Central clearing for repurchase transactions could prevent the kind of runs on the repo market that triggered the financial crisis in 2007-2008, writes Jeff Penney, senior advisor to McKinsey & Company, managing member of financial services consulting firm High Line Advisors, and former Merrill Lynch executive.
During the crisis and continuing today, most repo agreements are made privately between a borrower and a lender. In central clearing, by contrast, a clearing house sits in the middle of a repurchase transaction, setting standards and acting as the borrower to every lender and the lender to every borrower.
Some critics view central clearing as a dangerous concentration of risk, but Penney argues that properly run clearing houses will control risk better than fragmented bilateral agreements and, as the hub of many trades, they can be a valuable source of information for regulators.
From Penney’s April 2011 paper, “Out of the Shadows: Central Clearing for Repo”:
The principal benefit of a clearing house mechanism is the mutual obligation of its members to meet the obligations of any single member. This shared liability encourages members to allow the clearing house to enforce risk guidelines such as membership and trading rules, collection of performance bonds, timing of events, collateral haircuts, and the maintenance of a dedicated clearing fund in excess of the margin on individual trades. As a result, rating agencies have bestowed a AAA-rating on such entities.
Other benefits could include access to Federal Reserve loans and services, more accurate pricing of collateral, expansion of acceptable collateral, better liquidity and price transparency, anonymous trading through an electronic system that displays bids and offers, better acceptance of longer-term repos, and lower capital requirements, Penney writes.
The repurchase market is the key funding mechanism for shadow banking. The collapse of the repurchase market drove the credit crisis in 2008. Yet, oddly, the Dodd-Frank Act mostly ignored repos.
“The focus of regulation has been on whether banks have adequate capital, but it has not focused on whether they have adequate funding. Loss of funding can overwhelm any capital base,” said Penney.
Penney notes that the Dodd-Frank Act requires central clearing for some derivatives. The same structure would benefit repo, he writes.
Repurchase agreements (repo) are the largest part of the “shadow” banking system: a network of demand deposits that, despite its size, maturity, and general stability, remains vulnerable to investor panic. Just as depositors can make a “run” on a bank, repo lenders can take their money out of the market, thereby denying the lifeblood of cash to broker-dealers (stand-alone or those owned by banks or bank holding companies), which rely on leverage to operate.
The entire shadow banking system has been demonized as a place where loans are hidden within derivatives among nonbank counterparties rather than displayed on the balance sheets of traditional, regulated banks. In reality, the shadow banking system is a legitimate market for secured financing, in which cash is lent in exchange for collateral.
Repo in particular has many positive attributes, including disclosure on the balance sheet; nevertheless, the financial crisis exposed several flaws in the secured financing markets in general and repo in specific, and the Federal Reserve System ultimately interceded with liquidity to prevent the further collapse of banks and broker-dealers.
While not categorized as a “derivative,” repo is an over-the-counter (OTC) contract that shares many key characteristics with derivatives, including a reliance on its counterparts to meet obligations over time. The inability of regulators to measure activity in OTC derivatives resulted in the passage of the Dodd-Frank legislation, which requires that certain instruments be moved to a central counterparty clearing house (CCP). As the nexus of all trades, a CCP provides visibility to regulators and credit intermediation for all market participants.
The benefits of central clearing are directly applicable to the repo market and are crucial to the global money markets that are relied on as a safe, short-term investment for individuals and institutions alike. Central clearing is needed to provide lenders with guaranteed return of cash without sensitivity to collateral or credit. A CCP also lays the groundwork for lenders to interact directly with borrowers in a true exchange with transparent pricing.
Central clearing of repo can also provide capital efficiency and more stable funding for banks and broker-dealers. Ultimately, a CCP for repo can evolve into a hub of funding activity for many forms of liquid collateral, thereby bringing the majority of the shadow banking system into full view.
Tri-party repo, where JP Morgan and Bank of New York Mellon already act as custodians for borrowers and lenders in a repurchase transaction, would also benefit from central clearing, says Penney. That’s because JP Morgan and Bank of New York Mellon manage collateral securities and cash for the two parties, but they are not a principal in the transaction and they don’t perform important tasks such as enforcing trading standards and managing risk, as a clearing house would, Penney writes.
Responding to concerns about the concentration of risk in a clearing house, Penney said it’s important that the clearing house be correctly implemented:
The concentration of transactions and their related risks at a CCP is far preferable to fragmentation of risks that are not visible to the market or to regulators. I could argue that the total systemic nature of shadow banking risk is the same, whether it goes through a central clearing house or not. The CCP does not create new net exposure … Rather, the CCP affords standardization, transparency, and consistent risk management. I don’t think that CCP’s “create” systemic risk so much as they shine a light on it.
Europe is ahead of the U.S. in using clearing houses, with nearly half of repo transactions being centrally cleared, Penney writes.
Meanwhile, Canada is also moving toward central clearing services for repo transactions. Agathe Côté, Deputy Governor of the Bank of Canada, Canada’s central bank, said in a speech June 28 that a central counterparty clearing house for Canadian-dollar repos is expected to be up and running later this year. Repos account for more than half of Canada’s shadow-bank, or market-based, financing, said Côté.
The financial crisis of 2007-2008 revealed the vulnerability of the repurchase market and the importance of reform. Penney writes:
Repo market contraction was the principal catalyst for the demise of the stand-alone broker-dealer model amongst the largest investment banking firms; Goldman Sachs and Morgan Stanley became bank holding companies so that they could raise cash against securities pledged to the Fed.
Loss of confidence in the interbank and money markets occurred quickly and with dramatic results. Once the market began to contract over credit concerns, a chain of events ensued: Lenders in the repo market withdrew their funds outright or via larger haircuts, and the interbank lending market collapsed; the shortfall in cash led dealers to raise capital; once all capital sources were tapped, dealers de-levered by selling assets, which in turn reduced the prices of the assets; ultimately the crisis wiped out the equity of many participants, resulting in insolvency and government bail-outs.
The challenge for the markets is to learn from this experience and to take steps to reduce vulnerability to another panic in the secured funding markets.
Until 2009, Penney was the Co-Head of Global Financing (prime brokerage, stock loan, clearing, and derivatives) and the Head of Americas Equity Sales at Merrill Lynch. Previously, he was the Product Manager for Financing Products and Co-Head of Equity Product Marketing at Morgan Stanley, according to his report. McKinsey & Co. has also published his study.
The major participants in tri-party repo include, according to Penney:
Bank of America/Merrill Lynch
Barclays Capital Inc
Credit Suisse Securities (USA) LLC
Citigroup Global Markets Inc
Daiwa Capital Markets America Inc
HSBC Securities (USA) Inc
Jefferies & Company Inc
JP Morgan Securities
Mizuho Securities Inc
Morgan Stanley & Co Inc
Nomura Securities International Inc
RBC Capital Markets LLC
RBS Securities Inc
UBS Securities LLC
Deutsche Bank Advisors
Goldman Sachs Asset Management
State Street Global Advisors
Western Asset Management