Part 2: Are JPM and BoNY the best we can do?

As the Federal Reserve and clearing banks JP Morgan Chase and Bank of New York Mellon struggle to reform the U.S. tri-party repo market, some students of the system think it might be better to install an independent middleman rather than to keep trying to sew patches on the current tattered model.

(Editors’ note: See accompanying story, “Tri-party repo’s problems are deep and unsolved,” about tri-party problems and proposed reforms.)

They will find some support in “Strengthening repo clearing and settlement arrangements,” a detailed analysis of some of the world’s leading repo markets, published in September 2010 by the Bank for International Settlements.

The Bank for International Settlements coordinates international financial regulations from its headquarters in Basel, Switzerland. One of its committees, headed by New York Fed president William Dudley, appointed a working group in June 2009 to conduct the international repo study. (See below for a list of the members of the working group.)

The working group noted that during the financial crisis some repo markets were more stable than others – politely declining to name the 800-pound disfunctional gorilla in the room, the U.S. tri-party market – and it set out to find out why. 

In general, repo markets are seen by market participants as a safer and more reliable source of funding than uncollateralised money markets. During the recent financial crisis, however, repo markets proved to be a less reliable source of funding liquidity than expected in some countries.

The researchers found seven issues related to repo market infrastructure that could affect a market’s resilience. (See below for a list of the seven issues.) All are features of the U.S. tri-party system, according to the Tri-Party Repo Infrastructure Reform Task Force, an industry group appointed by Dudley’s New York Fed in September 2009 to fix the U.S. market’s problems.

The report by the Bank for International Settlements shows that a key feature distinguishing the U.S. tri-party system from most other repo markets is that two commercial banks, JP Morgan and Bank of New York, act as middlemen. 

Usually the middleman – who finalizes transactions negotiated between the repo borrower and the repo lender, and selects, values and manages the collateral in the transaction – is an independent company, not a business that is itself involved in the financial markets, like a commercial bank. Sometimes the middleman also steps in the shoes of the parties, as a “central counterparty,” becoming the lender to the borrower and the borrower to the lender and absorbing any loss.

Using commercial banks as middlemen can be challenging, the Bank for International Settlements said:

The Working Group has identified three issues – access to repo clearing and settlement services, governance, and financial risk management – which might be particularly complex and demanding for those infrastructure providers that are part of an entity also providing commercial banking services.

About “access to repo clearing and settlement services”:

…repo clearing and settlement infrastructures in general should ensure fair and open access. If an infrastructure provider is also a competitor of some of its participants, ensuring fair and open access is particularly crucial to prevent the perception that access to infrastructure services is blocked, restricted or withdrawn for competitive reasons, ie not solely based on objective criteria. Access should also not be influenced by interests in other business lines.

About “governance”:

Where a repo infrastructure is part of an entity providing commercial banking services, great care should be taken to reflect the interests of all stakeholders (including users which are potentially also competitors) adequately in the governance processes.

About “financial risk management”:

To preserve participants’ confidence in the repo clearing and settlement infrastructure it is critical to maintain the infrastructure provider’s financial health. Confidence could be undermined by financial losses from other (banking) activities which could spill over and put the infrastructure activities at risk

An independent operator

For these reasons and more, Bruce Tuckman, director of financial markets research at the Center for Financial Stability in New York, wants to see JPM and BoNY replaced by an independent company that would operate the tri-party market like a utility – an idea also broached by Federal Reserve Chairman Ben Bernanke in a 2008 speech. (Update: Stanford University economist Darrell Duffie proposes a similar idea in “Replumbing Our Financial System: Uneven Progress,” March 17, 2012.)

Tuckman said this approach is needed because the two U.S. clearing banks have created a seriously flawed and fragmented system that gives them a competitive advantage and creates conflicts of interest. From a February 16 report:

There are significant conflicts of interest when a commercial bank acts as a dealer’s tri-party repo agent at the same time as it conducts bilateral business with that dealer.

A dealer experiencing financial difficulties can easily expose its repo counterparties and its commercial bank to losses. But, as a dealer’s tri-party repo agent, the commercial bank has both knowledge and opportunity to protect itself first and foremost.

Tri-party is popular in the U.S. in part because it’s cheaper than some other forms of repo, but it’s cheaper partly because regulators don’t require the clearing banks to add capital, or equity, to cover the considerable risk they assume when they extend credit to repo borrowers during the day, Tuckman said in a February 3, 2010, paper:

Imposing capital requirements and risk charges on intra-day risk would force the industry to address the  systemic risk of the system and would level the playing field in the provision of services to the secured funding market.

Tuckman also noted the technological complexity of having to coordinate systems at two separate commercial banking companies and at the Fixed-Income Clearing Corporation, a New York company that clears a segment of the tri-party market in cooperation with the two clearing banks. From his February 16 report:

Tri-party repo should be managed by an industry utility, not by businesses inside two large banks. The opportunity to create such a utility is better now than it has ever been, given the broad agreement as to the woeful inadequacies of the system’s infrastructure, the complexities of coordinating technology across two clearing banks and the FICC, and the conflicts of interest — made apparent during the crisis and the MF Global episode — of each tri-party repo agent also being a large commercial bank.

According to Financial Times reporters Michael Mackenzie and Henny Sender in a December 28, 2011, story, some Fed officials have similar thoughts:

An industry task force sponsored by the US Federal Reserve is working on a plan to scale back systemic risk in the funding market at the centre of the financial crisis and to reduce trader dependence on JPMorgan Chase and Bank of New York Mellon. …

While the issue is technical, it raises questions both about the ongoing vulnerability of the two so-called clearing banks in the market, JPMorgan and BNY Mellon, and their power over the Wall Street community in general.

Many officials at the Fed believe that such a role may not be appropriate for private institutions and that a public sector body may be more appropriate.

“The incentives are different for a private sector institution when under pressure,” said one senior Fed official. “There are conflicting objectives and when stresses rise, the banks may behave badly. The desire for security or collateral can be debilitating.”

Countrywide, Bear Stearns and Lehman Brothers all had their financing strangled by a tri-party clearing bank, according to former Treasury Secretary Henry Paulson, Jr.

A January 18 story by Reuters reporters Carrick Mollenkamp, Lauren Tara LaCapra and Matthew Goldstein raised the same issue, in relation to the MF Global failure:

The role that JPMorgan played as both a lender and middleman to MF Global illustrates the procedures banks can deploy to protect their own interests when dealing with weaker counterparties.

On one side of its ledger, JPMorgan and a syndicate of banks had lent MF Global $1.3 billion in its final week through a loan commitment the firm could draw down at any time. JPMorgan also was a primary banker for MF Global, a role that gave it significant insight into, and control over, MF Global’s accounts.

On the other side, JPMorgan was clearing some of the asset sales MF Global was making. In this role, its job was to take the securities from MF Global and the cash from the buyer and pass them along to the other party when the deal was complete.

Normally such trades can settle within a day or two, if the back-office mechanics function smoothly. But that week, the money didn’t arrive when MF Global executives expected, according to people familiar with the situation.

JPMorgan, a major lender to rival firms as well as one of Wall Street’s biggest middlemen in settling trades, has previously drawn scrutiny for protecting its own interests when rival firms ran aground. In 2008, a week before Lehman Brothers Holdings Inc. sought bankruptcy protection, JPMorgan demanded collateral to protect its role as counterparty to Lehman. While the request was not improper, Lehman’s bankruptcy estate later claimed Lehman posted the collateral because JPMorgan had threatened to withhold funding.

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”:

If the clearing bank exercises its discretion to discontinue providing credit to a dealer during the day, or to discontinue clearing the dealer’s trades, or to make significant demands for additional collateral from the dealer, then the dealer may be forced to shut down. Bernanke has pointed to the potential benefits of a triparty repo utility, which would have less discretion in rolling over a dealer’s repo positions and fewer conflicting incentives. In such a case, operational controls might be more cleanly monitored.

Tri-party repo in Switzerland, which has an independent middleman, has a more stable tri-party market than the U.S. does, according to the Celent study.

When we compared the performance of the two leading triparty repo markets in the US and Switzerland during the financial crisis, we found that the impact of the crisis was much more severe on the US tri-party market. Its effects were greater in the US across a number of parameters such as volumes, collateral used, weighted repo maturity, and repo margins. The inferior performance of the US market compared to its Swiss and even German counterparts provided the rationale for US reform.

In the Swiss tri-party market, the middleman is SIX Securities Services, an independent company whose main business is to hold securities for investors so the securities are easy to trade, according to the Bank for International Settlements report. A similar company in the U.S. is the Depository Trade and Clearing Corporation in New York, the largest company of its kind in the world.

Swiss tri-party differs from U.S. tri-party in several ways, according to the report by the Bank for International Settlements. For example, SIX does not offer extended intraday credit to borrowers. There’s less concern about defaults because commercial banks, securities dealers, insurance companies and money market funds all have access to central bank loans, not just commercial banks as in the U.S. In Switzerland, lenders get first dibs on reusing the collateral, not borrowers as in the U.S. Switzerland has highly standardized contracts, whereas in the U.S. there’s limited standardization of contracts.

Central counterparties

Two years ago Canada’s biggest banks and its central bank decided to build a repo system with an independent middleman. The effort proved to be difficult but not impossible. From a January 9 Toronto Globe and Mail story by Boyd Erman:

The project began after the 2008 global financial crisis, when crucial interbank loans known as repos started to seize up because banks didn’t trust one another to be able to repay the loans. The situation never got as dire in Canada as it did elsewhere, but the crisis was a clear signal that there was a potential problem in the works and the Bank of Canada wanted a safeguard.

So in 2009, Canada’s big banks got together to build one. Instead of dealing directly with one another, the banks would create a central clearinghouse that they would deal through, taking away the concerns about whether the bank on the other side would be able to make good. If a bank failed, the clearinghouse would pay up.

The banks hired Canadian Derivatives Clearing Corp. (CDCC), a part of TMX Group Inc., to construct the clearinghouse…. It seemed relatively simple – a proposal to clear one type of product, in one country. It has been anything but. The project has taken much longer than planned, and it’s significantly over budget.

Still, the Canadian facility opened February 21, years ahead of U.S. tri-party solutions. From reporter Erman February 24:

Canada’s new repo agreement clearing system is marking the end of its first week in operation, with contracts now flowing through the central counterparty run by Canadian Derivatives Clearing Corp.

After a long learning curve, the system opened for business on Feb. 21. It’s not fully up and running, as there will be a 13-week ramp up as more products are added to the clearing roster. So far, the system is reported by those monitoring it to be working smoothly.

The report by the Bank for International Settlements examined the role of central counterparties and found pros and cons, including the potential to provide stability and the danger of concentrating risk. It noted that markets with central counterparties generally fared better during the crisis than those without.

To the extent that counterparty exposures and counterparty risk are reduced by central counterparty clearing, a robust central counterparty can increase the resilience of repo markets in times of stress, when counterparty risk concerns are high.

Most repo markets are bilateral or tri-party. Central counterparties can be added to either. The Federal Reserve Bank of New York asked tri-party participants if they thought it would be useful to use a central counterparty in the U.S. tri party market. The task force said it considered the idea but decided against recommending it because it was too expensive and complicated.

That said, the Fixed-Income Clearing Corporation, which is a subsidiary of the Depository Trade and Clearing Corporation, is already the central counterparty for a U.S. repo market developed in 1998 in cooperation with JP Morgan and Bank of New York.

The market is GCF (General Collateral Finance) Repo, a service that increases repo efficiency by accepting any kind of U.S. government security as collateral, rather than requiring a certain security for each particular transaction. This lets the repos be traded throughout the day without specific collateral until the end of the day, and then all the trades are netted.

 Fixed Income Clearing Corporation is clearing about $335 billion in repos a day. It was one of four repo markets in the Bank for International Settlements study that  saw their business increase during the financial crisis.

Some think the Fixed-Income Clearing Corporation could be a central counterparty for the U.S. tri-party system.

Interest in using central counterparties for repo transactions is rising, according to the Bank for International Settlements report:

In Germany, Italy, France, Japan and the United Kingdom, central counterparties are core parts of the repo infrastructure arrangements. Central counterparties exist – but are of limited relevance – in the United States and Canada. However, Canada is in the process of introducing a new central counterparty for the repo market and Sweden is about to launch its first repo central counterparty. Finally, central counterparties are presently not used for the repo markets in Hong Kong and Switzerland, although Switzerland is evaluating the introduction of a repo central counterparty.


Members of the “Strengthening repo clearing and settlement arrangements” working group: (At the end of their report are the names of the people who represented these financial institutions on the working group.)

Chairman: Andy Sturn, head of oversight for Swiss National Bank
National Bank of Belgium
Bank of Canada
European Central Bank 
Bank of France 
Deutsche Bundesbank 
Hong Kong Monetary Authority 
Reserve Bank of India 
Bank of Italy 
Bank of Japan 
Banque Centrale du Luxembourg 
Netherlands Bank 
Sveriges Riksbank 
Swiss National Bank 
Central Bank of Russia 
Bank of England 
Federal Reserve Bank of New York 
Board of Governors of the Federal Reserve System 
Bank for International Settlements

The working group found seven issues related to a repo market’s infrastructure “that have the potential to affect the resilience of repo markets.” See the full report for more detail.

(1) the risks related to the extension of significant amounts of intraday credits within some repo settlement arrangements;

(2) the lack of transparency of some repo infrastructure roles, responsibilities, practices and procedures;

(3) concerns regarding protection against counterparty credit risk in repo transactions;

(4) inadequate capabilities for liquidating repo collateral in the event of a cash borrower’s default;

(5) the inefficient use of (high-quality) collateral due to constraints within repo clearing and settlement arrangements;

(6) procyclical effects of certain risk management practices; and

(7) a lack of transparency in the repo market.


One response to “Part 2: Are JPM and BoNY the best we can do?

  1. Peter Nowicki

    I agree with your take on this story and have been involved in trying to come up with a CCP solution for the markets for a long time. It has not been easy and it is hard to protect you ideas. As I read the story on BoNY in the FT today it is clear that BoNY and JOM should lead the effort to setup a stand alone CCP for this purpose.

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