The Issue Was Settled, Wasn’t It ?
On December 20, 2012 the Federal Reserve posted an announcement on their website about Recent Developments in Tri-Party Reform. For almost four years the Fed was concerned with potential flaws in the structure of the tri-party market that could destabilize the financial system during a financial crisis. In 2009, the Fed had appointed a Tri-Party Repo Infrastructure Task Force to make recommendations propose changes to the system and over the past four years representatives of the dealer/bank community, cash investors (money market funds) and clearing banks met and devised a strategy to reform the tri-party repo system to make it more stable in times of crisis. Though the Fed expected more radical reforms, the Task Force stuck to reforming the existing system and based on the announcement in December, it appeared substantial progress has been made.
JP Morgan had just shortened their daily “unwind” process, BNYM has installed new technology that would eventually eliminate the daily intraday credit extension related to the “unwind,” market participants were issuing better trade confirms, improving trade matching, and the largest dealers installed systems to reduce the need for intraday credit from the clearing banks. It appeared all, or at least most, of the Fed’s original concerns were addressed. At least, that’s what we thought.
The Bill Dudley Speech
Then, on February 1, just a few weeks ago, Bill Dudley, the President of Federal Reserve Bank of New York gave a speech that was highly critical of the industry’s reforms. In fact, he made it clear the industry still had a significant amount of work to do in reforming the tri-party Repo market. Though some progress had been made on intraday credit extension, almost no progress had been made on the “fire sale” issue – the risk that cash investors don’t have the capabilities to take possession of collateral and liquidate it if a dealer defaulted. In fact, Dudley outlined three possible actions the Fed would take if the industry did not address the “fire sale” issue quickly:
- The Fed might restrict tri-party collateral to Open Market Operations (OMO) eligible securities, that way in case there is a dealer default and/or a financial crisis, the Fed has the ability to step in and provide funding.
- The Fed wants a collateral liquidation mechanism established by tri-party Repo market participants and possibly back stopped by the central bank* to take away the liquidation process from the cash investors. Basically, they’re implying a tri-party Repo central counterparty (CCP). If the market doesn’t create it on its own, the Fed might push the entity through regulation.
- If the market does not create an orderly collateral liquidation mechanism, the Fed might use regulatory oversight to declare tri-party Repo an unstable source of funding for banks, thus require a collateral liquidation mechanism anyway.
Dudley’s speech basically summed up the Fed’s position: create a CCP for tri-party Repo or the Fed will limit the size of tri-party market through regulation and “reform.” In other words, if you don’t do it yourself, we will force you!
Tri-Party Reform Then
Back in late 2008, during the height of the financial crisis I remember sitting at my trading desk and listening to CNBC in the background. Henry Paulson was giving one of his regular press conferences and I heard him say something like, ‘and tri-party Repo is a threat to the entire financial system.’ That was the first time Repo market participants learned that the Fed and Treasury Department believed there were unacceptable risks in tri-party transactions.
What Is Tri-Party Repo?
Tri-party Repo is a Repo transaction with three parties involved instead of two. Whereas a traditional Repo transaction has two counterparties (a cash investor and a collateral provider) who exchange securities for cash, in a tri-party trade the two parties exchange cash for securities and a clearing bank holds the collateral for the life of the trade. The clearing bank is added into the transaction to perform risk management functions, price the collateral, and accommodate the collateral providers with substitutions. The clearing bank provides valuable services for both the cash investor and collateral provider. Tri-party Repo trades minimizes risks for cash investor and cuts down on settlements and ticket processing. The collateral provider has more time to allocate collateral at end of day, has more flexibility borrowing cash in the overnight market, and tri-party makes it easier to finance smaller pieces of securities.
The total size of the tri-party Repo market is approximately $1.865 trillion. In the U.S., tri-party Repo collateral is about 36% U.S. Treasurys, 38% agency mortgages and the remaining 26% of “other” collateral, which includes: federal agencys, ABS, CMOs, corporates, money markets, etc. Only 21.3% of tri-party securities are not eligible collateral for the Fed’s Open Market Operations.
The First Issue
The original risk highlighted by the Fed was that the two major clearing banks, JP Morgan Chase and Bank of New York Mellon, were exposed to significant risk from the tri-party “unwind” each day. As a result, they were extending the dealer community (the collateral providers) an unacceptable amount of intraday credit.
“The Unwind” Risk And Intraday Credit
In order to fully understand “the unwind,” you must understand the Fed Wire securities settlement system and how it relates to tri-party Repo. The Fed Wire officially opens each day at 8:30 am and closes at 3:00 pm, though there is extra time after the close for “reversals” and the resettlement of problem trades. During the 6 1/2 hour period between 8:30 am and 3:00 pm, any institution settling a U.S. Treasury, federal agency, or agency MBS must deliver and receive their securities during that period of time in order for it to count as a “good” settlement that day. A security can be delivered by the seller to the buyer at 8:31 am or at 2:59 pm, either time or any time in between counts as a “good” settlement. And here is where the controversy arises. In the past, cash investors would return the securities to the collateral providers (dealers) at 8:31 am each morning. That’s what’s called “the unwind,” the return of securities at the beginning of the day. Given all the securities moving in anout of a dealer bank and changes in their securities holdings each day, the collateral providers are not ready to deposit new collateral into the tri-party accounts for the current day’s trades until around 4:00 pm. That leaves a period of approximately 7 1/2 hours each day when the cash investors had their cash and the dealer had not yet allocated the new collateral. The clearing bank was effectively funding the collateral for 7 1/2 hours each day. That might not seem significant at first, but consider what happens if the dealer declared bankruptcy between those hours or some other crisis event occurs. It means the clearing bank is holding the collateral for a trade from the night before and is taking the credit risk on the counterparty and the securities. The minimal Daylight Overdraft fees the clearing banks charged did not compensate them for the credit risk they were assuming. The clearing banks were effectively stuck with a risk they could not control nor were they being priced correctly.
“The Unwind” risk exists because of the structure of the securities settlement system. As the cash investors sought to limit their credit exposure to dealers, they began returning securities first thing in the morning, reducing their credit risk by holding the securities for only about 16.5 hours each day. In essence, the cash providers were receiving an interest rate on their cash for a full day (24 hours) when they were really only lending money for about 16.5 hours each day. The clearing banks were being forced to carry the credit risk for the remaining period.
Tri-Party Repo Reform Infrastructure Task Force
In order the address flaws in tri-party structure, the Fed established the Tri-Party Repo Reform Infrastructure Task Force in September 2009. The Task Force was made up of representatives of all the major participants in the tri-party industry, including the cash investors (money funds), collateral providers (dealer banks) and the two major clearing banks, JP Morgan Chase and Bank of New York Mellon. They were charged with making the tri-party system more resilient and specifically to make recommendations and initiate changes to eliminate the massive extension of intraday credit by the clearing banks. Overall, the Task Force was successful in initiating a road-map to address intraday credit extension. They pressed the clearing banks to add technology to change the settlement process, eliminate to automatic unwind of daily tri-party trades, and the clearing banks increased Daylight Overdraft fees which helped securities settlements get processed faster. These enhancements and the scheduled changes [below] will ultimately lead to less credit extension by the clearing banks. However, the Task Force recommendations and accomplishments did not satisfy the Fed. The Fed was looking for broader reform, perhaps an overhaul of the entire tri-party system.
There was a fatal flaw in the assignment given to the Task Force, and it goes back to “the unwind” and settlement system. Reducing the intraday credit extension by the clearing banks was really just shifting risk from the clearing banks back to the cash investors and collateral providers. In the end, no one particular group was willing to agree voluntarily increase their share of the credit risks. The recommendations by the Task Force, though helpful, were not the complete overhaul of the system that the Fed had in mind. The Fed disbanded the Task Force at the end of 2011. By February of 2012, the Fed let it be known they were still unhappy about the lack of progress in tri-party reform. They informed the market they were considering placing restrictions on the tri-party market and for much of 2012 the Fed asked dealer banks to voluntarily reduce their use of tri-party financing.
The Second Issue
Whereas “the unwind” and intraday credit extension problem is mostly addressed, most of the market believe the tri-party reform issue was settled, but the Bill Dudley speech on February 1 put reform back in the spotlight. The Fed is looking for radical reform in the entire system and they are now stressing another risk, the “fire sale” risk born by the cash investors.
“Fire Sale” Risk
Though the Fed members had mentioned the “fire sale” issue briefly in the past, the Dudley speech brought it front and center. In the Fed’s view, the cash investors (money funds) are not set up to liquidate collateral if a dealer defaults. First and foremost, money market mutual funds are not allowed to hold some of the collateral they finance through tri-party trades, so in a dealer default, they would be forced to liquidate the securities immediately, in a quick “fire sale.”
The Fed has a point. Many cash investors are not active investors in the ABS or CMO markets and would not be able to properly estimate a security’s value and manage a proper liquidation. It is a risk. However, remember the cash investors receive a haircut on the value of the securities and those securities are priced by an independent source, the clearing bank. The haircut is supposed to take into account the volatility and liquidity of the underlying collateral. For example, most agency CMOs are over-collateralized by 5% [see below]. If the collateral is being priced correctly and the haircut is appropriate, then the cash investors have a sufficient cushion against “fire sale” losses. From a “free market” perspective, if a cash investor chooses to finance illiquid securities, they should understand the risks they’re assuming.
|Asset Group||Cash Investor Margin Levels|
|10th Percentile||Median||90th Percentile|
|ABS (Investment & Non Investment Grade)||3.0%||7.0%||15.0%|
|Agency Debentures & Strips||2.0%||2.0%||4.0%|
|CMO Private Label (Investment & Non Investment\ Grade)||3.0%||8.0%||17.5%|
|Corporates (Investment & Non Investment Grade)||3.0%||5.0%||15.0%|
|US Treasuries Strips||2.0%||2.0%||2.0%|
|US Treasuries excluding Strips||2.0%||2.0%||2.0%|
Tri-Party Reform Now
Here’s what’s really happening in tri-party reform in a quick summary. All in all, the Fed has identified risks inherent in the tri-party infrastructure and market participants are adopting reforms to address the risks, but the end result will be just shifting risks from one group of participants to another.
- “The Unwind”: Clearing Bank Intraday Credit Extension – By limiting the amount of intraday credit extension by the clearing banks, it moves the risk out of clearing banks and back to the cash investors and collateral providers.
- The “Fire Sale” Risk – Any new mechanisms or reforms to limit the “fire sale” risk for cash investors is moving risk away from the cash investors and back to the collateral providers.
- Establishing A CCP For Tri-Party With A Fed Back-Stop – If it’s truly the Fed’s intention to eliminate the “fire sale” risk from the cash investors, it means the creation a CCP and the entire system will have pooled risk with a Fed back-stop.
Remember, during each progression and attempt to eliminate the risk for one group, that risk is not disappearing, it is just shifting from one group to another. As the intraday credit extension risk is eliminated, and then the “fire sale” risk is eliminated and if a CCP is set up with the Fed’s back-stop, it means the risk is ultimately shifting back to the Federal Reserve.
Here’s my view: it all goes back to pricing risk accordingly. At first, the clearing banks weren’t properly pricing the risk of intraday credit extension. That’s being addressed. Now, the Fed is worried the cash providers are not pricing the “fire sale” risk correctly. The risk of the cash investors should be priced in the haircuts taken as margin on the trades. In essence, the Fed is saying the money funds are not pricing their haircuts correctly. It would be a better reform to require larger haircuts on illiquid and hard to price securities than to force a whole market into a tri-party Repo CCP with the taxpayers ultimately guaranteeing it.
* Title VIII of the Dodd-Frank Act created the term “Financial Market Utility” (FMU) for entities that clear and/or settle securities and funds. The Act permits systemically important FMU’s (including Central Counterparties) to have accounts at Federal Reserve Banks to access payment and settlement services. It also permits the Fed to extend credit to FMU’s. If a CCP is introduced into the tri-party market then the market effectively becomes “Quadro-Party” – the cash investor, the collateral provider, the clearing bank, and the CCP.