By Steven K. Beckner
(MNI) – “Systemic weaknesses” are continuing to stand in the way of
much needed reforms in the U.S. Tri-Party Repo Market, according to
research by the New York Federal Reserve Bank released Monday.
A key reform which is needed to reduce or ideally eliminate the
time gap that occurs each day when repo market participants unwind and
rewind their repurchase agreements, argue New York Fed senior economist
Adam Copeland and several colleagues.
Without reform, vulnerabilities in the market — particularly in
the event of a dealer failure — could lead to system-wide financial and
economic problems, they warn.
Repos, in effect collateralized loans in which the holder of a
security agrees to sell it and buy it back at a lower price, are a major
source of liquidity on Wall Street. But they became a source of
instability in the wake of the Lehman Brothers collapse in September
2008.
Since then, the New York Fed has been working with major financial
institutions to reform and strengthen the so called tri-party repo
markets, in which a clearing bank is involved in facilitating
settlement.
But Copeland and his fellow researchers make clear they think the
progress made so far has been unsatisfactory in a market which they have
previously estimated at roughly $5 trillion.
“A well-functioning tri-party repo market depends on the ability to
efficiently allocate a dealer’s securities — the collateral in the
transaction — to the various repos that finance those securities,” they
observe. But they say contend that this collateral allocation is less
than efficient.
“In the United States, collateral allocation currently involves
considerable intervention by dealers, which slows the entire process,”
write Copeland, New York Fed staffers Antoine Martin and Susan
McLaughlin and Stanford professor Darrell Duffie.
They complain that “collateral allocation is also complicated by
the need for coordination between the Fixed Income Clearing Corporation
(FICC), which clears some interdealer repos, and the clearing bank,
which facilitates the settlement of tri-party repos.”
“The length of time necessary to allocate collateral in the
tri-party repo market has been a significant obstacle to market reform,”
the researchers add.
Another “impediment to reform,” they allege, is the “unwind
process” — the settlement of expiring repos that occurs before new
repos can be settled.
This “unwind” creates a need for intraday funding to tide dealers
over in the period between when they return cash to investors and when
they get new cash from the settlement of new repos. In the tri-party
repo market, this intraday financing is provided by the clearing banks.
The dealers’ reliance on intraday credit is one of the three
weaknesses of the market highlighted in a New York Fed white paper on
infrastructure reform.
Copeland and company warn “such reliance creates potentially
perverse dynamics that increase market fragility and financial system
risk.”
They conclude that changes are needed in the structure of the
tri-party repo market. In particular the time it takes to coordinate the
process of collateral allocation needs to be greatly shortened, they
say.
“The collateral allocation process in the tri-party repo market
currently requires a considerable amount of time, partly because of the
desire of some dealers to intervene in this process,” they write. “In
addition, the need to settle in the GCF (General Collateral Finance)
market before the rest of the tri-party repo market only extends the
length of the process.”
“Settling in the GCF market also requires coordination between the
Fixed Income Clearing Corporation and the clearing banks as well as
communication between their systems,” the researchers note.
“A similar form of coordination is required with the Depository
Trust Company,” they continue. “The time required to allocate collateral
makes it difficult to settle new and expiring repos simultaneously and
thus to reduce the dealers’ reliance on credit from their clearing
banks.”
Copeland and colleagues say “this factor has been an obstacle to
ongoing reforms of the tri-party repo market.”
Another problem is that “the daily time gap between the unwind and
rewind of repos drives much of the demand for intraday credit from the
clearing banks, contributing to the fragility of the market in several
ways.”
“First, the gap between unwind and rewind means that there is a
twice-daily transfer of exposure from a dealer’s investors to its
clearing bank, and then from its clearing bank back to its investors,”
they write. “This handoff can create a perverse dynamic if the dealer
comes under stress, as both the cash investor and the clearing bank may
want to be the first to reduce exposure to the dealer.”
“Moreover, if a dealer declares bankruptcy during part of the day,
its clearing bank could be weakened,” they go on. “This could create
spillovers to other dealers that use this clearing bank for their
tri-party activity, because investors may fear exposure to the clearing
bank. It could also lead cash providers whose cash accounts are at the
clearing bank to demand their cash on short notice, further exposing the
clearing bank or promoting a fire sale of some collateral.”
Copeland and his fellow authors warn that “a dealer failure could
disrupt the clearing bank’s ability to function and thus undermine its
ability to conduct other important payment, clearing, and settlement
activities.”
They warn “this could not only destabilize the tri-party repo
market, but also serve as a channel for transmitting systemic risk more
broadly throughout U.S. and even global financial markets.”
They maintain that “a collateral allocation process that allows for
the simultaneous settlement of new and expiring repos would eliminate
the gap between unwind and rewind, reducing the dealers’ need for
intraday credit.”
“The clearing banks could design a collateral allocation system
that achieves the various optimization objectives desired by dealers,
thereby removing the incentive for them to manually intervene in the
process,” they write. “The resulting collateral allocation process would
also need to be transparent to investors, allowing them to evaluate
their own settlement risks.”
** MNI **
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