Fire hazard
30 June 2015
There is still work to be done to reform the triparty repo market in the US
Image: Shutterstock
The warning from Fitch Ratings that the repo market is still at risk if a 鈥榝ire sale鈥� of assets hits financial markets appears to have prompted the Federal Reserve Bank of New York to issue an update on triparty repo reform鈥攊ts first since February 2014.
The rating agency鈥檚 study of corporate bond liquidity, released in the middle of June, focused on the characteristics of corporate bonds pledged as collateral in the triparty repo market.
Corporate bond collateral characteristics such as long-dated maturities, low trading frequency and wrong way risk could raise risks of a forced unwinding of repo-funded trades in a scenario where risk aversion increases sharply, according to Fitch.
鈥淪uch risk aversion could limit the ability of dealers to finance securities in the repo market. Cash investors such as money market funds could also be forced to sell collateral in the event of a dealer default.鈥�
On top of this, maturity mismatches between short-term repos and the long-term corporate bond collateral that they finance could exacerbate fire sale risk if trades are unwound quickly, argued Fitch. 鈥淥ver 90 percent of the bonds in our collateral sample have maturities of one year or more. These bonds carry greater interest rate risk, and could be more difficult to sell in a period of market dislocation.鈥�
The effects that a fire sale could have on repo have long been mooted, with the Financial Stability Oversight Council commenting in its latest annual report on financial markets: 鈥淧revious annual reports have highlighted structural vulnerabilities in the triparty repo market.鈥�
鈥淪ignificant progress has been made in this market in recent years, in particular reducing market participants鈥� reliance on intra-day credit from clearing banks. The risk of fire sales of collateral deployed in repo transactions remains an important financial stability concern.鈥�
According to the Federal Reserve, up to $250 million per day in corporate bonds can be liquidated without negatively affecting bond prices. But total corporate bond triparty repo collateral averaged approximately $75 billion in 2014. 鈥淔orced selling of even a small fraction of that amount could accelerate price pressure during periods of market stress,鈥� added Fitch.
Triparty update
Then, having heard nothing from the Federal Reserve Bank of New York for more than a year (publically, at least), it provided an update on the implementation of the now-disbanded Tri-party Repo Infrastructure Reform Task Force鈥檚 seven-point roadmap for reform on 24 June.
A key aspect of the reform roadmap, finalised in 2012, was to drastically reduce the share of triparty repo volume that is financed with intra-day credit from a clearing bank. BNY Mellon announced in early May that this had been achieved: the secured credit extended in the triparty repo market was reduced by $1.44 trillion, or 97 percent, resulting in the practical elimination of such credit in its programme.
BNY Mellon also introduced a range of enhancements including Automated Deal Matching, which captures instructions independently from repo counterparties and ensures all parameters of a triparty repo trade match prior to settlement. Meanwhile, Auto Collateral Exchange now allows triparty repo trade collateral to automatically substitute securities for cash, significantly upgrading the way collateral is optimised and allocated.
Other enhancements such as rolled trade functionality, rebalancing capabilities and a new settlement algorithm have also been introduced.
鈥淎s the market leader for triparty collateral management, we embraced the task force recommendations and proactively addressed the necessary changes without disrupting the market,鈥� commented Brian Ruane, CEO of broker-dealer and triparty services at BNY Mellon, in May, when the bank made its announcement.
鈥淭hrough a comprehensive set of operational and technology improvements, as well as the strong partnership with our clients and other market participants, we have significantly reduced systemic risk and positioned our clients for success moving forward in this market.鈥�
Acknowledging this success, the New York Fed said in its 24 June statement: 鈥淎s a result, the share of triparty repo volume that is financed with intra-day credit from a clearing bank has dropped markedly, from 100 percent as recently as 2012, to a level averaging 3 to 5 percent today (as compared with the task force鈥檚 original target of no more than 10 percent). Clearing banks, dealers and investors all made changes to their practices and processes that helped to achieve this goal.鈥�
But, as Fitch warned, issues remain that could cause problems if markets are sufficiently shocked. The last leg of the task force鈥檚 reform roadmap is the full alignment of general collateral finance (GCF) repo settlement with the new triparty settlement process.
鈥淭he settlement process for the majority of GCF repo trades that occur between dealers at the same clearing bank is largely aligned with the reform goals; minimal intra-day credit is used, and settlement occurs between 3:30pm and 5:15pm,鈥� explained the New York Fed.
鈥淗owever, the subset of GCF repo transactions that occur between dealers at different clearing banks are still unwound at 8:30am, and still require uncapped, discretionary extensions of intra-day credit by the clearing banks to settle. This is a potential source of market instability in periods of stress.鈥�
鈥淲hen triparty repo lenders reduce the provision of financing to a repo borrower, the borrower may seek to obtain funding in GCF repo, where trades are arranged anonymously by inter-dealer brokers. In a full-blown stress event, GCF repo usage, and the associated intra-day credit needed to settle that GCF repo activity, could balloon suddenly and significantly, to levels that a clearing bank is unwilling or unable to support through the provision of the necessary intra-day credit.鈥�
The GCF task was supposed to be completed this year, but the New York Fed admitted that 鈥渢he work required to align settlement of these inter-bank GCF repo trades with the broader process will stretch beyond 2015, given the complexity of the reengineering challenge involved as well as the contention of this effort with other near-term changes that are required for other purposes鈥�.
Finally, the New York Fed admitted in its statement that the risk of a fire sale of collateral by a dealer that is losing access to repo financing (pre-default), or by creditors of a dealer once it has defaulted (post-default), are concerns.
鈥淪ubstantial progress has been observed to date with respect to pre-default fire sales, due to capital and liquidity regulations that have prompted dealers to extend the tenor of their financing for less liquid asset,鈥� the New York Fed was keen to stress.
鈥淏ut as yet, no mechanism exists to address the challenge of coordinating sales of collateral by the creditors of a defaulted dealer in an orderly manner.鈥�
鈥淭he New York Fed acknowledges current industry efforts to develop central clearing mechanisms for repo financing, which may offer opportunities to establish a process for orderly liquidation of assets of a defaulted member, which is a common feature of central counterparties in other markets.鈥�
Indeed, the Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust and Clearing Corporation (DTCC), confirmed last year that it wants to provide central clearing for the $1.6 trillion institutional triparty repo market. It is currently discussing its proposals with regulators. They would see the FICC process more than 70 percent of the market.
Murray Pozmanter, DTCC managing director and head of clearing agency services, said at the time that centralising the clearing and settlement of repo transactions through FICC could potentially 鈥渉elp to prevent another squeeze in triparty funding such as the one observed in 2008 when funds sharply reduced their lending during the run up to the Lehman failure鈥�.
鈥淚t would also provide regulators with a broader and more comprehensive view of the repo market for the monitoring and management of systemic risk as well as mitigate risks associated with a fire sale in the triparty marketplace.鈥�
The rating agency鈥檚 study of corporate bond liquidity, released in the middle of June, focused on the characteristics of corporate bonds pledged as collateral in the triparty repo market.
Corporate bond collateral characteristics such as long-dated maturities, low trading frequency and wrong way risk could raise risks of a forced unwinding of repo-funded trades in a scenario where risk aversion increases sharply, according to Fitch.
鈥淪uch risk aversion could limit the ability of dealers to finance securities in the repo market. Cash investors such as money market funds could also be forced to sell collateral in the event of a dealer default.鈥�
On top of this, maturity mismatches between short-term repos and the long-term corporate bond collateral that they finance could exacerbate fire sale risk if trades are unwound quickly, argued Fitch. 鈥淥ver 90 percent of the bonds in our collateral sample have maturities of one year or more. These bonds carry greater interest rate risk, and could be more difficult to sell in a period of market dislocation.鈥�
The effects that a fire sale could have on repo have long been mooted, with the Financial Stability Oversight Council commenting in its latest annual report on financial markets: 鈥淧revious annual reports have highlighted structural vulnerabilities in the triparty repo market.鈥�
鈥淪ignificant progress has been made in this market in recent years, in particular reducing market participants鈥� reliance on intra-day credit from clearing banks. The risk of fire sales of collateral deployed in repo transactions remains an important financial stability concern.鈥�
According to the Federal Reserve, up to $250 million per day in corporate bonds can be liquidated without negatively affecting bond prices. But total corporate bond triparty repo collateral averaged approximately $75 billion in 2014. 鈥淔orced selling of even a small fraction of that amount could accelerate price pressure during periods of market stress,鈥� added Fitch.
Triparty update
Then, having heard nothing from the Federal Reserve Bank of New York for more than a year (publically, at least), it provided an update on the implementation of the now-disbanded Tri-party Repo Infrastructure Reform Task Force鈥檚 seven-point roadmap for reform on 24 June.
A key aspect of the reform roadmap, finalised in 2012, was to drastically reduce the share of triparty repo volume that is financed with intra-day credit from a clearing bank. BNY Mellon announced in early May that this had been achieved: the secured credit extended in the triparty repo market was reduced by $1.44 trillion, or 97 percent, resulting in the practical elimination of such credit in its programme.
BNY Mellon also introduced a range of enhancements including Automated Deal Matching, which captures instructions independently from repo counterparties and ensures all parameters of a triparty repo trade match prior to settlement. Meanwhile, Auto Collateral Exchange now allows triparty repo trade collateral to automatically substitute securities for cash, significantly upgrading the way collateral is optimised and allocated.
Other enhancements such as rolled trade functionality, rebalancing capabilities and a new settlement algorithm have also been introduced.
鈥淎s the market leader for triparty collateral management, we embraced the task force recommendations and proactively addressed the necessary changes without disrupting the market,鈥� commented Brian Ruane, CEO of broker-dealer and triparty services at BNY Mellon, in May, when the bank made its announcement.
鈥淭hrough a comprehensive set of operational and technology improvements, as well as the strong partnership with our clients and other market participants, we have significantly reduced systemic risk and positioned our clients for success moving forward in this market.鈥�
Acknowledging this success, the New York Fed said in its 24 June statement: 鈥淎s a result, the share of triparty repo volume that is financed with intra-day credit from a clearing bank has dropped markedly, from 100 percent as recently as 2012, to a level averaging 3 to 5 percent today (as compared with the task force鈥檚 original target of no more than 10 percent). Clearing banks, dealers and investors all made changes to their practices and processes that helped to achieve this goal.鈥�
But, as Fitch warned, issues remain that could cause problems if markets are sufficiently shocked. The last leg of the task force鈥檚 reform roadmap is the full alignment of general collateral finance (GCF) repo settlement with the new triparty settlement process.
鈥淭he settlement process for the majority of GCF repo trades that occur between dealers at the same clearing bank is largely aligned with the reform goals; minimal intra-day credit is used, and settlement occurs between 3:30pm and 5:15pm,鈥� explained the New York Fed.
鈥淗owever, the subset of GCF repo transactions that occur between dealers at different clearing banks are still unwound at 8:30am, and still require uncapped, discretionary extensions of intra-day credit by the clearing banks to settle. This is a potential source of market instability in periods of stress.鈥�
鈥淲hen triparty repo lenders reduce the provision of financing to a repo borrower, the borrower may seek to obtain funding in GCF repo, where trades are arranged anonymously by inter-dealer brokers. In a full-blown stress event, GCF repo usage, and the associated intra-day credit needed to settle that GCF repo activity, could balloon suddenly and significantly, to levels that a clearing bank is unwilling or unable to support through the provision of the necessary intra-day credit.鈥�
The GCF task was supposed to be completed this year, but the New York Fed admitted that 鈥渢he work required to align settlement of these inter-bank GCF repo trades with the broader process will stretch beyond 2015, given the complexity of the reengineering challenge involved as well as the contention of this effort with other near-term changes that are required for other purposes鈥�.
Finally, the New York Fed admitted in its statement that the risk of a fire sale of collateral by a dealer that is losing access to repo financing (pre-default), or by creditors of a dealer once it has defaulted (post-default), are concerns.
鈥淪ubstantial progress has been observed to date with respect to pre-default fire sales, due to capital and liquidity regulations that have prompted dealers to extend the tenor of their financing for less liquid asset,鈥� the New York Fed was keen to stress.
鈥淏ut as yet, no mechanism exists to address the challenge of coordinating sales of collateral by the creditors of a defaulted dealer in an orderly manner.鈥�
鈥淭he New York Fed acknowledges current industry efforts to develop central clearing mechanisms for repo financing, which may offer opportunities to establish a process for orderly liquidation of assets of a defaulted member, which is a common feature of central counterparties in other markets.鈥�
Indeed, the Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust and Clearing Corporation (DTCC), confirmed last year that it wants to provide central clearing for the $1.6 trillion institutional triparty repo market. It is currently discussing its proposals with regulators. They would see the FICC process more than 70 percent of the market.
Murray Pozmanter, DTCC managing director and head of clearing agency services, said at the time that centralising the clearing and settlement of repo transactions through FICC could potentially 鈥渉elp to prevent another squeeze in triparty funding such as the one observed in 2008 when funds sharply reduced their lending during the run up to the Lehman failure鈥�.
鈥淚t would also provide regulators with a broader and more comprehensive view of the repo market for the monitoring and management of systemic risk as well as mitigate risks associated with a fire sale in the triparty marketplace.鈥�
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