Regulators talk tough about tri-party reform

If the industry task force working to make the tri-party repurchase market more stable in a crisis won’t do the job, regulators may have to do it for them.

That tough warning comes from William Dudley, president of the Federal Reserve Bank of New York, in a September 23 speech before the 2011 Bretton Woods Committee International Council meeting in Washington, D.C.

In a surprising show of force, Dudley seemed to be throwing down the gauntlet, telling the world’s most powerful bankers and brokers – including tri-party giant JP Morgan Chase – that if they can’t get their act together on tri-party reform, regulators can impose solutions.

From Dudley’s speech:

I have my doubts whether the next set of industry recommendations to reduce risk in the triparty repo market will be sufficient to eliminate all the major potential sources of instability—including inadequate risk management practices and lack of resiliency to a dealer default.

Experience suggests that it is not easy for market participants to agree on measures that enhance financial stability when this goal conflicts with the commercial and business interests.

If the private sector falls short in this instance, public authorities may need to intervene and impose more forceful regulatory solutions.

(For a list of key tri-party participants, see below.)

Dudley’s speech repeats a warning issued by the Financial Stability Oversight Council in its 2011 annual report to Congress released July 26, but Dudley has a bigger hammer because  the New York Fed works intimately with the tri-party market 24/7.

In a ground-breaking story September 26 –  ground-breaking because the U.S. press so rarely writes about repos – Wall Street Journal reporter Min Zeng said:

Three years after the collapse of Lehman Brothers triggered a panicked credit crunch, changes aimed at bolstering safeguards in a key segment of the short-term lending market have fallen behind schedule, leaving the sector vulnerable to systemic risks at a sensitive time in world markets.

Now, the slow progress in a private-sector-led effort to strengthen the settlement structure for tri-party securities repurchases, or repos, has prompted a senior Federal Reserve official to signal that financial regulators may need to step in and push the overhauls forward.

Even better, Zeng provided this context:

The tri-party repo market has shrunk from a peak of around $2.8 trillion in 2008 following the financial crisis. The size of that market, and the systemic risks that went along with it, were a key motivation for the Fed’s moves to pump liquidity into the banking system.

And get this. Here’s the headline:

Tri-Party Repos Remain Vulnerable to Systemic Shocks

Imagine. The r-word (repo) is even in the headline.

In RepoWatch’s view, this is one of the most important stories about the crisis clean-up that the U.S. press has written, because it tells how little has changed in the pivotal tri-party repurchase market, and why.

Tri-party repo is a corner of the usually-bilateral repurchase market, where JP Morgan Chase and Bank of New York Mellon act as middlemen, performing such services as settling transactions and valuing and managing collateral. RepoWatch estimates tri-party represents about one-fourth of U.S. repo transactions, including all of those conducted by the Federal Reserve to implement monetary policy and many conducted by money market funds. Daily transactions are now at about $1.6 trillion, according to the Federal Reserve.

In 2008 JP Morgan withheld tri-party financing from Bear Stearns and Lehman Brothers, triggering their collapse – which then caused the Reserve Primary money market fund to break the buck – and intensifying fears that Goldman Sachs, Merrill Lynch, Morgan Stanley and maybe even JP Morgan itself would be next.  This was the seminal systemic risk most responsible for the Federal Reserve’s dramatic intervention in the financial markets in 2008, according to Federal Reserve Chairman Ben Bernanke.

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, but the task force has been unable to settle on reforms.

In Dudley’s speech, he described the conditions in the tri-party repo market that led up to the crisis:

Poor infrastructure design can serve to mask and obscure participants’ understanding of the credit and liquidity risks that they are exposed to. A good example of this is the triparty repo market, which plays a central role in providing funding on a collateralized basis.

This market for short-term credit evolved in the United States in a manner in which transactions between lenders and borrowers covered only part of each day—from late afternoon to early morning. During the middle of the day, the two large clearing banks supplied huge amounts of intraday credit to the major securities dealers.

Borrowers’ assumed this credit would always be available to them, and did not appreciate the rollover risk to which they could be exposed if a clearing bank decided not to lend to them during the day. Similarly, triparty lenders underestimated their exposure to borrowers, believing that the clearing banks would always return their funds each morning.

When triparty borrowers encountered funding pressures, these assumptions were starkly called into question.

The private sector Triparty Repo Infrastructure Task Force, created in 2009, has made progress toward the objective of creating a more stable triparty market, but deeper change is needed to achieve real systemic risk reduction in this market.

Dudley also expressed doubt that efforts to bolster bank liquidity have been adequate. Liquidity is a gauge of how readily a bank can access cash. In the crisis of 2007-2008, bankers needed to raise cash when repo lenders withrew, but they found themselves stuck with mortgage securities they couldn’t sell.

On the liquidity side, there has also been progress. U.S. banks have bolstered their liquidity buffers and the Basel Committee has proposed a liquidity coverage ratio requirement that effectively would require large, systemically important banks to hold sufficient liquid assets so that they could reasonably conduct their operations for 30 days without having to raise any new funds.

In addition, the industry is reengineering how the triparty repo system operates in order to significantly reduce the large intraday exposures of the two clearing banks in the system. This is important because, as we saw during the financial crisis, very large intraday exposures can prove destabilizing.

However, I would argue that progress on the liquidity front has not progressed as far as desired.

First, many banks remain dependent on short-term funding to finance longer-term assets from counterparties that tend to flee at the first signs of distress. In particular, money market mutual funds remain vulnerable to runs. Such runs can occur even when the underlying risks remain negligible, making money market mutual funds a source of instability. Just a question from an investor about the fund manager’s exposures can cause the fund manager to withdraw funding from a counterparty. This may be market discipline, but it does not operate in a way that makes the financial system more stable. The SEC is leading an effort to reform the money market mutual fund industry.

Second, the Basel liquidity coverage ratio is under review to ensure that it accomplishes its goals without creating adverse unintended consequences. It will be implemented but in a somewhat altered form, since the proposal is not locked down to the same degree as the Basel III capital standards.

Further, markets and regulators still don’t have enough information about financial institutions, Dudley said:

Similarly, information about counterparty exposures is not broadly available. Occasionally, information is revealed following specific stress tests, but disclosure is very incomplete and irregular.

Nor is good pricing information on many financial market instruments such as OTC derivatives readily available. This may ultimately change as such OTC derivatives instruments become more standardized, are centrally cleared, and the data associated with such trades are reported to trade repositories—but, as noted earlier, this still lies off in the future.

Similarly, implementing a global legal entity identifier standard that would enable regulators (and potentially others), to easily aggregate information on a consolidated legal entity basis is still a work in process.

The Office of Financial Research, created by the Dodd-Frank Act, is working on that last point, as are industry groups, according to Securities Technology Monitor.

Finally, Dudley warned that the post-crisis reforms have had little impact on shadow banking, and he explained why:

Similarly, there has been little progress made with respect to reengineering the financial system so that the transmission mechanisms act to dampen rather than amplify shocks.

However, I wouldn’t be very critical here. This is particularly difficult work for several reasons.

First, it is difficult because it relates to how all the parts of the financial system interact. It requires a holistic approach and an evaluation of how the financial system responds to shocks. Up to this point, regulatory reform efforts have been more focused on individual banks and infrastructures, rather than how the entire system functions.

Second, it is difficult because the evaluation must extend to entities and activities that operate outside of the more tightly regulated core—including, of course, the so-called “shadow banking system.”

In the U.S., some of this responsibility undoubtedly falls to the Financial Stability Oversight Council, which was created by the Dodd-Frank Act. But this is a relatively new institutional arrangement and how well it will be able to perform its mission in practice remains to be determined. Similarly, on an international basis, the Financial Stability Board has undertaken an initiative to evaluate risks within the shadow banking system, but this effort is also still in a fledging stage.

It sounds like Dudley believes the FSOC is responsible for reforming the U.S. repurchase market, and he’s not sure they’re up to the task.


*Members of the Tri-party Repo Infrastructure Reform Task Force are:

Darryll Hendricks, head of strategy for UBS Investment Bank

Clearing Banks
Bank of New York Mellon
JPMorgan Chase

Bank of America
Barclays Capital
Citigroup Global Markets Inc
Credit Suisse
Deutsche Bank
Goldman Sachs
JP Morgan Chase
Morgan Stanley
UBS Investment Bank

Fannie Mae
Federated Investors
State Street

Hedge Funds
Citadel Investment Group

Depository Trust & Clearing Corporation

Industry Groups
Investment Company Institute,
Securities Industry and Financial Markets Association,
Managed Funds Association


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s