Federal Reserve Steps Up Role in Tri-Party Reforms

The U.S. Federal Reserve will step up its oversight of reforms in the $1.7 trillion tri-party repo market because the industry is taking too long to eliminate the reliance on the intraday credit of the two clearing banks, which results in massive systemic risk, according to a Fed statement.

The U.S. central bank is reviewing the initial recommendations of the Tri-Party Repo Infrastructure Task Force and determining how the groups recommendations can better be implemented. The Fed says it may also consider restricting the types of collateral that can be financed in tri-party repo or even develop an industry-financed facility to foster the orderly liquidation of collateral in the event of a dealers default, according to a Fed statement.

The task force was formed in 2009 under the auspices of the Federal Reserve to figure out how to fix the systemic risks in the industry. Members include the two clearing banks (J.P. Morgan and BNY Mellon) along with dealers, investors, hedge funds, utilities, industry groups and technical advisers.

The key area of reform is to eliminate the daily unwind process. Clearing banks hold dealers collateral on a daily basis in return for a line of credit used to settle the repos. At the end of the day, the clearing bank returns the cash and collateral to the dealers.

The Fed explains why that is problematic: Clearing bank exposure to a single dealer is uncapped and can routinely exceed $100 billion. In the event of an intraday dealer default, a clearing bank would have to take the dealers entire portfolio of securities being financed via tri-party repo onto its balance sheet. This could affect the financial health of the clearing bank because its intraday exposures loom large relative to its capital. Liquidating such a large portfolio would take time, and the clearing bank would run the risk that the market value of the collateral would be less than the amount owed to the clearing bank.

The task force addressed the daily unwind and a number of other systemic problems in its initial assessment of the tri-party repo business. Since then, J.P. Morgan and BNY Mellon have established automated collateral substitution as well as three-way trade confirmation and three-way trade matching. The task force has also been publishing monthly reports on the size of the tri-party repo market. Yet while the clearing banks and the wider industry has implemented a number of the reforms, much yet remains to be done, and the $1.7 trillion tri-party repo business still relies on the intraday credit risk of the two clearing banks.

Despite these accomplishments, the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged, a Fed statement reads.

The task force issued its final report this week, acknowledging that the reforms will require more time and technical implementation than the task force originally estimated, and will constitute a multi-year project. The report identified an ultimate target state for the industry, including seven reforms that it says still need to take place: non-maturing trades will not unwind; most new and maturing trades will settle by 3:30 p.m., with smaller batches of trades settled thereafter; a common rule set for each dealers trades will be outlined in bilateral repo documentation; collateral allocation and optimization processes will be streamlined and automated; secured credit will be capped at 10% of a dealers tri-party book; clearing banks may process multiple transactions simultaneously; and general collateral finance repo settlement will be better integrated with tri-party repo settlement.

The Fed was clear in its belief that the task force has not gone far enough to push through the implementation of its own recommendations. While the task force has been an essential forum for generating and developing ideas, it has not proved to be an effective mechanism for managing individual firms implementation of process changes, the statement continues.

Task force members have put in considerable time and effort over the past two years to help bring about these improvements and to develop an improved understanding of what further changes are needed, says Darryll Hendricks, chairman of the Tri‐Party Repo Infrastructure Reform Task Force. The complex dependencies and relationships involved in the tri‐party repo infrastructure have made this collective forum essential, although now it is time for this work to move on to the next phase.

The role of the task force in guiding the reforms will be reduced as the Fed intensif[ies] its direct oversight of the infrastructure changes that the clearing banks and FICC [Fixed Income Clearing Corporation] are undertaking in order to reduce market reliance on intraday credit, according to the Fed statement.

For more on the systemic risk associated with the tri-party repo industry, read Tri-party: The overwhelming question, Global Custodian, Summer Plus 2010.