–NY Fed’s Dudley Committed to Manage Risk, Resilience in Tri-Pty Repo
By Steven K. Beckner
(MNI) – The New York Federal Reserve Bank released a “white paper”
Monday containing task force recommendations for reforms of the market
for tri-party repurchase agreements — the huge market whereby large
financial institutions obtain short-term funding of their operations.
The Task Force on Tri-Party Repo Infrastructure, which was created
by the New York Fed-sponsored Payments Risk Committee in 2009,
recommends steps to “dampen the potential for problems at one firm to
spill over to others, clarify the credit and liquidity risks borne by
market participants, and better equip them to manage these risks
appropriately.”
The key element of task force recommendations, which are being put
out for a 30-day comment period, is “to reduce reliance by market
participants on intraday credit provided by tri-party repo agents,” says
the white paper.
“Other complementary recommendations are designed to foster
improvements to credit and liquidity risk management practices of market
participants, enhance market transparency, and decrease the likelihood
and mitigate the negative effect of default by a large cash borrower.”
New York Fed President William Dudley welcomed the task force
recommendations, saying, “The Federal Reserve is committed to initiating
actions, as necessary, to promote strong risk management practices by
all market participants and the stability and resilience of financial
markets more broadly. The work of the task force represents an important
step in this direction.”
Repurchase agreements, whereby securities are sold with an
agreement to repurchase it at a certain price at a later date, are like
collateralized loans. In the tri-party market, two government securities
clearing banks act as “tri-party agents,” facilitating transactions
between cash lenders such as mutual funds and cash borrowers, such as
fixed income securities broker dealers — often acting on behalf of
brokerage clients.
U.S. tri-party repo transactions settle entirely on the books of
one of two “clearing banks”: Bank of New York Mellon (BNYM) and JP
Morgan Chase (JPMC).
The tri-party repo market first developed in the 1980s and grew
dramatically, as a report by the Payment Risk Committee explains,
because of its “treatment of repurchase transactions in bankruptcy, the
use of securities as collateral (including daily margining and
haircuts), and the custodian services of the Clearing Banks which
provide protections that do not exist for bilateral repo investors or
unsecured creditors.”
“As a result, the U.S. repo market contributes significantly to the
liquidity and efficiency of the U.S. Treasury and Agency (including
Agency MBS) securities markets, which collectively make up approximately
75% of the total collateral in the U.S. repo market,” says the report.
“The importance of the U.S. repo market is underscored by the fact that
it is the market in which the Federal Reserve operationally implements
U.S. monetary policy.”
At its peak in 2008, the tri-party market provided financing of
$2.8 trillion worth of securities. But as the financial crisis
intensified, the market became vulnerable and suspect. So the task force
was launched at the New York Fed’s behest.
As conditions in credit markets deteriorated in 2008 and 2009,
“weaknesses were revealed in the infrastructure supporting tri-party
repurchase agreements,” says the white paper. “These weaknesses had the
potential to amplify instability in the financial system.”
To avert a collapse in confidence in the tri-party repo market, the
Fed established the Primary Dealer Credit Facility (PDCF) and the Term
Securities Lending Facility (TSLF) to help primary dealers meet their
funding needs and provide liquidity. But those facilities have now been
closed, and the white paper says, “Concerns about the infrastructure
persist … and must be addressed to increase the resiliency of this
critical market to future stresses.”
The task force, chaired by UBS senior vice president Darryll
Hendricks, was created to “address the weaknesses in the infrastructure
of the tri-party repo market that became visible over the course of the
financial crisis,” according to a document released by the New York Fed.
Among those perceived weaknesses were: “the market’s reliance on large
amounts of intraday credit made available to cash borrowers by the
clearing banks that provide the operational infrastructure for these
transactions.”
Also, “the risk management practices of cash lenders and clearing
banks were, with the benefit of hindsight, inadequate and prone to
pro-cyclical pressures.” And there was “a lack of effective plans by
market participants for managing the tri-party collateral of a large
securities dealer in default without creating potentially destabilizing
effects on the rest of the financial system.”
The task force, which included major tri-party repo market
participants, service providers, industry groups and others and received
input from the New York Fed and the Securities and Exchange Commission,
identified the following areas for improvement: operational efficiencies
and arrangements; issues related to dealer liquidity risk management;
margining practices and loss anticipation; contingency planning in the
event of Dealer default; and transparency measures.
It made the following recommendations:
* “Operational Arrangements: Specific actions must be taken to
reduce the marketfs reliance on intraday credit provided by the
Clearing Banks and clarify the credit and liquidity risks borne by
market participants;
* “Dealer Liquidity Risk Management: Dealers should account for the
loss of secured funding within their liquidity risk management plans and
liquidity stress tests, and size liquidity buffers accordingly;
* “Margining Practices: Margining practices must be broadly
strengthened. A number of margining best practices are recommended;
* “Contingency Planning: Cash investors should develop ‘liquidation
plans’ for the management and liquidation of repo collateral in the
event of Dealer default;
* Transparency: Greater market transparency is needed in all
respects. Transparency of collateral valuation is an essential component
to secured funding. Broad availability of real time prices for many
collateral types should be used by Clearing Banks and Dealers to provide
same-day valuation information for as large a population as possible.”
It is expected that, after the public comment period, the New York
Fed will seek to have these recommendations implemented and that it will
continue to monitor the tri-party repo market to determine if its
resiliency has been strengthened to face any future financial strains.
** Market News International **
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