SocGen Quants Aim to Disrupt a Slice of $12 Trillion Repo Market

(Bloomberg) -- A sliver of the $12 trillion market lubricating the gears of global finance could become the next trading ground for Wall Street quants, if Societe Generale SA has its way.

Repurchase agreements -- which banks and asset managers use to borrow money by putting up their securities as collateral -- came under the spotlight in the coronavirus crisis. But now might be just the time for systematic players to pounce on easing funding pressures and calmer markets.

To that end, SocGen is touting a rules-based strategy that mimics repo trades beloved by hedge funds, who have long arbitraged the difference charged between short- and long-term borrowing against assets.

The idea is that investors can enjoy the same returns by simply tracking an index hitched to equity repo, which comprises 10% of Europe’s market for repurchase transactions. The trade speculates on the cost of borrowing against a basket of stocks constituting the EuroStoxx 50 Index.

It’s part of the marketing boom in the world of alternative risk premia, strategies that by and large plunged in last month’s unprecedented cross-asset turmoil. Now the repo market’s hefty premiums are said to offer an attractive stomping ground for yield-chasing investors.

“Even before the crisis, there was the theme of finding truly uncorrelated sources of return,” Olivier Daviaud, a strategist at the French bank, said in an interview. “As of today it’s one of the few strategies that provides an interesting entry point without being in a large drawdown.”

The repo market is where everyone from money-market fund managers and broker dealers to investment bankers access liquidity by borrowing against securities of all stripes. As the financial system’s plumbing, it can also shine a light on infrastructure weaknesses.

The BIS blamed structural problems for a September spike in U.S. repo rates, including a diminished capacity at key banks to supply funding and increasing use of the market by hedge funds raising cash. More recently, the Federal Reserve intervened to help ease a worldwide credit crunch and prevent short-term lending from seizing up.

While recent coronavirus-linked stresses in Europe spurred losses in the SocGen strategy before being doused by ECB intervention, they’ve also jacked up the level of premium in the trade to a record, according to a note from the French bank.

Yield Thirst

In recent years institutional investors embraced exotic alternative risk premia trades such as short-volatility and dispersion to generate steady income. With central banks around the virus-lashed world slashing rates, this thirst for yield looks set to resume.

The repo strategy buys and sells equity futures contracts as a way to simulate the carry between short- and long-term rates. Backtests show an index tracking the trade has returned 3.4% annualized over the past decade, according to the research note.

While the agreements are over-the-counter instruments, a proxy for repo rates can be found in listed total return futures. Buying a total return future is economically equivalent to borrowing cash at the prevailing repo rate, while selling a contract means lending money against collateral. Germany’s Eurex exchange lists the contracts.

The majority of repo is based on debt securities which for quants can’t be as easily mimicked with a listed derivative.

The SocGen strategy is exposed to all manner of risks, not least a rise in the equity repo rate itself and a steepening of the futures curve. Repo watchers such as Credit Suisse Group AG’s Zoltan Pozsar have warned that deep-rooted problems make the short-term funding market more prone to clogging up.

“The regulatory framework and the proactiveness of central banks make us think the risk of a prolonged and serious blow-up in the funding market is mitigated,” said Daviaud.

It’s a natural pitch for SocGen in one key respect: Structured-product issuers like the French bank buy longer dated total-return futures to hedge their own debt exposures, according to Stuart Heath of Eurex’s equity and index product design team. The more buying demand on the other side of the trade, the easier it is for issuing institutions to offset those exposures.

“This trade existed previously in the over-the-counter market,” said Heath. As for a systematic strategy, “there’s enough volume, open interest and liquidity to make that potentially sensible,” he said.

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