PRIMARY DEALERSHIP AND THE REPO MARKET IN EUROPE: A MARKET MAKER POINT OF VIEW

Stefano Bellani OECD global forum on Government Securities Markets and Public Debt Management Rome,27th November 2003

Primary Dealership and the Repo Market in Europe: a Market Maker point of view

„ Liquidity investments, Central Banks operations and bond traders positions, all

impact the repo market activity „ The activity of a Primary Dealer is strictly related with the financing & covering

of his positions. An efficient Repo market is key to the implementation of trading and market making strategies, as well as to the enhancement of the liquidity of government debt market „ Primary Dealers trading strategies, EU government bond repo markets

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

structure, Treasury role, settlement and documentations are all crucial to the shaping of an efficient market for government debt

1

Agenda

„ Repo Market Role in Financial Markets „ Market Maker’s Role in the Bond Market „ Market Making activity and Repo „ Relative Value and Repo Rates drivers „ Treasury’s Roles in the Repo Markets

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ Settlement systems „ Legal Documentation „ Repo & Primary Dealership: a Market Maker’s Recommendation „ Annexes

2

Repo Market Role in Financial Markets The Repo market is at the centre of the Money Market in Europe „ Repo as a liquidity product „ Securitized Loan

— Deposit/Investment tool — Central Banks monetary policy intervention

„ Repo as a security product

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ Underlying Security becomes the driver

— Financing & covering of Bond positions — Instrumental to support all Market Maker and Primary Dealership activities

3

Market Maker’s Role in the Bond Market

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

Government Bond Market is characterized by: — Bonds having high correlation and high substitution level (among themselves) — Single Bond liquidity relatively limited vs. market size and the investors allocation — Issuer Debt Profile, driven by redemption & new issuance, is not necessarily timed with market expectations and Investors allocation’ choices — Directional trading concentrated on Futures contracts & Benchmarks

As a result the role of the Market Makers is to step in to provide single bond liquidity with the objective of minimizing bond market bid offer. Their activity is therefore key to create a buffer and match short-term supply & demand imbalance in the bond market.

4

Market Making activity and Repo The activity of the Market Maker is more specifically aimed to: — Make market to clients, distribute auctions “underwriting” — Trade Relative Value positions across the Bond Curve (bonds mispricing, arbitrages) — Positioning on market expectations (directional & curve trades)

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

The objective of most of these strategies is to combine correlated bond & spread positions that will (hopefully) realign with time, while contributing to improve the overall market liquidity. The successful implementation of trading and market making strategies involves entering into Long and Short Bonds positions that have to be carried over time: therefore the efficient financing and sourcing of the related securities is key to the enhancement of the liquidity of government debt market, through the reduction of cash market bid offer.

5

Relative Value and Repo Rates drivers „

Supply & Demand of bonds define bond repo level vs. General Collateral funding level

„

Theoretical repo rate & forward asset swap

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„

„

„

Bund 4.75% 4/7/08 trading in the cash market @ 104.40 for value 14/11/03, dirty price 106.1261

„

Asset Swap: L–12 bp

„

PVBP: 4.33

„

Target Fair Value: L-9 bp

„

The Theoretical repo rate is such to realign the bond to his fair value (asset swap) for any given term horizon, in other words we make the assumption that all the bonds trade at their fair value on a forward basis

Market should trade between GC level and the Bond Theoretical curve „

Expected return of strategies is positive

„

Realignment timeframe can be event driven (auction, year end)

„

Bond supply overcome market demands/positions

„

EOC stock lending/DVP fail

„

Treasuries’ intervention

Market can also overshoot the Theoretical repo rate (market specialness higher than theoretical) because of: „

Market segmentation (cash vs. repo, high retail & mutual funds holdings)

„

Lack of transparency

„

Specific Event (auction, buy-back, buy-in)

6

Relative Value and Repo Rates drivers General Collateral & Break Even Repo Rates for Bund 4.75% Jul 08 2 .5

100% 90%

2

80% 70%

1 .5

60% 1

50%

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

40% 0 .5

30% 20%

0 1

7

14

30

60

90

-0 .5

180

270

360

10% 0%

M a r k e t P r o b a b i li t y o f r e a li g n m e n t

G e n e r a l C o lla t e r a l

B u n d 7 /0 8 M a r k e t R a te s

B u n d 7 /0 8 T h e o r C u rv e

7

Relative Value and Repo Rates drivers General Collateral & Break Even Repo Rates for BTP 4.25% Feb 19 2.5

100% 90%

2

80%

1.5

70%

1

60% 0.5 50% 0 PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

1

7

14

30

60

90

180

-0.5

270

360

40% 30%

-1

20%

-1.5

10% 0%

-2

Market Probability of realignment

General Collateral

BTP 2/19 Market Rates

BTP 2/19 Theor Curve

8

Relative Value and Repo Rates drivers Bond specialness is a combination of forces pulling in different directions, these are the major Repo Rate drivers, „ Market dynamics and lenders/borrowers preferences: „ Market Positions & Client Flows

+/-

„ Bond asset swap/bond basis richness

+

„ Accounting, regulatory & tax issues

+/-

„ Country preferences (settlement & ECB repo)

+

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ Bond and repo specifics: „ Repo term

-

„ Bond maturity

+

„ Bond outstanding

-

„ Specific events (Auctions, Buy-Backs)

+

„ Market distortions and inefficiencies „ Retail/mutual funds/Central Banks net buyers of bonds

+

„ DVP settlement

-

„ Non DVP/EUREX Delivery/Buy-in procedures

+

9

Treasury’s Roles in the Repo Market

„ Treasuries’ attitudes and activity in the Repo Market are relatively differentiated:

— Cash Management operations, mostly aiming to place liquidity (UK, FR, BEF, HOL, DEM, SP, FIN) — Primary Dealers Repo Facility (UK, BEF, HOL, FIN) — Discretionary market intervention (FR, DEM, FIN) — Dealership evaluation and market monitoring (IT, FR)

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ Primary Dealer Repo Facility is clearly the market preferred approach:

— Supports Primary Dealers in their market making obligations — Helps absorbing client flows — May represent a floor to repo rates/help settlement efficiency „ Discretionary Market Intervention is clearly a more flexible approach:

— It doesn’t incentive any moral hazard — Constitutes a “parachute” to save from market dislocation & manipulation

10

Settlement Systems

„ Settlement System still very fragmented

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

— Euroclear & Clearstream leading consolidation process — Consolidation is happening at the company level, whereas procedures & systems are yet to become fully integrated — Cross Border settlement & Central Bank repo participation can still be an issue due to position pre-funding — Fail repairs & Overnight market activity still limited (except UK) — Need to develop more Automatic Settlement Lending Programs in domestic markets (I.e. EOC, Clearstream)

11

Legal Documentation

„ Executed documents are essential to minimize credit exposure: „ Collateral Management (MTM, haircuts, margins) „ Positions Netting „ Right to liquidate securities in case of counterparty default

„ Documentation PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ Standard document for non $ Repo: GMRA (Global Master Repo

Agreement), EMA (European Master Agreement) and GPSLA (Global Master Securities Lending Agreement) „ But also domestic agreement: French and German Master Repo

Agreement (AFTB and Rahmenvertrag fuer Wertpapier darlehen)

12

Repo & Primary Dealership: a Market Maker’s Recommendation „ Repo activity included in Primary Dealership rules

— Activity can be monitored, favoured but not subject to mandatory requirement (it is a “credit” product requiring balance sheet usage) — Monitoring criteria: volumes, term period & specials „ Development of Electronic Trading Platforms

— Price distribution — Improve liquidity — Sustain volume growth/Improve straight through processing & settlement efficiency „ Treasury should play some degree of market activity

— Cash management — Bond lending PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ Settlement system should be designed to limit the amount of “unproductive” collateral

— Settlement cycles, O/N activity — Efficient Cross Border deliveries — Automatic Bond Lending (Euroclear/Clearstream model) „ Effort to incentive the adoption of a legal standard

— Providing for Netting and Liquidation rights — Possibly based on ISMA/EMA to facilitate international involvement — Cross products netting agreement

13

Annex: the European Repo market in a snapshot „ Total outstanding: 4,050 billion (up 23% from last year) „ Cash currency: EUR 76%, GBP 9%, USD 9%, JPY 3% „ Negotiation type: direct 52%, voice brokers 30%, e-trading 18% „ Underlying collateral type: Euro-15 Government 77%, corporate and

agency 10%, others 13% „ Country of underlying collateral

6%

7%

22%

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ Term of transactions

31%

4% 18%

7%

5%

11%

6%

21% 10%

G e rm a n y

16%

10% It a ly

F ra n c e

UK

S p a in

B e lg iu m

26% O th e rs

Open U p to 3m

O/N U p to 6m

U p to 1w U p to 1y

U p to 1 m F w d -F w d

Source: ISMA European Repo market survey - June 2003

14

Annex: Recent Trends in the Government Repo Market in Europe „ Increase of Electronic Trading volumes „ Liquidity „ Straight through settlement/Cost Efficiency „ Automation: position, quotation „ Expansion of Central Counterparties products „ Balance Sheet & Settlement Netting „ Anonymous Trading „ Credit Protection

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

„ The Future „ Growth of anonymous trading „ Merger of European Clearing Houses (LCH, Clearnet) to allow for new netting

opportunities „ Increased integration of repo markets in Europe: settlement, market

conventions, cross-border moves

15

Annex: General Collateral Repo Rates vs. Money Market Rates EUR GC tracks Eonia Curve: plentiful supply of Euro Govies collateral 2.50

2.40

2.30

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

2.20

2.10

2.00

1.90 1

7

14

30

Euribor

60

Eonia

90

180

270

360

General Collateral 16

Annex: General Collateral Repo Rates vs. Money Market Rates GBP GC tracks Libor with wider spread: relatively scarce Gilts supply 4 .6 0 4 .5 0 4 .4 0 4 .3 0 4 .2 0

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

4 .1 0 4 .0 0 3 .9 0 3 .8 0 3 .7 0 3 .6 0 1

7

14

30

L ib o r

60

S o n ia

90

180

270

360

G e n e r a l C o lla te r a l 17

PRIMARY DEALERSHIP & REPO MARKET IN EUROPE

Copyright 2003 J.P. Morgan Chase & Co.—All rights reserved. JPMorgan is the marketing name used on global equity research issued by J.P. Morgan Securities Inc. and/or its affiliates worldwide. J.P. Morgan Securities Inc. (JPMSI) is a member of NYSE and SIPC. This presentation has been prepared for our institutional clients and is for information purposes only. Additional information available upon request. Information has been obtained from sources believed to be reliable but J.P. Morgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) does not warrant its completeness or accuracy. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMorgan may act as market maker or trade on a principal basis, or have undertaken or may undertake an own account transaction in the financial instruments or related instruments of any issuer discussed herein and may act as underwriter, placement agent, advisor or lender to such issuer. JPMorgan and/or its employees may hold a position in any securities or financial instruments mentioned herein. Information has been obtained from sources believed to be reliable but J.P. Morgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) do not warrant its completeness or accuracy. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMorgan may trade on a principal basis, or may have undertaken or may undertake an own account transaction in the financial instruments or related instruments of any issuer discussed herein and may act as underwriter, placement agent, advisor or lender to such issuer. See above for specific disclosures relating to marketmaking, underwriting, analyst ownership, firm ownership over 1%, and investment banking compensation. JPMorgan and/or its employees may hold a position in any securities or financial instruments mentioned herein. JPMSI distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Clients should contact analysts and execute transactions through a JPMorgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise. Please read each report carefully for a discussion of valuation methods used, and the reasonable basis for any price objectives (or price targets) including discussion of risks. The compensation of equity research analysts responsible for preparation of this report is based on a number of factors, including the overall performance of JPMorgan, the global investment bank, and institutional equities.

15