Frontclear shines a spotlight on Africa’s repo & swap markets
11 July 2016
Q: Frontclear seems to be focused on building a more inclusive and stable repo and swap markets in Africa, what is so important about developing these markets?
Africa’s capital markets have developed rapidly in recent years. Many countries have, for instance, successfully developed a local government primary bond market, extended yield curves and achieved some level of liquidity. However, without parallel and sufficient attention paid to the development of African repo & swap markets, the success of primary and secondary bond markets will remain sub-optimal.
The development finance community has played a key role in this progress, with a relative emphasis paid to extending the maturity profile of capital market instruments. This is certainly the goal. However without an active and liquid secondary bond market, investor interest - domestic or global - will remain hampered. The repo & swap markets are central to deeper and have a more liquid capital markets, for reducing systemic risk, and ensuring a more efficient allocation of liquidity. Frontclear has been established in response to policy calls for a more balanced development approach to include focus on short term money markets.
Q: Repo markets are seen to be central to deepened and liquid capital markets, for reducing systemic risk and ensuring a more efficient allocation of capital. But what exactly is ‘repo’?
Repo is a market instrument that is a form of short-term borrowing for dealers in government securities. Dealers sell a security to an investor with an agreement for the seller to buy-back the security at a later date. The party that originally buys the securities effectively acts as a lender which holds the securities as collateral. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest.
Q: What then is the benefit of liquid repo and swap markets for the broader capital markets?
There are three core advantages to true repo markets:
- Because repos are secured money market instruments, they reduce credit risk and hence smaller players have better access to liquidity and the market is more stable in times of stress.
- Repos play an important role in bond markets. Primary dealers are able to fund their bids at primary treasury securities auctions, underwriting their positions at reasonable costs by lending out their existing stock for cash in repo markets. Well-functioning repo markets also facilitates secondary markets by reducing the inventory of bonds held on the books of dealers, enabling them to continually borrow bonds when required to honor their pricing commitments as well as to hedge short-term price fluctuations.
- Liquid repo markets contributes to a central banks’ capacity to effectively implement monetary policy and reduce systemic risk. Repo markets do so by echoing monetary signals more widely into the market.
Q: What is the current state of repo & swap markets in Africa?
Many markets have established repo markets and enjoy some level of liquidity, notably in larger markets such as South Africa and Nigeria. However, in other markets, structural problems hinder their development. For instance, there are no true repos yet in East Africa. In Kenya, Rwanda, Tanzania and Uganda, there is an interbank instrument called an ‘horizontal repo’. In Burundi, there is the “pension livrée” (the French name for repo). In Ethiopia and Malawi, there is nothing as yet. However, neither horizontal repo nor “pension livrée” are true repos, that is, neither is secured by the transfer of title to collateral by means of a true sale. The markets are thus characterized by low trading volumes or simply inactivity. Where they do exist, they tend to be short dated, with very shallow access by only the larger banks for longer maturities. Often markets are vertical where trading is only between banks and central bank.
Swap markets allow market participants to manage market risk, and exploit funding advantages in different currencies. Liquid and stable swap markets are a fundamental window through which African market participants can access global financial markets.
Swap markets have also taken hold in many leading economies on the continent. However, as with repos, smaller players are often unable to access these markets due to high perceived credit risk or a lack of knowledge and capacity. The markets are thus relatively shallow and narrow, as only top tier players have access.
Q. How does Frontclear contribute to the repo and swap market development in Africa?
To date, Frontclear has entered the Kenyan and Nigerian market, having guaranteed swap and repo transactions between banks. The guarantee “clears” the transaction, allowing banks to eliminate credit risk and thereby extend maturities of transactions, allows smaller players to enter the market, and make better use local currency collateral. The goal is to execute demonstrative transactions, based on global standard documentation and legal structures, that move the market forward.
In addition to guaranteeing or “clearing” transactions, Frontclear has a very aggressive technical assistance program to build capacity and knowledge in addition to promoting and enabling market environment. The latter entails working with regulators on the continent to improve the legal framework and settlement systems for these kinds of transactions. Frontclear started operations in 2015 and has, in a short period of time, established partnerships with leaders in the field, notably international banks active in the continent as well as the International Capital Market Association (ICMA), International Swap and Derivatives Association (ISDA), ICAP and the Africa Financial Markets Association (ACI) and intend to partner with leading development institutions. We look forward to rolling out in new markets, notably with our current expansion to Ghana, Ivory Coast, Uganda, Rwanda and Zambia.