Doubt cast on key tri-party repo reform

Three years after the financial crisis, Wall Street banks still have not fixed one of the most dangerous flaws in the markets, and they said July 6 they will not be able to meet an October 2011 deadline for reform because they haven’t figured out what to do.

They vowed to have a solution by mid-September and a new timetable for getting the work done.

In the crisis of 2008, one of U.S. regulators’ greatest fears was for the tri-party repurchase market, where JP Morgan Chase and Bank of New York Mellon act as clearing banks for about one-fourth of U.S. repo transactions, including those conducted by the Federal Reserve to implement monetary policy and many conducted by money market funds.

“To avert a collapse in confidence in the tri-party repo market, the Federal Reserve took extraordinary actions,” acknowledged a report by the Federal Reserve Bank of New York.

In their role as tri-party clearing banks, JP Morgan and Bank of New York settle transactions and they value and manage collateral. The mechanics of the tri-party transactions* require them to extend credit to the repo borrowers during the day. In 2008 that exposed Morgan and Mellon to potentially huge losses when repo borrowers like Bear Stearns and Lehman Brothers  spiraled toward insolvency.

In 2009, the New York Fed formed a task force of the large bank companies, mortgage giant Fannie Mae and the New York Fed to study ways to reduce the potential for systemic risk in tri-party repo. The task force issued 16 recommendations in May 2010. Among the recommendations was one they said was the most important, eliminating the intraday credit by October 2011.

That’s a deadline tri-party participants won’t meet, according to a July 6 progress report. The original plan, to improve existing proceedures, turned out to be inadequate, and a “substantial” rebuilding of the system will be needed, the task force reported. The progress report says the task force is “exploring approaches” to solving the intraday credit risk.

From the report:

The Task Force reiterates that its key end-state objective is the practical elimination of intraday credit. Originally, the Task Force had hoped to achieve this objective in 2011, along the lines outlined in the documents released by its Operational Arrangements Workstream at the end of 2010. Based on a thorough review, the Task Force has concluded that it is not possible to streamline the current settlement process sufficiently to position all cash and collateral to execute a simultaneous “unwind and rewind” of maturing and new trades early enough in the afternoon to be workable for market participants.

Accordingly, in order to achieve the end-state objective, the Task Force is now actively exploring approaches that entail a more substantial re-engineering of tri-party repo settlement mechanisms, including the potential adoption of multiple batch or real-time settlement approaches. In addition, the Clearing Banks have committed to significant further automation and enhancement of collateral allocation routines and algorithms, which will provide important support for such approaches.

The Task Force committed to the Federal Reserve Bank of New York that it will complete a revised plan for achieving its end-state objectives, including a detailed timetable, by mid-September 2011. This plan will be posted to the Task Force’s website at that time.

Meanwhile, the Brits seem to be making some progress, according to a July 5 news release from Euroclear UK and Ireland, the area’s central securities depository.

In both the U.S. and U.K. tri-party markets, repo borrowers and lenders make their deals in the afternoon and undo them the next morning. Even if the loan is for more than a day, it’s still undone each morning and renewed each afternoon, so the borrower can trade the repo collateral during the day. The clearing bank, or the settlement bank in the U.K., becomes the borrower’s interim repo lender during the day.  That’s where the intraday risk resides.

Euroclear is no longer going to unwind the longer-term deals every day.

From reporter Chris Kentouris’ July 8 story for Securities Technology Monitor:

Lenders and borrowers no longer have to worry about the potential error in not moving cash and securities between each other daily. Settlement banks used by cash lenders and borrowers to settle their repurchase agreements will no longer have to extend as much credit to the borrower or the lender on an intraday basis to ensure that in the event of a default the cash lender receives its cash back if the collateral put up by the borrower wasn’t enough to cover the cash amount.

Cash lenders and borrowers use 13 settlement banks in the UK to settle their repo agreements in Euroclear UK and Ireland’s settlement platform called CREST. Alhough those settlement banks can seize title of client assets to cover intraday exposures, market conditions can change the price of the collateral and impact just how much the settlement bank can actually recoup.

The U.S. task force said in its July 6 progress report that it is progressing on other aspects of tri-party reform.

None of the changes, however, will prevent another run on the tri-party repo market, like the one that felled U.S. investment banks in 2008, and they may even make it worse, the New York Fed has reported. The U.S. task force said it tried to agree on a solution for panics, but it could not. Moody’s, however, believes the reforms could lessen the risk of a run.

Tri-party repo in the U.S. is dominated by giant broker-dealers. On a typical day in June, three dealers – names not disclosed – accounted for 40 percent of the action, which averaged $1.66 trillion, down from $2.8 trillion at its height in early 2008, according to reports posted by the New York Fed.

RepoWatch is heartened to see that the U.S. tri-party repo announcement of delays made the July 7 Wall Street Journal, even though it was only a three-paragraph brief on page C7. That does seem like a strange way to treat the uncertainty of such an important crisis reform. But on the positive side, the brief by Cynthia Lin actually mentions the r-word (repo), even in the headline “‘Repo’ reforms lag.” Sadly, the item has been deleted from the online version of the July 7 markets briefs.


* Here’s Moody’s explanation of the intraday credit risk, as reprinted in the Financial Times:

An “unwind” of all outstanding repo trades occurs every morning between 8am and 8:30am, when the tri-party agent returns the collateral to the dealer and the cash to the cash investor. At that time, the tri-party agent does not receive cash from the dealer in exchange for the return of the collateral to the dealer. Instead, until the transaction – whether a term repo or a rolling overnight repo – is “rewound” in the afternoon, the tri-party agent is lending to the dealer, secured by a lien on all of the dealer’s collateral (including what was returned during the unwind) held at the bank. The purpose of the unwind is to provide dealers access to all of their securities (including those that are pledged on repo) to settle trades, which occur throughout the day. Because securities are returned to the borrowers, cash must be returned to the lenders so they are not subject to unsecured risk. Such intra-day credit extension by the agents, while it is the norm, is not guaranteed by the clearing agreement and can be withdrawn at any point, particularly if the dealer’s creditworthiness deteriorates.

Here’s the New York Fed’s explanation of the intraday credit risk:

According to current operational practices, a cash lender and a cash borrower arrange their tri-party repo transactions bilaterally in the morning, agreeing on the tenor of the repo, the amount of cash provided, the value of the collateral provided, and the repo rate, among other parameters. The actual securities used as collateral are assigned later by the tri-party agent (or, in some cases, by the cash borrower), such that they meet the schedule of acceptable collateral specified by the cash lender. After the terms of the transaction are agreed upon, the dealer notifies its clearing bank. In some cases, only the very basic terms of the repo are communicated.

Late in the day, the clearing bank, adhering to the terms of the transaction provided by the borrower, settles the repos by simultaneously transferring collateral and cash between the borrower’s and lender’s cash and securities accounts at the clearing bank. In other words, securities are moved from the borrower’s securities account to the lender’s securities account and the corresponding cash amounts are transferred from the lender’s cash account to the borrower’s cash account; this process “locks” the borrower’s securities in the lender’s account. A dealer allocates specific securities to each transaction using its clearing bank’s or its own collateral optimization engine, as constrained by the schedule of acceptable collateral. Overnight, the lender holds the collateral, which exceeds the value of the cash loan by the value of the haircut, to offset the risk that the borrower will not be able to return the appropriate amount of cash the following day.

Prior to 8:30 a.m. each day, the clearing bank extends credit to each dealer and returns the securities that were pledged as collateral so that the dealer can deliver any securities that are sold to buyers. Throughout the business day, broker-dealers buy and sell securities for their own and their client-owned positions. These securities are delivered into and out of the dealer’s securities account at its clearing bank.

This process of returning the collateral to the dealer is referred to as “unwinding” the repo, and it generally applies to all repo transactions, even those term transactions not maturing that day. The unwinding each morning creates an overdraft in the dealer’s cash account at its clearing bank when the clearing bank returns the repo collateral to the dealer and returns the cash borrowed by the dealer to the lender’s demand deposit account. Once their cash is returned through the unwinding, the majority of cash lenders elect to leave the cash in uncollateralized demand deposit accounts at the clearing banks, because most of this cash is typically reinvested at the end of the day.

The intraday overdraft, which remains in place between the morning unwinding and the end-of-day lock-up, or “rewinding,” imposes on the clearing bank a credit exposure to the dealer that is collateralized by the securities in the dealer’s account. Dealers use the cash they receive from lenders at the end of the day to extinguish these overdrafts. Concurrently, the dealer’s cash account at the clearing bank is adjusted for the offsetting cash transactions. Because dealers typically do not have sufficient cash balances at their clearing bank to pay for their securities purchases during the day, the clearing bank extends intraday credit to the dealer and takes a lien on the dealer’s security as collateral.



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