Aug.SBC Examines the Tri -Party Repo Market; Remaining Challenges

AT TODAY’S SENATE BANKING SUBCOMMITTEE HEARING, lawmakers discussed remaining challenges to the tri-party repurchase (repo) market, specifically focusing on the Federal Reserve Bank of New York’s task force that was formed in 2009 to address the problems highlighted by the financial crisis, and the more recent 2012 report issued by the Financial Stability Oversight Council (FSOC) on the financial industry’s progress in implementing the task forces’ recommendations. Lawmakers also questioned the panel of witnesses on what further steps are needed to help reduce risk in the tri-party repo marketplace. 

Subcommittee Chairman Jack Reed (D-R.I.), Ranking Member Mike Crapo (R-Idaho) and Sen. Jeff Merkley (D-Ore.) were the only Senators in attendance. All expressed concern regarding the oversight of the tri-party repo marketplace. In addition, while members noted that progress has been made since the financial crisis to reduce risk in the repo marketplace, Reed and Crapo voiced their concerns regarding the industry’s intra-day credit exposure and the potential systemic problems associated with fire sales in the event of a large dealer fault. 

In his opening statement, Reed noted that the tri-party repo marketplace peaked at $2.8 trillion at the height of the financial crisis and has fallen to roughly $1.7 trillion today. He added that the financial crisis exposed three weaknesses: 1) markets reliance on intra-day credit from the clearing banks; 2) the pro-cyclical risk management practices or procyclicality of risk management practices; and 3) the lack of effective plans to support the orderly liquidation of the defaulted dealer’s collateral. 

Reed mentioned the positive changes to the repo marketplace in response to the task force report, such as moving the daily unwind of some tri-party repo transactions which shortens the period of intra-day exposure, and the implementation of a mandatory three way trade confirmation between dealers, cash investors and the clearing banks. However, Reed also noted the FSOC’s 2012 report that found “limited progress” has been made so far in reducing “an alliance with this market on intra-day credits or improving risk management and collateral practices to avoid fire sales in the event of a large dealer fault.” Reed went on to mention that the FSOC found the industry’s suggestion that it would take years to limit the intra-day credit associated with tri-party settlements, “unacceptable.” 

Testimony 

In his opening testimony, Matthew Eichner, Deputy Director of the Division of Research & Statistics, Board of Governors of the Federal Reserve System, discussed the benefits of the tri-party repo marketplace adding that the Federal Reserve has a strong interest in the “smooth functioning and resiliency of this market.” 

Eichner reflected on the flaws in the marketplace highlighted by the financial crisis, adding that clear vulnerabilities remain despite the smaller size of today’s tri-party repo marketplace from its pre-crisis peak. The task force report made it clear, Eichner said, “that more fundamental changes to systems at both clearing banks and on the part of other market participants, as well as associated adjustments to market practices, would take significantly longer to implement.” 

Eichner noted the Federal Reserve’s concern with managing the collateral of a defaulting securities dealer in an orderly manner. His suggested solution “to this so-called fire sale problem” would likely require a marketwide collateral liquidation mechanism, but noted the challenges in designing and creating such a mechanism and that this approach would require additional study. 

In her testimony, Karen Peetz, Vice Chairman of BNY Mellon, described to lawmakers how the tri-party repo market operates, BNY’s role in the marketplace, and BNY’s internal efforts to reduce risk. 

To achieve risk reduction, Peetz said BNY Mellon has introduced a three-way trade confirmation process known as automated deal matching for dealers, agents and investors which “provides dealers and investors with an efficient and consolidated view of trade instructions, terms and modifications to ensure accuracy and transparency.” In addition, BNY is also in the process of identifying asset classes eligible for intraday credit associated with tri-party repo transactions, eliminating intraday credit associated with less liquid forms of collateral, and “are developing technology for a systematic approach to reforming the entire unwind process that will practically eliminate exposures by the end of 2014.” Peetz assured the Subcommittee that BNY Mellon is partnering with the Federal Reserve to reduce intraday credit concerns and implement reforms to enhance tri-party repo operations and to reduce systemic risk. 

In his opening testimony, Steven Meier, Executive Vice President of State Street Global Advisors, said there has been “considerable progress” towards  reducing systemic risk associated with tri-party repo transactions, but “there is still work to be done to eliminate these risks.” 

As a result of the task force discussions and findings, “participants are now more aware of the need for counterparty default contingency planning, the requirement of knowing both your counterparty and your collateral, the benefits of maturity extension, required analysis and judgment concerning collateral suitability, the need for focus on detailed repurchase transaction collateral schedules and the benefits of dynamic margining,” he said. 

In his testimony, Thomas Wipf, Managing Director and Global Head of Bank Resource Management at Morgan Stanley, said he agrees with the FSOC that more needs to be done “and the delay in soundly eliminating intra-day credit risks is unacceptable.” 

Wipf described the task force’s findings and said the remaining strategic issues fall into three categories: 1) complete clarity on the terms and limits for credit extension between the clearing banks and the bank dealers by asset class; 2) full implementation of a transparent settlement process with a clear timeline that enables all market participants to understand and manage their settlement risk; and 3) further building investor confidence and reducing intra-day risk be a meaningful and systemic reduction of collateral turnover between trade execution and maturity. 

Wipf said “it is clear” that the main and most important goal of reducing intra-day credit extension has not yet been achieved. At the same time, Wipf said “it is also clear, however, that the responsibility for this cannot be solely assigned to the two clearing banks. We in the bank dealer community have to take the immediate and incremental steps available through our liability management practices to become a bigger part of the solution.” He added that the status quo is “unacceptable” and collaboration between bank dealers and the two clearing banks to provide a set of strategic steps “to begin a tactical but meaningful reduction of intraday credit extension in parallel to building operational and system enhancements,” is required. 

Question & Answer 

Reed asked the witnesses to clarify the regulators’ role in addressing risk in the tri-party repo marketplace. 

Eichner said the Federal Reserve has become more active in an effort reduce risk after it became evident in 2011 that the task force would not be able to meet its 2010 commitments to eliminate intra-day credit. Eichner said the Federal Reserve Bank of New York’s July 18 press release details the Fed’s involvement and supervision. 

After listing a number of regulatory agencies, including the FSOC, Reed pressed Eichner for an answer on who is in charge, to which Eichner said all of the above. In addition, Eichner stated that the FSOC has, “I think a clear statutory responsibility to deal with situations where things threaten, as you suggest might be the case here.” 

Reed also asked the panel what the “stumbling block” has been to prevent dealing with the intra-day trading issue and whether it would be helpful if a required time was established for financial institutions to address the issue.  

Peetz said “we really are responsible to get a technology platform to enable simultaneous settlement between net and expiring trades and we are working on that now.” She added that BNY Mellon has already reduced the time needed to complete the platform from 2016 to 2014, to which Reed responded that a 2014 deadline “still exposes the system to risk that could be mitigated.” 

In a follow up question at the end of the hearing, Reed asked the panel whether “we have till 2014?” 

Eichner said “what we want to see is a very clear path to getting all of this done by 2014, but with many intermediate steps and pieces of risk reduction that occur along the way.”  

Wipf said the best outcome, and “how we think we can get to 2014,” is from clarity between the clearing bank and the bank dealers “in terms of what everyone can expect during times of stress and normal operating environments and then prudent liability management resting clearly with the dealers.” 

Crapo questioned the panel about simultaneous settlement being the ultimate objective and how the market would “ideally work” if the task force objectives are achieved. 

Peetz said the technology would enable trades that are maturing to be rolled “so you wouldn’t have the intra-day required for the whole book,” only on the activity that’s changing, which would reduce the amount of intra-day “significantly.” Peetz also said there would be higher quality collateral, dealers would be asked to pre-fund collateral that is not “high quality” and there would be an increased duration in tri-party transactions. 

Eichner said the key goal “is to make sure that it’s very clear who bears risk at every single moment and that those risks can be priced into people’s decisions.” 

Meier said he supported the elimination of the process of unwinding trades every day, particularly term trades, while Wipf said this would allow investors to have “a more stable pool of collateral that they can risk manage on a much more real-time basis.” Wipf added that if the books are pushed out and maturities are staggered, “the amount of actual credit that’s going to be extended can be reduced.”  

Crapo also discussed the Basel III framework’s two new minimum standards for funding liquidity (the liquidity coverage ratio and the net stable funding ratio) and asked the panel to what extent the new standards will affect the tri-party repo market. 

Eichner said the Basel III standards will provide additional impetus to dealers to more effectively manage risk. However, the standards do not focus much, if at all, on the settlement process and its reliance on intra-day credit and the liquidation of collateral of a dealer facing distress or default, he said. 

During his questioning, Merkley said he assumed the reason behind the repo playing such a big role in the marketplace is that it is the cheapest way to borrow, and asked the panel whether such a source of credit used and extended by dealers can create a huge systemic risk. 

Peetz said this issue is being looked at, “which is should dealers have limits on the amount that they can actually extend during the day.” Peetz said BNY Mellon is working with the industry and the Federal Reserve “to develop plans for that.” 

In follow up questions, Reed touched on a recent report by Fitch Ratings which indicated that there is a higher amount of structured finance paper pledged in repo transactions. Reed asked whether there is a potential problem where mutual funds, under the new 2a-7 rule about what the funds can and cannot hold, receive collateral back that they cannot hold or have to dispose of immediately. 

Meier said “I think this is a real risk.” He added that he would like to see the Federal Reserve start auditing the full contingency plans and actually ensure that people understand what they’re accepting as collateral. 

Reed also discussed an “alternative mode” to the tri-party repo market, which would include a financial market utility rather than clearing banks and asked what the panel thought about this alternative. 

Eichner said he remained concerned about the collateral liquidation problem and said the Federal Reserve believes additional work on this issue “can be done in the context of the clearing bank system.” However, Eichner said a utility is another possibility “and something that needs to be looked at.” 

Other panelists who commented found there to be no need for such a utility. 

For additional information on the hearing, please click here.