The previous version of this blog questioned why, when the Basel Committee on Banking Supervision issued a revision to the Leverage Ratio in January 2014, it had not allowed the netting of collateral in matched positions with the same counterparty.

There is a good reason for this and, I am afraid, the previous blog got the accounting wrong. If you try to net repo collateral as it appears on the balance sheet, then there is nothing to net against. The balance sheet shows the collateral for a repo but not for reverse repo (see below). This is because, although legal title is transferred, the risk and return on the collateral is not (and balance sheets show economic substance, not legal form).

Balance sheet of seller of 10 in collateral v 10 in cash (repo)

assets
collateral 10
cash 10

LR exposure 20

liabilities
repo payable 10
other liabilities 10

Balance sheet of buyer of 10 in collateral v 10 in cash (reverse repo)

assets
reverse repo receivable 10

LR exposure 10

liabilities
liabilities 10

Assume the same parties execute these transactions with each other. Without netting, the result (for both parties) is:

Balance sheet of party with repo of 10 in collateral v 10 in cash & identical reverse repo

assets
reverse repo receivable 10

LR exposure 10

liabilities
repo payable 10

Note the collateral passes through. So, no netting is needed. The cash borrowed in the repo is removed from the balance sheet by the lending in the reverse repo and replaced by a receivable item.

The result with the netting of cash is:

Repo of 10 in collateral v 10 in cash & identical reverse repo

assets
reverse repo receivable

LR exposure 0

liabilities
repo payable 0

Of course, the ability to net cash remains academic, given the third condition imposed by Basel.

The counterparties must intend to settle net, settle simultaneously or the transactions must be subject to a settlement mechanism that results in the ‘functional equivalent’ of net settlement. Functional equivalence is defined as the cash flows being equivalent, in effect, as a single net amount on the settlement date. This requires offsetting transactions to be settled through the same settlement system and the settlement arrangements must be supported by cash and/or intraday credit facilities intended to ensure that settlement of all the transactions will occur by the end of the business day and that the linkages to collateral settlement do not result in the unwinding of the net cash settlement, ie fails must not stop payment.

Another academic point may be whether tri-party repo would satisfy the condition, given that tri-party systems automatically substitute securities failing to be delivered and so ensure the uninterrupted payment of cash. The reason it is an academic point is because there is little or no nettable two-way business in tri-party repo.