U.S. Regulators: Repo is vital, and it’s dangerous

ShoutIn the past three months, U.S. regulators have issued nine warnings about danger in the repo market, a market they repeatedly describe as critical to the worldwide financial system but needing reform.

Is anyone listening?

The Financial Stability Oversight Council, created by The Dodd-Frank Act in 2010 to monitor the stability of the U.S. financial system, led off with its warning  on April 25, when it released its annual report.

That bad news was followed by speeches, papers, and threats from the Federal Reserve, the Federal Reserve Bank of New York, and the Securities and Exchange Commission.

These regulators worry about runs by lenders that could leave borrowers and clearing banks insolvent; fire sales of securities by borrowers and lenders that could drive losses throughout the financial markets; stiffed lenders who might not be able to get their hands on their collateral or sell it; runs on money market funds; and more.

Here’s a quick look at some of what they said:

(1) “Financial Stability Oversight Council 2013 Annual Report,” by the Financial Stability Oversight Council, April 25, 2013. 

The U.S. financial system has strengthened in the past year, the council wrote, but “significant risks to the financial stability of the United States remain.” Of the seven risks they worried about, No. 1 was the tri-party repurchase market, which is the segment of the repo market that uses J.P. Morgan Chase and Bank of New York Mellon to clear the transactions between repo borrower and repo lender.

The tri-party repo market remains vulnerable to runs by lenders in the event that concerns emerge regarding the financial condition of borrowers such as securities broker-dealers, who depend heavily on this channel for short-term funding. Additional risks stem from the continued heavy reliance on discretionary intraday credit in the settlement process, and the limited capacity of lenders to manage the ramifications of a default by a major borrower.

Some progress has been made in increasing the resiliency of the tri-party market. The reliance on intraday credit extended by the clearing banks has begun to decline and, as additional changes are made to the settlement process, should be largely eliminated by the end of 2014.

Nonetheless, a default of a large broker-dealer or other large borrower would leave lenders with large volumes of collateral that they would likely seek to liquidate quickly.

This “can induce fire sales in times of market stress,” the council said.

(2) “Evaluating Progress in Regulatory Reforms to Promote Financial Stability,” a speech by Federal Reserve Governor Daniel K. Tarullo, May 3, 2013.

It’s fine to worry about tri-party repo, Tarullo said, but this gets at only part of the problem.

More than five years after the failure of Bear Stearns marked an escalation of the financial crisis, and nearly three years since the passage of the Dodd-Frank Act, debate continues over the appropriate set of policy responses to protect against financial instability. …

I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to counteract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particularly in addressing the risks posed by short-term wholesale funding markets. …

Severe repercussions were felt throughout the financial system, as short-term wholesale lending against all but the very safest collateral froze up, regardless of the identity of the borrower. …

In short, the financial industry in the years preceding the crisis had been transformed into one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed the new system’s reliance on wholesale funding. …

… relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs. … significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions (repo, reverse repo, securities lending and borrowing, and securities margin lending). …

… the attention paid by the Federal Reserve and other regulators to money market funds, and the steps taken by the Federal Reserve to reduce the risks associated with the extension of intraday credit by clearing banks in triparty repo funding markets … are useful … but they do not address head-on the dynamic described (in this speech). …

I do not think that the post-crisis program of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is in place.

(3) “The Risk of Fire Sales in the Tri-Party Repo Market” by Brian Begalle, Antoine Martin, James McAndrews, and Susan McLaughlin, Federal Reserve Bank of New York, May 7, 2013.

These New York Fed economists describe the tri-party repo market as “a large and important market where securities dealers find short-term funding for a substantial portion of their own and their clients’ assets.”

They name three systemic risks associated with this market:

1) the market’s excessive reliance on clearing-bank provision of intraday credit to complete settlement, 2) poor liquidity and credit risk management practices on the part of various classes of tri-party repo market participants, and 3) the absence of any mechanism to mitigate the risk of fire sales of collateral in the aftermath of a large-dealer default.

This paper is about No. 3. Prior to the financial crisis, a good example of this problem was the failure of the Long-term Capital Management hedge fund in 1998, which these authors describe.

Both repo borrowers and lenders can trigger fire sales, the authors explain. For example, borrowers can trigger fire sales if they’re suddenly forced to sell large volumes of securities to repay lenders. Lenders can trigger fire sales if borrowers don’t repay and lenders are suddenly stuck with, and need to sell, large volumes of securities they don’t want.

Fire sales can drive down the value of securities held by other financial institutions, spreading the danger.

Who are the borrowers and lenders in this market? Broker-dealers are the borrowers, the authors write. Lenders are mainly “money market mutual funds, securities lenders, and other institutional cash providers such as mutual funds, insurance companies, corporate treasurers, and state and local government treasurers.” More than half of the lenders are money market funds and securities lenders.

How big is this problem?

Large dealers’ repo books currently range between $100 billion and $200 billion and, in some cases, reached peak levels in excess of $400 billion prior to the financial crisis. There are currently no external constraints in place to prevent dealer repo books from reverting back to comparable peak levels in the future.

For positions this large, even the liquidation of collateral usually viewed as liquid, such as agency mortgage-backed securities, could prove challenging over a compressed time frame. Additionally, approximately 15 percent of the assets financed in this market, almost $300 billion at the end of 2012, are private obligations that are not backed by the U.S. government or its agencies …

(4) “Monitoring the Financial System” by Federal Reserve Chairman Ben Bernanke, speech at the Federal Reserve Bank of Chicago, May 10, 2013.

In the run-up to the crisis, the shadow banking sector involved a high degree of maturity transformation and leverage. Illiquid loans to households and businesses were securitized, and the tranches of the securitizations with the highest credit ratings were funded by very short-term debt, such as asset-backed commercial paper and repurchase agreements (repos). The short-term funding was in turn provided by institutions, such as money market funds, whose investors expected payment in full on demand and had little tolerance for risk to principal. …

When investors lost confidence in the quality of the assets or in the institutions expected to provide support, they ran. Their flight created serious funding pressures throughout the financial system, threatened the solvency of many firms, and inflicted serious damage on the broader economy.

Securities broker-dealers play a central role in many aspects of shadow banking as facilitators of market-based intermediation. To finance their own and their clients’ securities holdings, broker-dealers tend to rely on short-term collateralized funding, often in the form of repo agreements with highly risk-averse lenders. The crisis revealed that this funding is potentially quite fragile….

… important risks remain in the short-term wholesale funding markets. One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower. The Dodd-Frank Act has provided important additional tools to deal with this vulnerability, notably the provisions that facilitate an orderly resolution of a broker-dealer or a broker-dealer holding company whose imminent failure poses a systemic risk. But, as highlighted in the Financial stability Oversight Council’s most recent annual report, more work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market.

(5) Treasury Market Practices Group Announces Market Practice Recommendations to Support More Timely Trade Confirmation in the Tri-Party Repo Market, May 23, 2013.

The Treasury Market Practices Group sounded a little exasperated as it called for more professional standards in the tri-party repo market in May.

Trades should be finished by 3 p.m., they said. Cancellations and corrections should be rare and only done when somebody made an honest mistake. Stop using corrections to change the terms of a deal you agreed to earlier. Be organized. Don’t come running in at the last minute. Anytime a change comes along after 3 p.m., senior staff should check it out.

This matters, they said, because:

Smooth, predictable, and efficient settlement and clearing are crucial for preserving the liquidity and function of the Treasury, agency debt, and agency MBS markets. A well-functioning tri-party repo market is critical to the health and stability of the U.S. financial markets as it is closely interconnected to other payment clearing and settlement services and serves as a key source for funding and investment. Moreover, a tri-party repo market that is more stable under market stress provides support for continuous market liquidity and price transparency in U.S. government and corporate securities markets.

We’re going to be watching, the group said, and if you don’t shape up, you may hear from us again.

The Treasury Market Practices Group is made up of people who work for securities dealers, banks, mutual funds, investment funds, clearing companies and other financial institutions. They meet regularly to “discuss and promote best practices related to trading, settlement and risk management in the Treasury, agency debt and agency MBS markets,” according to the New York Fed, which sponsors the group.

(6) “Regulatory Landscapes: A U.S. Perspective,” a speech by Federal Reserve Vice Chair Janet L. Yellen, June 2, 2013.

 A major source of unaddressed risk emanates from the large volume of short-term securities financing transactions –repos, reverse repos, securities borrowing and lending transactions, and margin loans–engaged in by broker-dealers, money market funds, hedge funds, and other shadow banks.

Regulatory reform mostly passed over these transactions, I suspect, because securities financing transactions appear safe from a microprudential perspective.

But securities financing transactions, particularly large matched books of securities financing transactions, create sizable macroprudential risks, including large negative externalities from dealer defaults and from asset fire sales. The existing bank and broker-dealer regulatory regimes have not been designed to materially mitigate these systemic risks.

The global regulatory community should focus significant amounts of energy, now, to attack this problem.

The perfect solution may not yet be clear but possible options are evident: raising bank and broker-dealer capital or liquidity requirements on securities financing transactions, or imposing minimum margin requirements on some or all securities financing transactions.

(7) Shadow Banking” by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky, Federal Reserve Bank of New York, July 18, 2013.

Four of the economists who have done the most to illuminate shadow banking in recent years are back with a detailed look at that murky world.

Accompanied by eight detailed charts that show how shadow banking works, the economists describe the market and its vulnerabilities and predict that Congress’ recent crackdown on traditional banks is going to make shadow banking even more profitable and popular.

In the shadow banking system, credit is intermediated through a wide range of securitization and secured funding techniques, including asset-backed commercial paper, asset-backed securities, collateralized debt obligations, and repurchase agreements. While we believe the term “shadow banking,” coined by Paul McCulley (2007), to be a somewhat pejorative name for such a large and important part of the financial system, we have adopted it for use here.

Prior to the 2007-09 financial crisis, the shadow banking system provided credit by issuing liquid, short-term liabilities against risky, long-term, and often opaque assets. …

… credit intermediaries’ reliance on short-term liabilities to fund illiquid long-term assets is an inherently fragile activity that can make the shadow banking system prone to runs. During the financial crisis, the system came under severe strain, and many parts of it collapsed. …

While much of the current and future reform efforts are focused on remediating the excesses of the recent credit bubble, we note that increased capital and liquidity standards for depository institutions and insurance companies are likely to increase the returns to shadow banking activity.

For example, as pointed out in “Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System” by Pozsar, the reform effort has done little to address the tendency of large institutional cash pools to form outside the banking system.

Thus, we expect shadow banking to be a significant part of the financial system, although almost certainly in a different form, for the foreseeable future.

(8) “Magnifying the Risk of Fire Sales in the Tri-Party Repo Market” by Leyla Alkan, Vic Chakrian, Adam Copeland, Isaac Davis, and Antoine Martin, Federal Reserve Bank of New York, July 17, 2013.

A recent New York Fed staff report details the risks of fire sales in the tri-party repo market.

The first risk, termed pre-default fire-sale risk, occurs when a dealer is under stress, but has not defaulted. A stressed dealer may be forced to sell its securities quickly, an action that likely depresses market prices and creates fire-sale conditions. Tri-party repo investors can aggravate this risk by quickly withdrawing funding from a troubled dealer, and so forcing that dealer to sell even more securities quickly.

The second risk, termed post-default fire-sale risk, occurs after a dealer default, when that dealer’s investors receive the repo securities in lieu of repayment. Fire sales can then occur if investors attempt to liquidate these securities in an uncoordinated and rapid pace. In this scenario, investors as a group will be trying to sell off a substantial amount of collateral at the same time. …

By our calculations, money market funds and securities lenders are the two largest classes of investors, together representing just about half of the market. Their dominant presence heightens the risk of both pre- and post-default fire sales, so it is important for market participants and regulators to take this fact into account when evaluating tools to address the fire-sale vulnerability in the tri-party repo market.

(9) “Counterparty Risk Management Practices with Respect to Tri-Party Repurchase Agreements,” U.S. Securities and Exchange Commission, July 17, 2013.

The SEC issued this polite “Guidance Update” to money market funds to call their attention to dangers in the tri-party repo market and to suggest actions they might want to take to avoid another 2008-style meltdown.

Money market funds have significant portfolio holdings of tri-party repos (approximately $591 billion at the end of 2012). Even though many money market funds may stop rolling over repo holdings of a counterparty that comes under financial pressure, it is possible that a money market fund could face the sudden default of a tri-party repo. Accordingly, as a matter of prudent risk management, money market funds and their investment advisers are encouraged to consider the legal and operational steps they may need to take if a repo counterparty fails and the repos it issued default.

The SEC suggested these ways that a money market fund might be able to prepare in advance for a tri-party repo default:

1. Consider filling out required documents ahead of time, “to the extent practicable.”

2. Make sure you are “capable of appropriately holding, valuing, trading and accounting for the collateral underlying the fund’s repos” in case you’re suddenly stuck with the collateral instead of the repo.

3. Know if securities laws let you hold that kind of collateral.

4. Know if your repo will be tangled in the bankruptcy should the borrower fail. Know how that would affect you.

5. Make sure that in a crisis you know when and how to notify the SEC, the fund’s board of directors and shareholders.

The Guidance ends:

A repo counterparty default could create adverse consequences for fund shareholders. The staff recognizes that it is not practical to expect money market funds to plan for every contingency that can arise from the default of a tri-party repo portfolio holding. Nevertheless, appropriate advance planning for portfolio defaults may help funds manage such adverse events more smoothly and lessen the chance that such a default has harmful effects that could have been ameliorated.

(Editor’s note: Does it seem remarkable, dear readers, that the SEC feels it has to give money market funds this commonsense advice?)

A week later, took a look at this market that is causing such heartburn among regulators.

Here’s the lead to “Lingering Danger in the Wholesale Funding Market” by Sheyna Steiner,, July 24, 2013:

Five years after the devastating events of the financial crisis, many of the most vulnerable parts of the financial system remain susceptible to problems like those seen in 2008.

“The money market fund industry and the repo market is really the major fault line that goes right under Wall Street,” says Dennis Kelleher, president and CEO of Better Markets, a nonprofit, nonpartisan organization that promotes the public interest in strengthening the financial system.


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