Contingent NBFI Repo Facility (CNRF) – Explanatory Note 24 July 2024
Introduction
In September 2023, the Bank of England (the Bank) set out that work had begun to develop a new lending facility to address severe market dysfunction that threatens UK financial stability arising from shocks that temporarily increase non-bank financial institutions’ (NBFIs) demand for liquidity.footnote [1]
As a first step in this work, the Bank is developing the Contingent NBFI Repo Facility (CNRF) to supply cash to eligible pension funds, insurance companies and liability-driven investment funds (LDI funds) against UK sovereign debt (gilts) for a short lending term.
This Explanatory Note, which should be read alongside the accompanying Provisional Market Notice, provides additional detail on the background and design of the CNRF. The first section sets out the motivation for this work and the purpose of the new facility. The second section provides details on the rationale underpinning the expected design and parameters of the facility that are set out in the accompanying Provisional Market Notice.
The Bank has been working at pace to design the CNRF, and we expect to open for applications in 2024 Q4. Ahead of opening for applications, the Bank would welcome feedback on the proposed design and operational features from financial market participants – including any insurers, pension funds and LDI funds that are interested in signing up to the CNRF, as well as the broader NBFI sector and relevant regulators. Please send any queries or comments to CNRFapplications@bankofengland.co.uk.
It is in the collective interests of all participants that this new facility is effective at delivering liquidity to eligible counterparties when activated, in order to restore UK financial stability. In the event that the CNRF is activated during a period of market stress, the Bank cannot guarantee that it will be able to onboard and lend to counterparties that have not signed up in advance. We would therefore encourage firms to sign up at the point we open for applications.
We would also encourage potential counterparties familiarise themselves with the expected design and operational features of the CNRF and assess what steps they would need to take in order to be ready to apply and begin the onboarding process in a timely way, prior to any shock unfolding. This includes the way in which counterparties would deliver collateral to the Bank and how they would satisfy regular test trades.footnote [2]
Motivation and purpose of the Contingent NBFI Repo Facility
The Bank has a mandate to promote the financial stability of the UK. As NBFIs continue to grow in significance both in terms of total market footprint and influence over the supply of finance to UK businesses, the impact NBFIs have on financial stability has increased.
Past events such as the 2020 ‘dash for cash’ and 2022 LDI episodes have shown that vulnerabilities in NBFIs can propagate liquidity stresses in the gilt market, for example via investor deleveraging, liquidity mismatches in funds, liquidity demands from margin calls and insufficient market participant preparedness to meet them.footnote [3] These have all led to periods of forced selling of gilts by NBFIs, which have been exacerbated by limited dealer intermediation capacity. These events can lead to self-reinforcing price spirals, which may threaten UK financial stability.
It is first and foremost for NBFIs to manage the liquidity risks they face. While progress has been made both in the UK and internationally to address the vulnerabilities in NBFIs, the Financial Policy Committee (FPC) has recognised it is vital that domestic and international regulators continue to develop and implement policies that mitigate vulnerabilities in the system of market-based finance, to ensure that it can absorb and not amplify severe but plausible shocks.footnote [4]
But it is not feasible for NBFIs to maintain a level of resilience that would self-insure against the most extreme system-wide liquidity stresses, where increased liquidity demand may lead to forced selling among NBFIs. In such circumstances, central bank facilities can support financial stability by providing backstop liquidity by lending to NBFIs, reducing their need to sell assets.
To tackle any future episodes of dysfunction in core UK markets effectively, the Bank is therefore working to expand its toolkit so that it can provide liquidity directly to NBFIs at times of severe liquidity stress in those markets.
Our initial focus is the gilt market. This reflects the gilt market’s size, interconnectedness to other markets and the real economy, and its importance to financial stability.
The purpose of expanding the Bank’s toolkit is to be able to address severe gilt market dysfunction that threatens UK financial stability arising from shocks that temporarily increase non-banks’ market-wide demand for liquidity. It is not intended to provide liquidity support to eligible firms facing idiosyncratic liquidity or balance sheet stresses. As noted above, the primary responsibility for ensuring appropriate resilience remains with NBFIs themselves.
The Bank is expanding its toolkit for addressing severe gilt market dysfunction that threatens UK financial stability in two phases. In the first phase, the Bank is developing the CNRF, which will allow eligible pension funds, insurance companies and liability-driven investment funds to borrow cash against gilts at times of severe gilt market dysfunction. And in parallel to the development of the CNRF, the Bank is exploring how to design a facility that would enable broader access, to include more ICPF counterparties and reach a broader set of NBFIs that are relevant to the functioning of UK core markets. The CNRF is an important step towards the Bank’s goal of expanding its toolkit to support the supply of liquidity at times of severe gilt market stress to a broader range of NBFI and its development is helping us to progress the work to develop the broader facility.
For the CNRF, eligibility will be limited to insurance companies, defined benefit pension schemes, and liability driven investment (LDI) funds (collectively ICPFs). These entities are major holders of gilts and may be exposed to a material risk of gilt sales as part of their liquidity risk management during shocks. They are also an important part of the NBFI sector to cover in order to maximise the effectiveness of the tool. The effectiveness of the CNRF must also be balanced against the need for eligible firms to continue to have a sufficient level of ex-ante resilience.
There are constraints on the Bank’s ability to increase the overall number of its counterparties through the launch of the CNRF. This reflects the novel nature of the CNRF and the operational considerations of the Bank onboarding a new set of diverse counterparties. As such, eligible ICPFs will need to make a material contribution to the gilt market in order to maximise the effectiveness of the CNRF in addressing severe gilt market dysfunction that threatens financial stability, while the broader facility is still under development. We are still refining and finalising the eligibility criteria for assessing firms’ contribution to the gilt market, we anticipate that this is likely to be based around ICPFs’ holdings of gilts and related gilt market activity.
There may remain circumstances in which central bank lending may not entirely mitigate the most severe liquidity shocks and address the most severe gilt market dysfunction. However, it is preferable where possible to backstop market functioning by lending to counterparties rather than purchasing assets. Collateralised lending presents less risk to public funds, lower moral hazard and reduces unintended spillovers to monetary policy from financial stability interventions.
Design of the Contingent NBFI Repo Facility
This section sets out the rationale for the expected design parameters of the CNRF that are set out in the July 2024 Provisional Market Notice, and how these design choices reflect its purpose as a backstop to address severe gilt market dysfunction that threatens UK financial stability. Further details will be provided via a Market Notice and other documentation when the tool is launched for applications.
Tool activation and frequency of operations
The CNRF is designed to provide a backstop to be used at times of market-wide stress, and not by individual firms to mitigate idiosyncratic liquidity stress. The Bank envisages that the CNRF will be contingent and will only be activated at the Bank’s discretion during times of severe gilt market stress that threaten UK financial stability, when the demand for liquidity is outside the reach of the Bank’s existing facilities to lend to banks and other SMF participants, and when lending via the CNRF is likely to be effective in tackling gilt market dysfunction. It is expected that the CNRF would remain active until the Bank judges such risks to have subsided. To inform these decisions, the Bank will draw on a range of information to monitor market conditions including financial market data and market intelligence.
Bidding and allocation process
For the CNRF to be effective in mitigating market-wide stress, it must ensure that liquidity is supplied quickly and with certainty at sufficient volumes to restore regular market functioning. The Bank therefore intends that operations will operate as a full allotment at a fixed price, subject to counterparties remaining within counterparty-specific borrowing limits (set out in detail in the July 2024 Provisional Market Notice).
At activation, it is envisaged that the Bank will specify the price of borrowing through the CNRF and that all bids at this price will be accepted at the full amount bid, subject to borrowing limits. This means the price and amount of liquidity available to any counterparty will not vary depending on the bids of other counterparties, providing certainty that they will receive the full amount of their bid.
Lending term
The Bank will announce the term of lending for the CNRF via a Market Notice at the point of activation and it will be calibrated to reflect the nature of the shock.
The term of lending will be set to balance flexibility with operational burden, for both counterparties and the Bank. A short lending term would mean that the Bank can exit swiftly from the gilt market once orderly market functioning is restored, and counterparties would not be left with relatively costly borrowing from the Bank. But it increases operational costs if the term of lending is shorter than the duration of the stress and firms need to roll over their borrowing. For most stress events, we expect a lending term of 1 to 2 weeks would achieve the right balance between these considerations.
Pricing and fees
The Bank will announce the pricing of the CNRF via a Market Notice at the point of activation and it will be calibrated to reflect the nature of the shock. This will allow the Bank to respond flexibly and appropriately to the nature of the shock.
As a backstop facility, the Bank intends that pricing would be set such that it is not below comparable SMF facilities, and is attractive in times of stress but expensive relative to pricing in normal times. This will help ensure market participants continue to self-insure against a range of liquidity shocks. It will also encourage usage of the facility when conditions require market-wide liquidity support while ensuring a return to private markets as conditions normalise. Chart 1 shows the price (as a spread over Bank Rate) that ICPFs have paid for private market repo lending on average during normal market conditions in the past, and the volatility in price seen during the 2020 ‘dash for cash’ stress episode.
Chart 1: ICPF daily repo rates as a spread over Bank Rate, weighted by trade volumes
The Bank expects to charge eligible counterparties a fee for use of the CNRF to reflect the costs of operating the facility. This will be set at a level to encourage early sign-up. We expect to review the approach to setting this fee and communicate further details when the CNRF opens for applications.
Collateral and risk management arrangements
The CNRF is designed to address severe gilt market dysfunction that threatens UK financial stability. As such, eligible collateral for the facility will be limited to gilts only (both conventional and index-linked, including unconventional gilts such as strips).
To ensure that the facility can provide liquidity across counterparties, achieve market-wide impact and that NBFIs do not encumber a large proportion of their gilt holdings with the Bank, counterparties will be subject to individual borrowing limits and concentration limits on the amount that each counterparty can borrow against a single ISIN.
