The tri-party repurchase market is more vulnerable to panic and abuse and further from being fixed than has previously been understood, based on recent reports.
This matters, because tri-party was the chief trouble spot in the financial markets in 2007 and 2008, and its reform is vital, federal officials have said.
From a February 15, 2012, statement by the Federal Reserve Bank of New York:
The tri-party repo market is an important part of the U.S. financial system. However, as observed during the recent financial crisis, the tri-party repo market’s infrastructure exhibits significant structural weaknesses that undermine market stability in a stressed environment. The Federal Reserve was forced to take extraordinary policy actions beginning in 2008 to counteract the effect of these flaws and avert a collapse of confidence in this critical financing market. These structural weaknesses are unacceptable and must be eliminated.
In spite of these strong words from the Fed, here’s the bottom line that emerges from several reports:
Critical transactions in the U.S. financial markets occur on a substandard system overseen by two clearing banks, JP Morgan Chase and Bank of New York Mellon, and the Federal Reserve Bank of New York who were blind for years to the dangers.
That blindness was at least as serious as their failure to see the dangers in the mortgage waste that was piling up in the financial markets at the same time.
(Editor’s note: See accompanying story, “Are JPM and BoNY the best we can do?” about alternative structures for the U.S. tri-party market system.)
The Fed’s approach to fixing tri-party repo is to work with Wall Street firms toward a solution. In September 2009, the New York Fed formed a task force of JP Morgan, Bank of New York, and giant repo borrowers and lenders to study ways to reduce the potential for systemic risk in tri-party repo. (See below for a list of the task force members.).
This meant reform efforts would be developed in private by the same people who created the crisis in the first place. Tri-party did not become part of congressional deliberations or the July 21, 2010, Dodd-Frank Act, which essentially ignored tri-party reform except to put the Fed in charge.
After many meetings, the Fed’s task force released its final report February 15, saying it has made important progress but reforms will take longer than it expected, some will not be completed until perhaps 2016, and even then they won’t fix all of the Fed’s concerns.
The New York Fed said in a statement the same day that it will oversee the implementation of the reforms going forward and the Federal Reserve will work with Wall Street firms to try to find other ways to fix the still-unresolved dangers. Developments will be noted at the task force web site.
In other words, reform of tri-party repo will come years from now, if at all.
For anyone who reads the task force’s reports, this is a sobering conclusion.
That’s because the reports lay out in the starkest terms a fly-by-the-seat-of-your-pants system where the parties to a transaction – the repo borrower, the repo lender, and the clearing bank – might not know what the others were doing.
Deals were sealed in an almost by-guess-and-by-golly way, leaving both the repo borrower and the repo lender at the mercy of their clearing bank, which might have to make decisions without having key information.
Through the work of the task force, the two clearing banks have made real improvements. But huge gaps remain.
First, some background
Tri-party repo is a corner of the usually-bilateral repurchase market. It was begun in its current form in 1985, with the encouragement of the Federal Reserve, to be a safer and cheaper alternative to bilateral repo.
In tri-party, JP Morgan and Bank of New York act as middlemen, performing such services as finalizing transactions negotiated between the repo borrower and lender and selecting, valuing and managing the collateral in the transaction. JP Morgan gets about 44 percent of the tri-party business, while BoNY has about 56 percent, according to a November 10, 2011, study by senior analyst Anshuman Jaswal at the research firm Celent, “Triparty Repo in the US – Well Begun But Far from Done.”
In their role as tri-party middlemen, JP Morgan and Bank of New York were Ground Zero for systemic risk in 2007 and 2008, in part because the mechanics of the transactions meant that they, not the repo lender, were at risk if the repo borrower defaulted during the day. Fear for the safety of the two giant banks and the critical tri-party system propelled some of the Fed’s most dramatic actions during the crisis.
Currently, about $1.7 trillion in repo loans are outstanding every day on the tri-party market, down from a high of $2.8 trillion in early 2008, according to the Federal Reserve. This includes all repos conducted by the Federal Reserve Bank of New York to implement monetary policy, most of the repo loans made by money market funds, and many of the repo loans received by the Fed’s 21 Primary Dealers.
Primary Dealers are major securities dealers who are approved to conduct monetary-policy transactions for the Fed. In February, about $90 billion of the daily tri-party transactions were repo loans made by the Fed to its Primary Dealers, the Fed reported. Primary Dealers also do many of their non-Fed deals through tri-party. (See below for more information about Primary Dealers and for lists of Primary Dealers today and during the financial crisis. Almost every name made famous by the crisis is there.)
The Fed began using the tri-party market for its repos in 1999, as part of a plan to keep credit flowing in case of tension in the days around the turn of the century. The Fed committed to tri-party just after a repo run nearly felled Long-Term Capital Management hedge fund in 1998 and just as the run-up to the historic financial crisis in 2008 was beginning. Presumably the Fed could go back to bilateral deals if it had to.
Tri-party is a concentrated market, with the largest lenders each providing more than $100 billion a day in financing and the three largest borrowers doing about 35 percent of the borrowing. Individual companies routinely borrow more than $100 billion daily, with the largest dealers borrowing more than $200 billion, according to the New York Fed.
Tri-party is a tightly knit market that exists mainly to serve the 21 Primary Dealers, their repo lenders, the two clearing banks and the Federal Reserve.
According to the task force reports, here’s how the tri-party repo market worked at the time of the financial crisis:
-During each day, traders on the repo desks at companies that wanted to borrow, like securities dealers or hedge funds, negotiated $2.8 trillion in repurchase transactions with repo desks at companies with cash to lend, like money market funds, pension funds or investment pools. In early 2008 the largest dealers were each borrowing more than $400 billion a day, according to the New York Fed.
For our example, let’s say that one day Lehman Brothers negotiated a $100 billion repo loan from Prime Money Market Fund, with JP Morgan serving as Lehman’s clearing bank.
-That evening Lehman told JP Morgan to make the deal happen. So JP Morgan took $100 billion in cash from Prime’s account, electronically, and gave it to Lehman’s account, and JP Morgan took at least $100 billion in securities electronically from Lehman’s account and gave them to Prime’s account. Prime trusted that JP Morgan would transfer enough collateral to meet the terms that Prime had negotiated with Lehman.
-The next morning before 8:30 a.m. JP Morgan used its own money to pay back Prime’s account, with interest, and it returned the securities to Lehman’s account, but it didn’t collect $100 billion from Lehman. At that point, JP Morgan became Lehman’s lender, secured by a lien on the securities in Lehman’s account.
-That evening, JP Morgan returned the securities to Prime, or to another lender that had negotiated a repo loan for Lehman during the day. At that point, JP Morgan got its $100 billion back.
In tri-party jargon, JP Morgan unwound the repo in the morning and rewound it in the evening. Even if the repurchase agreement was a long-term contract, say for 30 days, JP Morgan unwound it every morning.
Why? JP Morgan did this because Lehman wanted to use its securities during the day, maybe several times during the day, to get other repo loans, to lend, to short stock, and to do other trades.
In retrospect, there were several serious problems with this process, according to New York Fed and task force reports.
-The entire system was vulnerable to a run by repo lenders like Prime. If they suddenly lost faith in the clearing banks or in major borrowers, they could slash their lending almost overnight. This is what happened in 2008.
-Because of the morning unwind (which left the two clearing banks extending up to $2.8 trillion in credit daily), a giant borrower that defaulted during the day could put one of the world’s largest financial institutions in danger and threaten the entire tri-party market and beyond.
-The clearing banks and repo lenders had no policy for dealing with the huge chunks of collateral that could land in their laps if a borrower defaulted. Each thought they could seize the collateral before the other – the clearing bank during the day and the lender at night. But once they had it, they had no procedure for selling it fast enough so they weren’t damaged financially, slowly enough so they didn’t drive down prices, and orderly enough not to spook other lenders.
Making this problem worse was the fact that 30 percent of the collateral on the tri-party market in 2008 was privately issued securities, including those backed by mortgages, instead of U.S. government securities, and they could be hard to sell, according to the Fed. (Today it’s 15 percent.)
Other problems noted in the reports:
-Money market funds sometimes accepted collateral their regulators did not allow them to own. This could force funds into panic selling when borrowers defaulted. It could drive funds to exit the market at the slightest tremor.
-No data was publicly available on the tri-party market, so few people knew how big and concentrated it was, whether lenders were adequately collateralized, or how much intraday credit the clearing banks were extending.
-Clearing banks and lenders could demand more collateral or withdraw loans, and clearing banks could refuse to process transactions, with little warning.
-There was no agreed-upon way to set the value of the collateral.
-Clearing banks had so little information about a borrower’s financing situation during the day that they could unnecessarily withdraw a borrower’s intraday credit and trigger a panic even when the borrower was financially sound. Countrywide, Bear Stearns, Lehman Brothers, and MF Global have made this complaint.
-JP Morgan and Bank of New York didn’t communicate with each other on a realtime basis.
-There was no established, mandatory process for settling and confirming transactions among all three parties. Clearing banks processed transactions relying mainly on data received from borrowers, who sometimes didn’t report deals at all and sometimes gave information that didn’t jive with the lender’s understanding of the deal. A clearing bank might not know until the end of the day that a borrower had not been able to renew all its repo loans. If a borrower couldn’t get all the financing it needed, there was no plan for prioritizing which collateral didn’t get financed. Lenders didn’t always get timely information from the clearing banks about the collateral they’d be receiving to secure their loan or when the collateral would arrive.
Errors in this settlement process were one reason the clearing banks unwound the deals every morning, according to the task force. Securities Technology Monitor reporter Chris Kentouris noted this problem in a December 12, 2011, story:
Until now, clearing banks relied primarily on transaction data received from broker-dealers, which could occasionally result in a mismatch between the two counterparties in their understanding of the trade details. Neither JPMorgan nor BNY Mellon has ever disclosed the frequency of the errors or costs involved.
Here’s the progress the task force has made so far in addressing these problems, according to its final report:
-Mandatory three-way trade confirmation began at the end of 2011. For the first time, the three parties to all tri-party transactions get an established, written confirmation of the deal and its terms.
-The daily unwind has been moved to 3:30 p.m., except for deals where the collateral is being reused (rehypothecated, in repo jargon) in another transaction. This reduces the clearing banks’ exposure from 12 hours to five. It gives the clearing bank more time to get information about a dealer’s financing situation during the day, lowering the danger that the clearing bank will unnecessarily withdraw credit. It puts lenders on notice that they can’t depend on the clearing bank all day to absorb a default.
-Clearing banks now have the technical capability to automatically substitute collateral. This is helpful when a borrower wants to reuse collateral that is tied up in a tri-party deal and has an acceptable substitute. This lessens the need for the unwind.
-Data on the tri-party market is now published monthly on the task force web site.
Where does this leave us? With lots to do.
Regarding the unwind, for example, the task force reported:
The Clearing Banks and some market participants consider that the risk exposures have been somewhat reduced (emphasis in the original).
The New York Fed put it this way:
Despite these accomplishments, the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged.
To achieve the goals stated in the task force’s final report, large commitments of time and money lie ahead. Technology upgrades alone will cost about $15 million, with the two clearing banks bearing 66 percent of the cost, dealers 27 percent, and lenders 7 percent, according to the Celent study.
Still, the clearing banks say they are charging forward with a plan to reach “Target State” by 2016, by which they mean to eliminate the intraday credit. They say they’re determined to succeed.
At this stage, it is clear that for some aspects of the Target State, a substantial amount of IT work must be done …. Nonetheless, all parties represented on the Task Force including both Clearing Banks have fully endorsed the Target State.
Meanwhile, the New York Fed said in its February 15 statement that it will work with tri-party users to consider additional steps, including (1) restricting the types of collateral that can be financed on the tri-party market and (2) requiring the industry to fund a special bank that would help repo lenders who suddenly find themselves stuck with collateral from a defaulted borrower.
Bruce Tuckman, director of financial markets research at the Center for Financial Stability in New York, thinks it’s odd that it falls to the Fed to care about the quality of the collateral. From a February 16 paper:
One might have thought that the clearing banks, particularly since they were extending such large amounts of intra-day credit, would have insisted that collateral be relatively easy to price and margin. For some reason, however, this did not prove to be the case: during the crisis clearing banks were holding seriously problematic collateral.
In 2008, fear about the quality of repo collateral, especially mortgage-related securities, helped trigger the market’s panic. That said, restricting the type of collateral now could limit a recovery in repo borrowing and in the flow of credit throughout the financial markets. Experts disagree on how big of a problem that would be for the economy. Repo transactions today are about 40 percent below early 2008 volumes.
As for the Fed’s idea for a special bank, here’s how that might work: The special bank could make the repo lender a loan, with money the special bank borrowed from the Federal Reserve. This would buy time for the repo lender to sell the collateral, or refinance it, in an orderly way. (The loans from the Fed to the special bank, and from the special bank to the repo lender, would be collateralized.)
This plan could be similar to some programs in Europe that a September 2010 report by the Bank for International Settlements said are helpful in stabilizing repo markets:
In particular, the possibility of re-using collateral for re-financing with the central bank can enhance the resilience of repo markets….This extends the cash lenders’ liquidity buffer and enhances their willingness to lend cash during times of stress.
Still, the idea of an industry-financed special bank is controversial. For example, some market participants don’t want to have to pay for it; and some market observers don’t think the Fed should have to backstop tri-party, as it did on an emergency basis in 2008, while others think that if the Fed’s going to backstop tri-party anyway, the industry should have to pay for it.
Why do JPM and BoNY do it?
If the tri-party market is so dangerous for the clearing banks, as the Federal Reserve maintains, and the repairs so onerous, why do the two banks persist? Both declined to answer that question. But it’s possible to make some educated guesses.
Apparently they think it’s profitable, even though fees paid by the borrowers are not big revenue producers. At JP Morgan, for example, tri-party operations are just one part of their Worldwide Securities Services segment, which had total net revenue in 2011 of $3.9 billion, or 4 percent of companywide total net revenue of $97.2 billion, according to the company’s 10-K annual report filed February 29 with the Securities and Exchange Commission.
Possibly the two banks like their clearing-bank positions because they gain influence, market intelligence and customers.
In 1994 reporter Andrew Sollinger wrote a story titled “The triparty is just beginning” for the January 1 edition of Institutional Investor magazine, in which he said tri-party was booming and that was “giving custodians something to celebrate.” Senior vice president Kurt Woetzel at Bank of New York told Sollinger that tri-party helped his bank attract customers:
….the bank’s ability to handle triparty transactions is a tempting draw for institutional investors in the market for general custody services. “We can say, ‘We’ve got a ready home for your cash at the end of the day,'” explains Woetzel.
It’s also possible the two banks believe their tri-party role makes them so critical to the financial markets that the Fed will protect them, considering them too big, and too important, to fail.
Other media reports
Following are other reviews of the tri-party task force’s final report, with the most recent listed first:
“Fewer Options for Repo Collateral May Pinch Money-Market Funds, Fitch Says” by Liz Capo McCormick, Bloomberg News, February 29:
U.S. prime money-market mutual funds may face lower yields and fewer investment choices in the market for borrowing and lending securities if the Federal Reserve restricts collateral options, according to Fitch Ratings….
“If certain types of collateral, specifically the lowest quality, are restricted, then there will be generally less collateral available and rates should fall,” Viktoria Baklanova, a New York-based senior director in Fitch’s fund and asset-management group, said yesterday in a telephone interview. “This would add to a generally very challenging environment for money-market funds both in terms of yield and credit. The overall direction the Fed is taking now is positive for containing systemic concerns, but there are always costs.”
“Rated US MMF Limit Nongovernment Collateral Backing Repos,” by Fitch Ratings, February 22:
The Fed is now expected to increase its direct oversight of the clearing banks and, potentially, introduce restrictions on the types of collateral that can be financed in triparty repo. We believe these additional restrictions would introduce more sound risk management and collateral practices. However, regulatory restrictions on the collateral types and haircuts, if introduced, would most likely negatively affect yield if they reduced the collateral supply and emphasized higher quality, lower risk securities.
“Fed pushes key funding market reform,” by Michael Mackenzie and Tracy Alloway, Financial Times, February 15:
US regulators are believed to be counting on Basel III requirements to help wean banks off overnight funding, effectively forcing reform on to the system.
“Task Force Failure Leads NY Fed Take Lead On Repo Reform,” by Michael S. Derby, Dow Jones Newswires, February 15:
The repo market, which came under extreme stress following the failure of Lehman Brothers in September 2008, allows banks and other institutions to borrow and lend bonds and, in turn, provides a vital source of short-term financing to banks. Since that crisis, regulators have worried that settlement failure between two counterparties in that market could undermine the entire financial system.
“Fed Tri-Party Repo Task Force Said to Take Diminished Role in Risk Reform,” by Liz Capo McCormick, Bloomberg News, February 15:
A Federal Reserve-sponsored group working to improve efficiency in the market for borrowing and lending securities will take a diminished role in efforts to cut systemic risk in the market for dealer financing.
The Tri-Party Repo Infrastructure Reform Task Force formed in 2009 to spearhead the efforts will no longer hold scheduled meetings, according to people familiar with the matter.
“NY Fed to increase repo oversight after reform delays,” by Karen Brettell, Reuters, February 15:
The tri-party agreements, or repos, are a prime source of short-term bank funding and are backed by Treasuries or riskier collateral, including mortgage-backed debt. Federal Reserve Chairman Ben Bernanke and others blamed repos as one of the leading factors behind the 2008 financial crisis. …
Reforming the tri-party market is seen as among the most vital measures needed to reduce systemic risks in financial markets still living in the shadow of the 2008 crisis.
Members of the Tri-party Repo Infrastructure Reform Task Force:
Most of the members of the task force are both borrowers and lenders on the tri-party repurchase market. (At the end of the Task Force’s final report is a list of the names of the people who represented these financial institutions on the task force.)
Darryll Hendricks, head of strategy for UBS Investment Bank
Bank of New York Mellon
Bank of America
Citigroup Global Markets Inc
JP Morgan Chase
UBS Investment Bank
Citadel Investment Group
Depository Trust & Clearing Corporation
Investment Company Institute,
Securities Industry and Financial Markets Association,
Managed Funds Association
Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies & Company, Inc.
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
UBS Securities LLC.
Primary Dealers during the financial crisis
BNP Paribas Securities Corp.
Banc of America Securities LLC
Barclays Capital Inc.
Bear, Stearns & Co., Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Countrywide Securities Corporation
Credit Suisse Securities (USA) LLC
Daiwa Securities America Inc.
Deutsche Bank Securities Inc.
Dresdner Kleinwort Wasserstein Securities LLC
Goldman, Sachs & Co.
Greenwich Capital Markets, Inc.
HSBC Securities (USA) Inc.
J.P. Morgan Securities Inc.
Lehman Brothers Inc.
Merrill Lynch Government Securities Inc.
Mizuho Securities USA Inc.
Morgan Stanley & Co. Incorporated
UBS Securities LLC
Currently, Primary Dealers are getting about $2.8 trillion in repo loans a day, down from a high of $4.6 trillion in March 2008, just before Bear Stearns collapsed. Primary Dealers are overseen by securities and banking regulators, not by the Fed, and the Federal Reserve says it has no responsibility for their behavior. From the Operating Policy:
The New York Fed continues to emphasize that the nature of its relationship with primary dealers is a counterparty relationship, not a regulatory one. This policy establishes the framework by which the New York Fed will prudently manage its counterparty risk consistent with its mandates to implement monetary policy and promote financial stability. … third parties are reminded that the designation of an entity as a primary dealer by the New York Fed in no way constitutes a public endorsement of that entity by the New York Fed, nor should such designation be viewed as a replacement for prudent counterparty risk management and due diligence.
The New York Fed pointed to this policy when it was criticized for approving MF Global to be a Primary Dealer in February 2011, just eight months before MF Global filed for bankruptcy.
Part of the deal the Fed makes with its Primary Dealers, when offering them the coveted role as a Fed partner in monetary-policy transactions, is that the Primary Dealers will be the Fed’s eyes and ears on the Street, keeping the Fed informed about important developments in the financial markets. From the Operating Policy:
The New York Fed expects a primary dealer to:
-participate consistently as counterparty to the New York Fed in its execution of open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee;
-provide the New York Fed’s trading desk with market commentary and market information and analysis helpful in the formulation and implementation of monetary policy;
-participate in all auctions of U.S. government debt;
-make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account holders.
Clearly, the Primary Dealers failed that second obligation in the run-up to the financial crisis.
This is a really great blog post.
Outstanding information! I am impressed by the quality and rigor of the details you provide about tri-party repo. Thank you for sharing this.
Do you think the scenario you describe in the Ti-Party flaws section describes what happened with MFGs repo-to-maturity trades?
i.e Did JPM unwind MFGs repo-to-maturity trade in the am, and then find itself unable to rewind it in the pm?, triggering the MFG cash crisis, and theft of customer funds?
Michael, I just don’t know. So many things are possible. JP Morgan played at least three roles in the MF Global saga: Lender, prime broker and tri-party clearing bank.
This February 6 description by the bankruptcy trustee sounds like you would expect in a market where securities and cash can be used for various purposes during the day, on the expectation that books will balance at the end of the day:
Meanwhile, this March 23 memo from the House Financial Services Committee seems to say that JP Morgan stopped extending tri-party intraday credit to MF Global on October 27:
Maybe the upcoming hearing Wednesday, March 28, by the House Financial Services Committee will help us better understand what happened.