The History of Tri-Party
Surprisingly, it took the bankruptcies of an assortment of small government bond dealers in the 1980s to create the Tri-Party market. Before the 1970s, all Repo trades settled DVP (delivery versus payment) and were only traded between securities dealers and money-center banks. As “customers” entered the Repo market, they routinely gave their cash to the securities dealer to hold in a safekeeping account. Sometimes called “Hold-In-Custody” (HIC) Repo and unaffectionately known as “trust me” Repo, the cash investors had a lot of faith in their securities dealers, trusting them to hold the cash, hold the securities, and price the securities accurately. These days, there would be many rules and regulations governing the HIC transactions, but back in the 1970s and 1980s there was virtually no regulation, in fact, only 25% of all bond dealers were under any regulation at all, and it may come as no surprise, it was those firms that were often defaulting or abusing collateral that they gave to customers in Hold-In-Custody Repo trades.
Lack of Regulation
Glass-Steagall, which is also known as the Banking Act of 1933, established regulation in the stock market, it separated securities dealers from banks, but quite surprisingly, the law did not apply to municipal bonds and government bonds. The SEC assumed regulation of many of the securities markets, but government securities were considered “exempt” securities and therefore most provisions of federal securities laws did not apply. The thinking was that letting the market operate free of government regulation allowed the Treasury and municipalities to sell their debt at the lowest cost. The system lasted for many years, but eventually abuses began to surface. The municipal bond market was the first to suffer from the effects of no regulation. In 1975, after the SEC had brought many cases against municipal bond firms for excessive mark-ups, misrepresentations, high-pressure sales techniques, and churning customer accounts, the industry set up the Municipal Securities Rule Making Board (MSRB) as a solution through self-regulation. The municipal bond market was finally under some minimal rules, but still there were no changes enacted in the government bond market.
Government bond firms operated with minimal capital, no mark-to-market on trading positions, Repo transactions with customers were often booked as “Hold In Custody,” allowing them to be mis-marked and under-collateralized. Though the Repo market had been functioning well for years, there were no industry standards and no standardized Master Repurchase Agreement. Overall, there was virtually no regulation in the government securities market, except for the 36 Primary Dealers that had some supervision by the Federal Reserve.
Lombard-Wall was one of those small, unregulated government bond dealers. With the spike in interest rates in the early 1980s, they had begun offering Hold-In-Custody Repo as a cash investment for thrifts (S&Ls), municipalities, and pension funds. In conjunction with their municipal bond underwriting, they offered “flex repo” to clients, where the excess cash generated from the bond underwriting would stay in the account and could be withdrawn as needed, sometimes lasting as long as several years. The firm collapsed on August 17, 1982 and it came to light they had under-collateralized many of their safekeeping Repo transactions. After the bankruptcy was announced, Lombard-Wall filed a “stay” provision in bankruptcy court, which was a temporary restraining order so that Repo counterparties could not sell the collateral without court approval. One month later, the court ruled that the Repo was not a “collateralized loan” and the Repo counterparties had the right to liquidate their trades. That was good for the Street counterparties (the dealer community), but customers who had left both their securities and their cash at Lombard-Wall had no ability to liquidate their trades and get their cash back.
Lion Capital Group
Lion Capital was another small broker-dealer, based in New York, that filed bankruptcy two years later in May 1984. Their fraud was even worse than Lombard-Wall. Whereas Lombard-Wall had mis-priced securities, Lion Capital had taken the securities out of the customer accounts and used them to pledge as margin to fund their own operations. Lion Capital’s customers lost $40 million due to securities missing from their safekeeping accounts.
E.S.M Government Securities
E.S.M. Government Securities was established in 1976 as a small municipal bond dealer in Fort Lauderdale, Florida. They were known for living the high life in Florida, driving Mercedes and Jaguars and the principals paid themselves salaries of up to $500,000 a year. E.S.M. had dozens of cities and municipalities as clients because they were known for offering the highest rates on Hold-In-Custody Repo, and they advertized the investments were backed by U.S. Treasury securities. The problem was, they were not. So if you thought all the potential safekeeping frauds were already covered, you’re wrong. They were pledging the same collateral to more than one client, so when they collapsed, the small amount of actual securities in their safekeeping accounts only went so far. All total, their customers lost about $300 million and those customers included: Home State Savings Bank in Cincinnati which took losses of $150 million and it set off run on Ohio S&Ls, American Savings and Loan Association in Miami, Florida lost $55.3 million, and the City of Beaumont, Texas lost $20 million.
Other bankruptcies followed including RTD Securities and Bevill Bresler and Schulman Group. Except for Drysdale, all the customer losses from the Repo market during the time period were due to collateral held (or not held) in safekeeping accounts or the failure of the firm to give customers adequate collateral. Between 1977 and 1985, failures in government bond dealers resulted in almost $1 billion in losses.
After Drysdale, Lombard-Wall, Lion Capital, RTD Securities, E.S.M. Government Securities, and Bevill Bresler & Schulman, there was calls for regulation in the government securities market and a strong desire to end the “Wild West” days of unregulated government securities. Congressional hearings on the safety of the market were held in 1985. At the same time, dealers were working on self-regulation to bring all government securities under an SRO called the Public Securities Rulemaking Board, similar to the MSRB except for U.S. Treasurys and Agencys. However, years after those failures, little progress was made and they were unable to even standardize or clean up Repo market practices, which was then seen as a need for government regulatory action. The Government Securities Act (GSA) of 1986 was passed and signed by President Reagan which required government securities dealers to register with the SEC or be regulated as subsidiaries of banks, the Secretary of the Treasury had the authority to make rules for custody, the proper use of customer securities, net capital ratios, and the allowable leverage for Repo transactions.
Not surprising, no one wanted to do “Hold-In-Custody” Repo after 1984. The Street had a major problem, HIC Repo was an easy source of funding for the dealer community and good source of return on cash investments for customers. The Street needed a safer way of transacting a safekeeping type of Repo transaction and they realized that an agent was needed to stand in between the cash provider and the securities provider. A few dealers approached a clearing bank to set up “safekeeping” arrangements where the bank would act as a joint custodian in the transaction, working as an agent for both Repo counterparties. The clearing bank agreed to provide a service to verify there was sufficient collateral to meet the amount of the loan, to hold and verify the securities in the account and to maintain proper margin. Sometime in 1985 or 1986, the Tri-Party market was born.