The $1.7 trillion tri-party repo market has been subject to increasing public scrutiny after the collapse of Lehman Brothers. In a recent written testimony before the U.S. House Financial Services Committee, Treasury Secretary Tim Geithner said: Tri-party repo and money funds are prominent examples of market structures and practices that were not robust enough to withstand a major disruption.
As a result, the Tri-Party Repo Infrastructure Reform Task Force, formed by the Federal Bank of New York in 2009, has issued a number of recommendations to reform the tri-party repo market. Key among the proposals is a desire to reduce the reliance by market participants on intraday credit supplied by tri-party repo agents, and an increase in liquidity risk management by dealers.
The Task Force is aiming for a practical elimination of intraday credit provided by the two Clearing Banks (in the case of the report, the tri‐party label refers to repo transactions that settle entirely on the books of one of two Clearing Banks in the U.S. market: Bank of New York Mellon and JP Morgan). This is defined as a point beyond which the residual amounts of intraday credit extensions are both small and can be governed by transparent bilateral arrangements, known in advance to participants.
Both BNY Mellon and J.P. Morgan have already promised to implement operations in order to reduce intraday credit by February 2011. The key method proposed is automated collateral substitution (auto-substitution), which aims to allow dealers access and settle trades that are financed with tri-party repo without unwinding the underlying tri-party repo transaction. If this is implemented successfully, up to 90% of the daily extension of credit would be reduced.
The Task Force also hopes to address liquidity risk management amongst dealers. Prior to the collapse of Lehman Brothers and Bear Stearns, many dealers assumed that intraday credit would be extended indefinitely by the clearing banks, no matter the market conditions. After the collapse of Lehman Brothers, governments across the world eventually extended credit indefinitely as intraday liquidity dried up. However, it is unlikely that the general public would accept such a bail-out in a similar situation again.
As a result, the Task Force has proposed that dealers must account for the potential withdrawal of credit extensions in their liquidity risk management plans and stress tests, and put in place liquidity buffers. The Task Force hopes that such a buffer would prevent a Lehman-type event, where market stress resulted in a self-fulfilling solvency for the beleaguered bank. The Task Force has also called upon regulators to help enforce improvements on liquidity management, although it is unclear how this would be implemented.
The Task Force report also repeatedly mentioned the need for cash investors to be aware of dealer credit quality through greater market transparency. Liquidation Plans should be developed by cash investors in case of a dealer default, taking into account custody relationships and losses through collateral volatility.
A collateral liquidation manager service, provided by the DTCC, was also mooted. The DTCC was unavailable for comment on the details of this service at the time of press.
Support for the reform has been offered from the Securities Industry and Financial Markets Association (SIFMA). Rob Toomey, managing director and associate general counsel, said: The recommendations issued will clarify, through significant operational enhancements, the credit and liquidity risks borne by all market participants, improve contingency planning and boost transparency in this market. These are all essential steps towards ensuring the tri-party repo market functions well, especially in a crisis situation.
Change is already apparent in the market, with the percentage of tri‐party repo trades unwound on a daily basis decreasing by an average of 10% from September 2009 to March 2010. However the New York Fed issued reservations about the breadth of the Task Force report, stating the steps proposed to increase cash investors preparedness for the sudden failure of a large dealer do not directly address concerns that such failure could prompt the simultaneous liquidation of large amounts of assets and create fire-sale conditions.
The New York Fed also pointed out the dealer funding costs may rise due to the increased awareness of investors to the risk of having to accept collateral in lieu of cash in the event of default. To compensate for the increased difficulties in obtaining secured financing, dealers may also pass on the increased funding costs to the investor.
The key players in the tri-party repo market are also expected to make a formal commitment to implement needed enhancements to tri-party repo infrastructure in a timely manner, according to the regulator.
The New York Fed is now seeking comment from the public on the proposed changes.
The full reform proposals, plus comments from the New York Fed, can be found here.
Results of 2010 Global Custodian Tri-Party Securities Financing Survey can be found here.