The tri-party repurchase agreement market has undergonesignificant reform, and shifting clearing to an industry utility should furtherreduce concerns.
The tri-party repurchase agreement (repo) market’s volumehas fallen precipitously since 2012. Corporates have only tiptoed into the U.S.repo market, but reform measures underway as well as a major proposal to reducerepo fire-sale risk may pick up their pace.
The tri-party repo market peaked at close to $2 trillion insecurities changing hands daily in mid-2012 and its volume now hovers around$1.6 trillion. The drop has coincided with reform measures underway by the twomain clearing banks, BNY Mellon and JP Morgan Chase. Those measures havereduced the intraday credit extended by those clearing banks for dailysettlement and prompted market participants to better manage their liquidityand credit risk.
The Federal Reserve Bank of New York said in a Februaryreport that those measures should be well-established by year end, butfire-sale risk had yet to be addressed by market participants. It noted the tri-partyrepo market was especially vulnerable to such risk because liquidity pressuresand credit losses stemming from a defaulted bank counterparty could push manycurrent repo lenders to liquidate collateral, pushing prices down further and “triggeringmargin calls and deleveraging well beyond the repo market.”
That’s enough to give any investor considering repo-marketlending the jitters, much less conservative corporates. In a tri-party repoagreement, typically a bank agrees to sell securities to the investor andrepurchase them later at a higher price, and the transaction is cleared by athird party.
Fire-sale concerns, however, may soon be greatly reduced.The Depository Trust & Clearing Corporation’s Fixed-Income Clearing Corp.(FICC) plans to file a proposal with regulators in the fourth quarter thatwould establish a central counterparty (CCP) clearinghouse. The CCP wouldliquidate a defaulted member’s losses in an orderly fashion and thus, echoingthe CCP strategy taken in other markets such as swaps, stem the risk of uncoordinatedcollateral fire sales and downward spiraling prices.
Subject to regulatory approval, said Murray Pozmanter,managing director and head of systemicallyimportant financial-market utility businesses at Depository Trust & Clearing Corp., the FICC’sparent company, “We hope to be active with the service in the first half of 2015.”
The DTCC’s proposal would replace the two current tri-party repoclearing banks with a highly specialized clearing facility, the FICC, whichalready provides a clearing platform for general collateral financing (GCF)trades, a repo market open only to Wall Street dealers. That means FICC willtake on the counterparty default risk, and while BNY Mellon and JP Morgan willretain the custody and settlement risk, the reforms they’ve undertaken shouldminimize them, Mr. Pozmanter said.
Repos have been a major funding source for Wall Streetbanks, who fully collateralize the short-term loans with securities or cash.Lenders have typically comprised money market funds and other investors underthe Investment Company Act of 1940, although BNY Mellon has said morecorporates have entered the market recently.
Concerns about the repo market faltering and the disruptionof Wall Street funding negatively impacting other financial markets during thefinancial crisis prompted regulators to intervene on several occasions. Reformbegan in 2012, after the Tri-party Repo Infrastructure Reform Task Forcereleased its final report.
Since then, the decline in repo volume “is mainly due to adecline in agency securities that are used for tri-party collateral, while thevalue of Treasury securities and other securities seems to have held roughlysteady,” note Mahmoud Elamin and William Bednar, respectively researcheconomist and research analyst at the Federal Reserve Bank of Cleveland, in anApril report.
In mid-August, the Wall Street Journal reported banksincluding Goldman Sachs, Barlcays and Bank of America, have significantlyreduced their activity in the tri-party repo market, where they act asmiddlemen between lenders and borrowers.
Peter Nowicki, formerly the head of Societe Generale’streasury finance desk who more recently has discussed developing repo CCPs withexisting clearinghouses, said a shrinking repo market may elevate financialmarket risk because banks can less effectively manage their balance sheets. Asolution such as a CCP could help stem and perhaps reverse that decline.
“If a CCP is established well, it can hugely limit risk,” Mr.Nowicki said.
Capital Advisors Group has offered separately managedportfolios that enable corporate clients to invest in repos for more than twoyears. Lance Pan, director of research at the firm, said recent money marketfund changes have sparked interest by corporates in tri-party repo investments,but whether the establishment of a repo CCP will be viewed favorable remains tobe seen.
Mr. Pan said BNY Mellon and JP Morgan are already very wellknown in the corporate treasury community and their credit is generallyapproved on an unsecured basis. And while the FICC may ultimately be a more “worthy”intermediary for clearing repos, he said, Capital Advisors would have tounderstand its business model and agree to its notation of safety andexperience before it can recommend the service to our clients.
“Bottom line is, the entry of FICCinto the tri-party market is probably a good thing for the stability of therepo market in general. It is too early to see how this benefit directly helpssmall repo lenders,” Mr. Pan said.
The FICC proposal would allow lenders to join as full orlimited-purpose members. Full members would be able to both lend and borrow inthe repo market, and they would take part in the mutualization of any lossesstemming from the default of another member.
The limited-purpose membership, which most 1940-Act fundswould likely opt for – and probably most corporates – would only expose alender to losses if it were an original counterparty with the insolvent member.This would eliminate the risk of having to swallow mutualized losses from acounterparty with which it hasn’t traded. In addition, a limited member’smargin requirements would be far less than collateral requirements imposed onfull members.
The Options Clearing Corp. (OCC) plans to file a similarproposal for tri-party equity repos, in which it would take on the clearingfunction now performed by the BNY Mellon and JP Morgan. The equity repo market,which equity rather than fixed-income is provided as collateral, is much newerand smaller, and it’s less likely to be used by corporates.