Tri-party repo reform seen as helpful but will not avert 2008-style panic

JP Morgan Chase and Bank of New York Mellon are making good progress in protecting themselves from the tri-party repo risk that threatened their survival in 2008, but little progress is being made in protecting taxpayers who may have to pick up the tab once more if the tri-party system seizes again.

That’s the RepoWatch takeaway from tri-party reports released by the Liberty Street Economics team at the New York Fed April 11 and the Securities Technology Monitor May 2.

Efforts to protect JP Morgan and BONY Mellon are proceeding on schedule, and bankers expect to issue a report within the next month detailing the progress in reforming the tri-party market on several fronts, bank officials told Securities Technology Monitor reporter Chris Kentouris.

But no one has figured out a way to successfully counteract the run on the repo market that caused the credit crisis in 2007 and 2008 and could do so again the next time a major borrower like Countrywide Financial, Bear Stears or Lehman Brothers defaults, Liberty Street economists said.

From the Liberty Street report, “Everything you wanted to know about the tri-party repo market, but didn’t know to ask,” by Lucinda Brickler, Adam Copeland, and Antoine Martin:

 … little progress has been made to address the problem associated with the liquidation of a large dealer’s portfolio.

… because some dealers fund such large portfolios of securities financed in the tri-party repo market, the failure of such a large dealer could lead to a fire sale, as investors try to sell their collateral in an uncoordinated fashion. In addition, many financial institutions have to mark their assets to market, so fire sales of securities financed in the tri-party repo market could spill over to other markets.

Tri-party, thought to represent about one-fourth of U.S. repurchase transactions, has about $1.6 trillion in outstanding repos daily, down from its $2.8 trillion height in early 2008.

An interesting factoid from the Liberty Street report, which includes an easy-to-understand explanation of how tri-party works, is that there are more than 4,000 repo lenders active in the tri-party repo market.

The largest provide more than $100 billion each in tri-party repo financing a day, according to the New York Fed.

The Liberty Street report does not give the number of repo borrowers, but it says most tri-party repo borrowing is done by the 20 primary dealers authorized to repo with the New York Fed, and 10 of those securities dealers do almost 80 percent of the tri-party borrowing.

Individual borrowers routinely finance more than $100 billion in securities through tri-party repo daily, with the largest positions exceeding $200 billion, down from more than $400 billion in early 2008, according to the New York Fed.

In tri-party repo, JP Morgan Chase and Bank of New York Mellon act as clearing banks for repurchase transactions, providing such services as settling the transaction and valuing and managing collateral.

In that role, they were Ground Zero for systemic risk in 2007 and 2008, in part because the mechanics of the transactions required them to extend credit to the repo borrowers during the day. Fear for the safety of the two banks and tri-party repo propelled some of the Fed’s most dramatic actions during the crisis.

From an industry study of the tri-party market after the crisis:

The potential for the tri-party repo market to cease functioning, with impacts to securities firms, money market mutual funds, major banks involved in payment and settlements globally, and even to the liquidity of the U.S. Treasury and Agency securities, has been cited by policy makers as a key concern behind aggressive interventions to contain the financial crisis.

In 2009, a shaken New York Fed formed a task force of the large bank companies, Fannie Mae and the New York Fed to study ways to improve tri-party repo. The Task Force on Tri-Party Repo Infrastructure issued 16 recommendations in May 2010, including eliminating the intraday credit by October 2011.

But none of the recommendations will prevent the next run, and may even make it worse, the  New York Fed reported. The task force tried to agree on a solution for panics, but they could not.

The Securities Technology Monitor report includes some details of steps the task force participants are taking to make the market safer and explains how the changes are expeced to work. From the article:

Mark Trivedi, managing director and chief operating officer for global clearing and custody at JPMorgan and co-chair of the task force’s Operational Arrangements Working Group, says that the task force will be publishing a report within the next month to detail the progress that borrowers, lenders and the clearing banks have made vis-à-vis the recommendations proposed a year ago. …

Among the task force’s critical recommendations: by February 2011, broker-dealers can automatically substitute one type of collateral for another in their tri-party deals. As of August 2011, lenders and borrowers must match trades prior to settlement.

The task force also said that by August 2011, clearing banks should unwind repurchase agreements as of 3:30 p.m. Eastern Time each day instead of at 8 a.m. in the morning. By October 2011, the clearing banks should also cap the amount of credit they provide broker-dealers.

From the Liberty Street study:

The financial crisis highlighted some problems with the tri-party repo market. A white paper prepared by the New York Fed describes how this market may contribute to systemic risk. The white paper mentions three key areas of concern: 1) the tri-party repo market’s dependence on intraday credit provided by the clearing banks, 2) risk management practices that may increase stress in bad times, and 3) the lack of effective and transparent plans to support orderly liquidation of a defaulted dealer’s collateral.

Market participants are making progress on the first two points, but little progress has been made on the third point, Liberty Street reports.

In the next few months, the tri-party repo market will change in important ways as the recommendations of the Task Force are implemented. It will be interesting to see how the market adapts to new ways of doing things and what reforms are enacted to increase the stability of the tri-party repo market regarding dealer defaults. While the Task Force has accomplished quite a bit, more needs to be done to address the risk associated with the default of a large dealer.