting Execution of financial reporting requirements (month/year end closing) Margin of securities (mark-to-market) If necessary margin calls Clearing & Continuous monitoring & control of settlement process Settlement Update nostro & customer assets/accounts Portfolio balancing In case of delivery failure, revise fails

Continuous monitoring & control of payment transactions

Repurchase/back transfer of securities and booking of business transaction at end of maturity

Lead function Support function

Source: BearingPoint

52 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

Asset Managers Emerge As Potential Target Group Asset managers can benefit not only from securities lending, but also from repo trading. Hedge fund companies are already a major player in the repo and securities lending market. However, repos are, so far, not widely used in the German fund industry. Until now, German asset managers use securities lending transactions to increase their portfolio profitability. By lending collateral they earn additional basis points (e.g. lending fee). However, in such transactions, the collateral provider does not receive liquitity which could than be invested. More recently, in addition to several other money market products (securities lending, floaters, commercial papers, debentures, asset swaps or currency forwards), some major German fund companies are increasingly transacting repos. They primarily trade bilaterally and only a few of them are connected to electronic trading platforms with CCPs. One reason for this is, as described in the previous section, that critical mass for investments in interfaces has not yet been achieved. Example for benefits of repo transactions: Cash income received from a repo transaction by the collateral provider can be invested in other, more profitable, money market instruments (e.g. mortgage bond floater with identical repo maturity). Significant pick-ups against EURIBOR (4-8 bps) can be achieved using repo deals to exploit spreads between EONIA-swaps and Euribor-fixings. This example shows the increasing importance of secured financing, recognizing its major advantages in terms of profitability with minimum risk in trading. However, the efficient integration of the repo and securities lending transactions will be key in order to maintain profitability.

BEARINGPOINT 53 THE ELECTRONIC REPO MARKET 2006

direct market share will stay at current levels in the 8. OUTLOOK medium term.

Increasing cost pressure will force brokerage fees Based on our interviews and the proceeding discussion, down. This will require brokers to consolidate or we expect the following developments in the electronic investigate alternative ways to generate profits in the repo market: repo market. To a greater extent, brokers might look BrokerTec will focus on expanding its liquidity for new strategies to co-operate more closely with further in the European government markets and ATS, using the existing infrastructure for clearing growing its credit repo business. As part of ICAP, and settlement of trades. This raises the questions: BrokerTec will attempt to gain more liquidity in the Should electronic trading be expanded outside the term business. current broker universe? Will voice brokers eventu- On the other hand, MTS Group, with most of its ally be replaced entirely by electronic?90 liquidity focused in the Italian market, will try to We expect a further increase of volumes in the tri- defend its share of this market and further penetrate party repo segment. As soon as the re-use function- other European markets. The new Tradeimpact ality has been made available and standardised colla- system release, which was launched in June 2005, teral baskets have been introduced in the tri-party should further improve usability and flexibility. segment, the increase of volumes will become even However, most participants still consider the MTS more significant. Another role that tri-party repo repo platform primarily as a domestic Italian player. service providers could play in the future is in the It is therefore our opinion that the repo volume of structured securities, emerging markets bonds, cor- MTS will increase but at a lower rate than its com- porate debt market or other non-government asset petitors. classes. In addition, tri-party agents might also look Eurex Repo has shown significant growth since our at strategies to co-operate more closely with ATS last survey and has positioned itself in an additional and benefit from the existing clearing functionalities segment in the secured money market. By being the in the future. first platform provider, integrated with an electronic The importance of secured financing is increasing. collateral management system linked to the Regulations, such as Basle II, will ensure this trend Deutsche Bundesbank, Eurex Repo has built an effi- continues. In particular, trading of baskets (e.g. cient, cash-driven secured money market. Its future ECB eligible baskets) of securities as collateral, success depends primarily on whether it will be able rather than individual securities, will spread. As a to gain more liquidity in both the special segment consequence, banks need to be able to better net for German government bonds and in the GC seg- their balance sheets. ment with Euro GC Pooling. Credit as an asset class is growing, diversifying repo With overall increasing market volumes, future bila- transactions. However, the repo community is cur- teral trading (the so-called direct OTC repo market) rently discussing whether credit derivatives, such as will concentrate most of its liquidity in structured Credit Default Swaps (CDS), should be acceptable products that require highly personalised services, as collateral. Credit repos are, therefore, still in their justifying the increased cost compared with more infancy and it remains to be seen whether the indus- automated trading channels. We expect that the try will develop in this area. In addition, it will be

54 BEARINGPOINT AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

interesting to see how decisions to include bank are ser-vicing multiple customers, can be used to loans as collateral affect the market. Furthermore, implement these technologies for a number of their we expect that equity financing is likely to develop clients. These out-sourcing strategies can reduce the along a similar path as fixed income did over the last setup cost for each of their customers.

10 years in terms of standardisation. In addition, banks that share a similar back-office Aside from the different market positions, other infrastructure can pool their trading volume to- trends in the electronic markets should be mention- gether and thus transact larger volumes over one ed. One of these trends could be a shift of the term trading channel. Moreover, standardised software business toward the ATS. BrokerTec has already products such as ANVIL, ION Trading, icubic or seen this development by providing a decent Martini are increasingly penetrating the repo mar- amount of liquidity for term business up to three ket. These software vendors and products are adap- months. This trend should continue. ting to the changing environment automatically

After the European interdealer market is fairly auto- through their release management. This reduces the mated, there is a need to develop an electronic mul- integration of new technologies to a minimum. tidealer market. With today's decreasing margins in With these trends emerging and the need for a se- the repo business, banks are looking for new ways to cured money market increasing, medium-sized reduce their transaction costs. Market entries by banks will look more and more into these standard- multidealer providers, such as the launch of Bloom- ise solutions to reduce the setup costs of these tech- berg's new "request for quote" model, in the B2C nological changes. This will lead the way for a more market have been successful. It will be interesting to commoditised and STP-driven market. see how this segment will develop further and gain The future trend in the repo market is one of in- market share. creased standardisation. This will cause some liqui-

After the fully implemented automated day-time dity to move from the unsecured market to the se- bridge and the recent intra-day borrowing fees wai- cured market. Also, changes to the regulatory envi- vers by Clearstream and Euroclear, major cross-bor- ronment (e.g. Basle II, Capital Adequacy Directive, der settlement issues are now solved. According to lifting of the state guarantee to German Sparkassen our interviewees, full interoperability between the and Landesbanken) will significantly impact vol- major ICSDs has now been achieved. It remains to umes in the repo market. This is especially true as be seen, how market perception will develop in the more balance sheet netting is required. If market coming months. conditions develop as expected, market share of electronically traded repos could grow by more than 40 Finally, there is the question of how banks will react percent. This survey suggests that market partici- to all theses changes. With larger banks already pants and platform providers still have all to play for being able to take advantage of these new technolo- in this market. Banks, in particular, need to find bet- gies, there are still a large number of medium-sized ter ways to integrate their collateral management banks that have to adapt themselves to this changing across asset classes, improve technological platforms environment. A couple of developments, which are and protocols and develop common market stand- currently taking place, could benefit these banks. ards to reap the full benefits of the repo market. For example, the trend of outsourcing the back-office infrastructure over to transaction banks, which

BEARINGPOINT 55

THE ELECTRONIC REPO MARKET 2006

APPENDIX I: LIST OF PARTICIPATING INSTITUTIONS

Institute Location/Department REPO ECB REPO BOND REPO Survey Survey Survey Survey Survey 2002 2003 2004 2005 2006 Aareal Bank AG Frankfurt/Trading X ABN AMRO London/Trading X Barclays Capital London/Trading X X X Bayerische Landesbank Munich/Trading X X X X Munich/Back Office X BrokerTec London/Management X X X Bundesrepublik Deutschland Frankfurt/Trading X X X X Finanzagentur GmbH Citigroup Global Markets Ltd. London/Trading X X X Clearstream Banking AG Frankfurt/Luxembourg/ X X Management Commerzbank AG Frankfurt/Trading X X X X X Frankfurt/Back Office X Credit Suisse First Boston London/Trading X Deutsche Bank AG Frankfurt/Trading X X X X X London/Trading X Frankfurt/Back Office X Deutsche Boerse AG Frankfurt/Management X X X Deutsche Postbank AG Frankfurt/Trading X Deutsche Verkehrsbank AG Frankfurt/Trading X X Dresdner Bank AG Frankfurt/Trading X X X X X DZ Bank AG Frankfurt/Trading X X X Frankfurt/Treasury X X eSpeed International Ltd. London/Management X X Eurex Bonds GmbH Frankfurt/Management X Eurex Clearing AG Frankfurt/Management X X X Eurex Repo GmbH Frankfurt/Management X X X

BEARINGPOINT V AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

Institute Location/Department REPO ECB REPO BOND REPO Survey Survey Survey Survey Survey 2002 2003 2004 2005 2006

Euroclear London/Management X X EuroMTS/MTS Group Frankfurt/Management X London/Management X X X Fortis Bank Brussels/Trading X X Goldman Sachs International London/Trading X HypoVereinsbank AG Munich/Trading X X X X X Munich/Back Office X ICMA Centre, University of Reading London X X X JP Morgan Securities Ltd. London/Trading X Landesbank Baden-Württemberg Stuttgart/Trading X X X

Landesbank Hessen-Thüringen Frankfurt /Trading X X X

Lehman Brothers International London/Trading X

London Clearing House London/Management X X MEFF/SENAF Madrid/Management X

Merck & Finck Munich/Trading X

Merrill Lynch London/Trading X

Morgan Stanley London/Trading X X X X Norddeutsche Landesbank Hannover/Trading X Royal Bank of Scotland London/Trading X SEB AG Frankfurt/Trading X

SegaInterSettle Zurich/Management X

Tradeweb London/Management X

UBS Ltd. London/Trading X X X

Zurich/Trading X X

Union Investment Frankfurt/Trading X

VI BEARINGPOINT THE ELECTRONIC REPO MARKET 2006

APPENDIX II: REFERENCES

Bank for International Settlements, "The Changing Shape of Fixed-Income Markets," BIS Working Papers, No. 104, 2001.

Boersenzeitung, "Bundesbank erleichtert Sicherheitenstellung", Nr. 35, February 18, 2006, p.18.

Bond Market Association, "Electronic Trading Survey: Consolidation, System Enhancements Aid Market Stability," October-November 2002.

Bond Market Association, "Financing by U.S. Government Securities Dealers," www.bondmarkets.com/Research/t3.shtml, 2005.

Borsa Italiana, "Closing of the acquisition of MTS by Borsa Italiana and Euronext", Press Release, Amsterdam, Brussels, Lissabon, London, Milan, Paris, November 21, 2005.

BrokerTec, "BrokerTec Europe's Leading Electronic Repo Platform Captures a 25 Percent Market Share of the Gilt Repo Market in Only Two Months," Press Release, February 7, 2002.

BrokerTec, "ICAP Completes Acquisition of BrokerTec Business," www.brokertec.com, July 2003.

Clearstream Banking, "The European Repo Market", Its Past, Present and Future, September 2005.

Clearstream Banking, "Securities and Collateral Management Services, Global Securities Finance," www.clearstream.com, December 2005.

Committee on the Global Financial Systems, "Structural Aspects of the Market Liquidity from a Financial Stability Perspective," Bank for International Settlements, March 2001.

Committee on the Global Financial Systems, "The Implications of Electronic Trading in the Financial Markets," Bank for International Settlements, January 2001.

Credit Suisse First Boston, "World Wide Repo Product Guide, New York, London Tokyo, 2003.

CrestCo, "CrestCo and Euroclear Complete Merger," www.crestco.co.uk, September 2002.

Deutsche Boerse, "Citigroup and Clearstream Launch New Quad-party Financing Services", Press Release, October 28, 2005.

Ensor, Benjamin, "German Repo Enters a New Era," International Securities Lending, Second Quarter 1997, pp. 42-48.

Eurex Repo, "The Electronic Repo Market-CHF Market Principles," www.eurexrepo.com/index2.html? 4&1&swx/chfmarket_principles_en.html, December 2005.

Eurex Media Release, "Eurex Repo continues growth in Q3/2005", Frankfurt, October 24, 2005.

Euroclear, "Meeting Services on the Single Platform", Consultation Paper, February 16, 2006.

EuroMTS, Company Brochure, www.euromts-ltd.com/content/about/brochure.pdf, December 2005.

European Central Bank, Money Market Survey 2004, May 2005.

BEARINGPOINT VII AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

European Central Bank, Money Market Survey 2005, January 2006.

Faulkner, Mark C., Association of Corporate Treasurers et al, "An Introduction to Securities Lending", London 2004.

Financial Times, "Remaining Platforms Battle for Dominance," The Financial Times, December 2, 2002.

GFI, "About GFI," www.gfigroup.com/portal/ index.jsp?pageID=def_about, December 2005.

GFI, "Repo," www.gfigroup.com/portal/index.jsp? pageID=def_repo, December 2005.

Giovannini Group, "Cross-Border Clearing and Settlement Arrangements in the European Union," 2001.

Giovannini Group, "Second Report on EU Clearing and Settlement Arrangements," 2003.

Global Custodian, "eRepo Rising-BrokerTec Pushes Fixed-Income Repurchase Into Cyberspace," Rick Buttler, Winter 2001.

Global Custodian, Tri-Party Securities Financing Survey, 2005.

Global Custodian, "The European Repo Market, The Next Wave of Growth", Sponsored Section in Clearstream Repo Survey 2005.

International Securities Lending, "An Anatomy of the European Repo Markets," Third Quarter 1997, pp. 26-33.

International Capital Market Association, "European Repo Market Survey"-Number 1-9, Conducted between June 2001 and June 2005, www.icma.org/surveys/repo.html.

Investor Services Journal, "Securities Lending Market Guide 2005-2006", www.isjforum.com.

Jordan, Thomas J., "Die Vorzüge des Repo sind bestechend - Besicherter Geldmarkt ist Pfeiler jedes zeitgemäßen Banken-Liquiditätsmanagements", Neue Zürcher Zeitung, Nr. 92, November 19, 2005.

Lumpkin, Stephen A., "Repurchase and Reverse Repurchase Agreements," Federal Reserve Bank of Richmond, Instruments on the Money Market, 1998.

MTS Group, Press Release, "MTS strategic consolidation process with Euronext and Borsa Italiana finalised", January 17, 2006.

MTS Group, Press Release, "The majority of the shareholders of MTS accept Euronext and Borsa Italiana's offer for 51 percent of the equity", July 1, 2005.

UBS/WDR, Repo Brochure, 1999.

Weber, Bernd, "Ausland greift Modell der Deutschen Börse heftig an", Boersenzeitung Nr. 36, February 21, 2006, p. 3.

Wechsler, Roger, "The Repo Transaction-An Innovation on the Swiss Market-Aspects of Posting and Backing Repos," Swiss Bankers Association, 1999.

“Controversy and congratulation”, Taking stock at the Clearstream Summit Luxembourg”. International securities Financing Magazine, December 2005, Page 48 - 53.

VIII BEARINGPOINT THE ELECTRONIC REPO MARKET 2006

APPENDIX III: GLOSSARY

Note that some terms have different meanings in context other than repo and securities lending.

Agent: A party to a repo or loan transaction that acts on behalf of a client. The agent typically does not take in risk in a transaction.

Beneficial Owner: A party that is entitled to the rights of ownership of a property. In the context of securities, the term is usually used to distinguish this party from the registered holder (e.g. a nominee) that holds the securities for the beneficial owner.

Buy-In: The practice whereby a buyer or lender of securities enters the open market to buy securities to replace those that have not been returned by a borrower. Strict market practices govern buy-ins. Buy-ins may be enforced by market authorities in some jurisdictions.

Buy/Sell, Sell/Buy: Types of bond transactions that, in economic substance, replicate reverse repos, and repos respec- tively. These transactions consist of a purchase (or sale) of a security versus cash with a forward commitment to sell back (or buy back) the securities.

Close-out (and) Netting: An arrangement to settle all existing obligations to and claims on counterpart falling under that arrangement by one single net payment, immediately upon the occurrence of a defined event of default.

Collateral: Securities or cash delivered by a borrower to a lender to support a loan of securities or cash.

Custodian: An entity that holds securities of any type for investors, effecting receipts and deliveries, and supplying appropriate reporting.

Delivery-by-Value (DBV): A mechanism in some settlement systems (e.g. CREST) whereby a member may sale or repurchase/borrow or lend cash overnight against collateral. The system automatically selects and delivers collateral securities, meeting pre-determined criteria to the value of the cash (plus margin) from the account of the cash taker/borrower to the account of the cash provider/lender and reverses the transaction the following morning. Introduction for UK gilt market planned for June/July 2006.

Delivery-versus-Payment (DVP): The simultaneous delivery of securities against payment of funds within a securities settlement system.

Euro GC Pooling: A product/service offered by Deutsche Boerse Group launched in 2005. Enables secured money market transactions (Overnight, TomNext, SpotNext and One Week Tender Term) electronically with a clearing via a CCP in combination with a real-time collateral management system.

Fail: The failure to deliver cash or collateral in time for the settlement of a transaction.

Free-of-Payment Delivery: Delivery of securities with no corresponding payment of funds.

BEARINGPOINT IX AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

General Collateral (GC): Securities that are not "special" in the market and may be used, typically, to collateralise cash borrowings.

Haircut: Initial margin on a repo transaction. Generally expressed as a percentage of the market price.

Hold-in Custody: An arrangement under which securities are not physically delivered to the borrower (lender) but are simply segregated by the lender in an internal customer account.

Margin, Initial: Refers to the excess of cash over securities or securities over cash in a repo/reverse repo or securities lending transaction. One party may require an initial margin due to perceived credit risk of the counterpart.

Margin, Variation: Once a repo or securities lending transaction has settled, the variation margin refers to the band within the value of the security used a collateral may fluctuate before triggering a margin call. Variation margin may be expressed either in percentage or absolute currency terms.

Margin Call: A request by one party in a transaction for the initial margin to be reinstated or to re-store the original cash/securities ratio to parity.

Mark-to-Market: The act of revaluing the securities collateral in a repo or securities lending transaction to current market values. Standard practice is mark to market daily. Major CCPs offer even intraday margining.

Market Value: The value of loan securities or collateral as determined using the last (or latest available) sale price on the principal exchange where the instrument was traded or, if not so traded, using the most recent bid or offered prices.

Open Transactions: Trades done with no fixed maturity date.

Pair-off: The netting of cash and securities in the settlement of two trades in the same security for the same value date. Pairing-off allows for settlement and net differences.

Prime Brokerage: A service offered to clients - typically hedge funds - by investment banks to support their trading, investment and hedging activities. The service consists of clearing, custody, securities lending, and financing arrangements.

Principal: A party to a loan transaction that acts on its own behalf or substitutes its own risk for that of its client when trading.

Proprietary Trading: Trading activity conducted by an investment bank for its own account rather than for its clien- t’s accounts.

Repo: Transaction whereby one party sells securities to another party and agrees to repurchase the securities at a future date at a fixed price.

Repo (or reverse) to Maturity: A repo or reverse repo that matures on the maturity date of the security being traded.

Repricing: Occurs when the market value of a security in a repo or securities lending transaction changes and the par-

XBEARINGPOINT THE ELECTRONIC REPO MARKET 2006

ties to the transaction agree to adjust the amount of securities or cash in a transaction to the correct margin level.

Reverse Repo: Transaction whereby one party purchases securities from another party and agrees to resell the securities at a future date at a fixed price.

Shaping: A practice whereby delivery of a large amount of a security may be made in several smaller blocks so as to reduce the potential consequences of a fail. May be especially useful where partialling is not acceptable.

Specials: Securities that for several reasons are sought after in the market by cash takers/borrowers. Holders of special securities will be able to earn incremental income on the securities by lending them out via repo or securities lending transactions.

Substitution: The practice in which a lender of general collateral recalls securities from the borrower and replaces them with other securities of the same value.

Third-Party Lending: A system whereby an institution lends directly to a borrower and retains decision-making power, while all administration (e. g clearing, settlement, monitoring) is handled by a third party, such as a global custodian.

Tri-Party Repo: Repo used for funding/investment purposes in which the trading counterparts deliver bonds and cash to an independent custodian bank or central securities depository. The so-called tri-party agent is responsible for ensu- ring the maintenance of adequate collateral value, both at the outset of a trade and over its term. It also makes the collateral to market daily and makes margin calls on either counterpart, as required. Tri-party repo services reduces the operational and system barriers to participate in the repo markets.

BEARINGPOINT XI AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

APPENDIX IV: NOTES

1 Please also see "The Electronic Repo Market 2002" 23 ATS with CCP and ATS bilateral model each have (1st Edition) and "The Electronic Repo Market 9 percent market share. 2004" (2nd Edition). www.bearingpoint.de. 24 Figures according to latest ICMA survey and 2 ICMA survey Nr. 9, June 2005, www.icma.org. Clearstream's European repo report, September 2005. 3 ICMA survey Nr. 9, June 2005, www.icma.org. 25 Ibid. 4 Count, not volume. 26 Ensor, Second Quarter 1997, p. 42-48. 5 ICMA survey Nr. 9, June 2005, www.icma.org. 27 The Microstructure of EuroMTS, University of 6 ICMA surveys No.1-9 & European Central Bank, Amsterdam and Bocconi University, 2005. Money Market Survey 2005, January 2006. The ECB survey confirms the secured segment as the 28 Ibid. largest money market segment. 29 Ensor, Second Quarter 1997, p. 42-48.

7 To be correct: Expansion to "non-collective safe 30 ICMA, European Repo Market Survey, June 2005. custody securities". 31 Global Securities Financing Survey, 2001 & 2005. 8 Lumpkin, p. 60. 32 "Securities and Collateral Management Services", 9 Wechsler, p. 9. Clearstream Banking, p. 5.

10 Ibid, p. 9. 33 Clearstream Banking, "The European Repo 11 Ibid, p. 9. Market", Its Past, Present and Future, September 2005. 12 UBS/WDR, p. 12. 34 ICMA, www.icma.org, European Repo Market 13 UBS/WDR, p. 12. Surveys, Edition 1 2001-Edition 9 2005. 14 Ibid, p. 9. 35 A white paper to the industry on the future of 15 Ibid. CCPs, DTCC.

16 Lumpkin, p. 70. 36 Giovannini Group, April 2003.

17 UBS/WDR, p.13. 37 With the exception of the Strategic Evaluation, 18 Bond Market Association, 2005. arguments in the chapter are based on a consensus of the survey and do not reflect the opinions of the 19 ICMA European Repo Market Survey, June 2005. authors. 20 Ibid. 38 For detailed information please refer to our 2004 21 ICMA European Repo Market Survey, June 2005. survey and the respective company websites.

22 ICMA, European Repo Market Survey, June 2005. 39 BrokerTec, "About Us" and "Mission," www.brokertec.com, accessed January 2006.

XII BEARINGPOINT THE ELECTRONIC REPO MARKET 2006

40 Ibid. 55 Repo, "The Electronic Repo Market-CHF Market Principles", www.eurexrepo.com, accessed January 41 BrokerTec, "Background," www.brokertec.com, 2006. accessed January 2006. 56 Jordan, Thomas J., "Die Vorzüge des Repo sind 42 Ibid. bestechend - Besicherter Geldmarkt ist Pfeiler jedes 43 BrokerTec, "ICAP Completes Acquisition of zeitgemäßen Banken-Liquidititätsmanagements", BrokerTec Business," www.brokertec.com, accessed Neue Zürcher Zeitung, Nr. 92, November 19, January 2006. 2005.

44 BrokerTec, "ICAP Signs Contracts to Acquire 57 For latest information about the Swiss franc repo BrokerTec Businesses For Up To GBP 181 market please refer to Million," www.brokertec.com, Press Release, www.eurexrepo.com/chf/principles.html. January 16, 2003. 58 Because of market structure and the fact that the 45 Result of the latest interviews in 2005/2006. Swiss National Bank is playing an important role 46 BrokerTec, survey interview, January 24, 2006. in the Swiss Franc repo market, the model cannot be compared with the Euro market. For further 47 BrokerTec, "BrokerTec Europe First to Offer details see www.eurexrepo.com. Electronic Trading in all 14 EU Government Bond and Repo Markets," www.brokertec.com, Press 59 Eurex Repo, "Euro Market Principles", www.eurex- Release, September 16, 2002. repo.com, accessed January 2006.

48 Incl. UK gilts. 60 According to the Eurex Repo Newsletter, January 2006. 49 According to BrokerTec interview, January 24, 2006. 61 For a complete list of participants please see www.eurexrepo.com. 50 According to BrokerTec. 62 Eurex Media Release, "Eurex Repo continues 51 For example, Dresdner Bank holds a dominant growth in Q3/2005", Frankfurt, October 24, position for third-party clearing over 2005. LCH.Clearnet. 63 EuroMTS Ltd, "Company Structure" page 52 Mission statement of Eurex Repo GmbH defined www.euroMTS-ltd.com/content/about/ in its business strategy (according to interviews overview.shtml, Accessed November 2005, MTS with management of Eurex Repo in 2004 and Group, Press Release, "The majority of the share- 2005). holders of MTS accept Euronext and Borsa 53 Liquidity figures provided by Eurex Repo, Italiana's offer for 51 percent of the equity", July 1, December 2005. 2005.

54 The Euro repo market is operated by Eurex Repo 64 MBE Holding, registered in Italy, is 51 percent GmbH, a subsidiary of Eurex Frankfurt AG; whe- owned by Euronext NV with the remaining 49 reas the Swiss Franc repo market is operated by the percent held by Borsa Italiana S.p.A. Eurex Repo department as part of Eurex Zurich.

BEARINGPOINT XIII AN ANALYSIS OF THE ELECTRONIC REPO MARKET IN THE EURO-ZONE

65 The 7 banks which increased their respective share- 78 For more details please refer to ISLA, "An holdings are: San Paolo IMI, Barclays Bank, BNP Introduction to Securities Lending", Paribas, Deutsche Bank, JP Morgan, Lehman www.isla.co.uk. Brothers and Société Générale. The 3 banks that 79 Source: BearingPoint, in addition to ISLA, "An took a stake in MTS for the first time were: Introduction to Securities Lending", HSBC, IXIS CIB, Royal Bank of Scotland. MTS www.isla.co.uk. Press release; January 17, 2006. 80 www.performanceexplorer.com, accessed February 66 MTS Group, Overview. www.mtggroup.org. 2006. 67 MEDIP-Special Market for Public Debt: the start- 81 In addition there are contract compare systems up year. such as SunGard or Pirum. 68 EuroMTS, www.euromts-ltd.com, accessed 82 www.drkw.com/eng/products_services/1381.php, December 2005. accessed February 2006. 69 EuroMTS, www.euromts-ltd.com, figures provided 83 For further information please see www.isla.co.uk. by MTS January 2006. 84 ISF Magazine, "A year of change. A year of growth. 70 ETCMS(Euroclear trade Comparison and mat- A future of possibilities", Interview with EquiLend ching service): Automatic matching and routing CEO Brian Lamb, December 2005. service for OTC transactions with CCP. 85 According to EquiLend's information; please see 71 London SPAN is a computerized system that calcu- www.equilend.com. lates the effect of a range of possible changes in the 86 price and volatility on portfolios of derivatives. Eurex survey interview; in addition see Eurex press release, "Eurex startet Marktplatz für besicherte 72 Size for shaping of transactions is currently under Wertpapierleihe", November 2005. review. 87 For more details please see www.secfinex.com. 73 Financial News, "Repos hold key to market strate- 88 gy", October 23, 2005. Number of transactions, not traded volumes.

89 74 For further information about product description This number refers to interviews with head traders please see www.lchclearnet.com. of key market participants. For London financial institutions, the rate is higher than 75 percent. 75 Deutsche Boerse, "Citigroup and Clearstream 90 Launch New Quad-party Financing Services", Press “Controversy and congratulation” Taking stock at Release, October, 2005. the clearstream summit Luxembourg”. International securities Financing Magazine, 76 For more details please refer to ISLA, "An December 2005, Page 48 - 53. Introduction to Securities Lending", www.isla.co.uk.

77 For more details please refer to ISLA, "An Introduction to Securities Lending", www.isla.co.uk.

XIV BEARINGPOINT THE ELECTRONIC REPO MARKET 2006

GLOBAL MANAGEMENT AND TECHNOLOGY AUTHORS CONSULTING FOR TODAY’S BUSINESS ENVIRONMENT Frank Gast Manager BearingPoint is a leading global management and tech- Phone: +49 69 13022 3359 nology consulting company that serves the Global 2000 Cell: +49 172 67 78 841 and many of the world's largest public services organi- [email protected] sations. Our experienced professionals help organisations around the world set direction to reach their goals Damian O’Sullivan and create enterprise value. Manager Phone: +44 870 405 0452 By aligning their business processes and information Cell: +44 7900 547 111 systems, we help our clients gain competitive leadership [email protected] advantage - delivering results in an accelerated time frame. To learn more, visit our Web sites at Jin Hyun Nam www.bearingpoint.com or www.bearingpoint.de Consultant Phone: +49 69 13022 5253 Cell: +49 172 66 02 175 DISCLAIMER [email protected]

All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.Therefore, BearingPoint assumes no liabi- lity to any party causes by errors or by statements of any kind in this study. No one should act upon such information without appropriate professional advice after a thorough examination of the facts of the particular situation.

BEARINGPOINT XV

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