Keyed by alarm at the Financial Stability Oversight Council over the pace of reforming the tri-party repo market, the Senate Securities Subcommittee examined reform options and the need to move quickly to implement them. Subcommittee Chair Jack Reed (D-RI) noted that FSOC’s annual report identified structural vulnerabilities in the short-term funding markets, particularly the tri-party repurchase market, as a continuing area of concern. The report stated that limited progress has been made in substantially reducing the reliance of this market on intraday credits or improving risk-management and collateral practices to avoid fire sales in the event of a large dealer default. Calling for greater government involvement, FSOC found unacceptable the industry’s suggestion that it will take several more years to eliminate the intraday credit associated with tri-party settlements.
In general, a repo or repurchase agreement is the sale of a portfolio of securities with an agreement to repurchase that portfolio at a later date. Tri-party repos are typically used by large securities firms and bank holding companies with broker-dealer operations to raise short-term financing from cash investors, such as money market mutual funds.
According to Senator Reed, three major weaknesses of the tri-party market were highlighted by the 2008 financial crisis: 1) the market’s reliance on intraday credit from the clearing banks; 2) the pro-cyclicality of risk management practices, and 3) the lack of effective plans to support the orderly liquidation of a defaulted dealer’s collateral.
Motivated by these risks, in 2009 the NY Fed formed the industry-led Tri-Party Repo Infrastructure Reform Task Force to address the problems highlighted by the financial crisis. The work of the Task Force led to important changes, including moving the daily unwind of some tri-party repo transactions from 8:30 am to 3:30 pm, which shortens the period of intraday credit exposure; implementing a mandatory three-way trade confirmation between dealers, cash investors and the clearing banks; and publishing of a monthly report regarding activity in the tri-party repo market to enhance the ability of regulators and market participants to call attention to emerging issues before they become systemic.
Noting that FSOC has sounded an alarm about the tri-party repo market and the need to more quickly implement additional reforms, Senator Reed said it is imperative to improve the tri-party repo market to make it safer and to benefit all market participants.Fed Deputy Director Matthew Eichner testified that the Fed is committed to working with market participants, the SEC and other regulators to enhance the resiliency of the tri-party repo market. Securities dealers affiliated with bank holding companies and other broker-dealers, as well as cash lenders, such as money market funds, must modify systems and protocols. To this end, noted the Fed official, engagement with the SEC will be particularly important given the Commission's role as the primary regulator of broker-dealers and money market funds.Eliminating the daily unwind and reducing reliance on intraday credit will materially reduce the potential for a recurrence of many of the problems evident during the financial crisis, said Mr. Eichner, but beyond that other vulnerabilities remain. A particular concern of the Fed and also FSOC involves the challenge of managing the collateral of a defaulting securities dealer in an orderly manner.
Larger securities dealers finance portfolios of securities that can easily exceed $100 billion and would be difficult to liquidate even under favorable market conditions without causing dislocations. The situation is further complicated by the fact that many cash lenders are highly risk averse, subject by regulation or prospectus to stringent limitations on their portfolio holdings, and may have limited operational capacity to manage collateral. As a result, they would be inclined to quickly liquidate securities that they had obtained from a failed dealer, reasoned the Fed official creating the potential for a fire sale that could destabilize markets and propagate shocks across the financial system.
In the Fed’s view, a solution to this fire sale problem would likely require a market-wide collateral liquidation mechanism. The challenges in designing and creating such a mechanism, which would almost certainly need the capacity to fund a significant volume of collateral for some period of time, are appreciable, and include assuring adequate liquidity resources even under adverse market conditions and developing rules for the allocation of any eventual losses across market participants.
Such capabilities typically exist today in the context of clearing organizations that have a formal membership structure, which allows for capital assessments and the sharing of potential losses. How this model might be adapted to a market more loosely organized around clearing banks, particularly in which certain less-liquid collateral types continue to be funded, remains unclear and, according to the Deputy Director, will need to be the focus of much additional study.