It seems the end of “tri-party reform” might be on the horizon. Back in January, Fixed Income Clearing Corp. (FICC) slipped in a small change to their membership criteria. It would allow a second tier of membership which does not require deposits to their default fund, effectively giving a green light for money funds to join the inter-dealer clearing platform. Up until January, FICC was only for the “dealer” community, customers (money funds) need not apply. Last week, the Fed published a “How To” guide for FICC’s GCF Repo Service which seems to be an educational tool for non-members. It’s a detailed blueprint for customers looking to join FICC’s GCF Repo. As one Repo market veteran and former desk head told me, “The fact that the Fed is writing about this means it is going to happen”
GCF Repo is effectively an inter-dealer tri-party service. In one way, it’s a competing platform for regular tri-party Repo, except the Fed isn’t worried about fire-sale risk in GCF Repo because FICC has vast experience margining and liquidating Repo defaults. So it appears the Fed’s solution to tri-party reform might be to push tri-party Repo into FICC. If this is the case, it’s strange that we needed all the debate last year. It’s like the government saying we need a national expresso coffee chain, then awarding the role to Starbucks. The solution was there all the time.
Tri-Party Reform – Quick Rewind
Way back in the 1980s, securities dealers needed cash to finance their trading positions. The money funds provided the cash and the dealers allocated collateral into a tri-party account at a clearing bank (JP Morgan Chase or Bank of New York). The securities were deposited into the account between 4:00 pm and 5:00 pm each evening. The next day, the money funds (cash providers) took their cash back when the Fed Wire opened at 8:30 am. That left the collateral sitting at the clearing bank until the dealers re-allocated the collateral that evening. The system had evolved so that the clearing bank was providing about 7 hours of intra-day credit to the securities dealers. The clearing banks were funding the dealer community for almost 1/3rd of the day. The Fed saw this as a systemic risk. I don’t blame them.
For a more detailed history, see my article: Tri-Party Reform, Then And Now
At first, tri-party reform meant tightening up the “unwind” period – the window during the day when the clearing banks were effectively funding the dealers. A lot of progress has been made here. However, as reform progressed, the Fed noticed that the money funds were holding the collateral longer, so the Fed became more concerned about fire-sale risk at the money funds. That’s the dilemma right now. By moving the unwind risk out of the clearing banks, the risk of holding securities during the day is now skewed more toward the money funds.
What Is “GCF Repo”?
GCF stands for General Collateral Finance. It was first introduced in 1998 by FICC and only FICC members can participate. All total, there are 65 dealers active in GCF market, and in 2013, about $500 billion traded each day. Think of it as a tri-party service for government securities (US Treasurys, Agencys and agency mortgages), and only for FICC members. So the idea is to get the customers into FICC in order to remove the fire-sale risk. In other words, let FICC handle it. It also follows the general trend in the financial markets over the past 25 years – moving from the dealer-to-customer execution model to the everyone-executes-in-the-same-place model. It makes a lot of sense as a tri-party reform solution.
Back Where We Started
But there’s a problem. Whereas the clearing banks made great progress in narrowing the “unwind” window for traditional tri-party, the unwind window for GCF is still very wide. That is, FICC receives the GCF Repo collateral back from the dealers first thing in the morning and then those dealers wait to reallocate the GCF collateral at the end of the trading day. While FICC holds that collateral, it’s extending intra-credit to the dealer banks. FICC, in turn, is using intra-day credit from the clearing banks.
If tri-party cash providers move into FICC, we’re basically back where we started related to the unwinding of collateral each day. One step forward, one step back However, it’s still a little different. Think of the aggregate amount of intra-day credit that the clearing banks were extending to the individual dealer banks directly. Now, that intra-day credit is being extended to FICC, because the unwind window goes through FICC and the dealer community backs FICC through the default fund. It’s theoretically the same amount of intra-day credit, except it’s pooled and extended to the industry utility (FICC) as opposed to the dealer banks individually.
The Fundamental Problem
Problem solved? Not so fast. There’s still another problem. GCF Repo is only for government securities, like U.S. Treasurys, agencys and agency mortgages. What’s not included in this possible tri-party reform solution is: CMBS, RMBS, corporates, equities, foreign securities, etc. Basically, all the securities that actually pose fire-sale risk. Remember, Bear Stearns and Lehman didn’t go down because they couldn’t fund their government securities. It was the other stuff that was the problem. Government paper is not where the fire-sale risk resides. Though this might appear to be a tri-party reform solution on paper, it doesn’t really solve the fire-sale risk problem.
It all goes back to the purpose of tri-party in the first place – the reason tri-party was developed – to fund the dealer community. Dealers need billions of dollars to finance their government securities positions, so they borrow cash from the money funds. The tri-party system evolved so that the clearing banks were providing intra-day credit. That was systemic. When the money funds starting providing the intra-day credit, that had fire-sale risk. Basically, the debate is about who holds the intra-day credit risk. If that risk moves to FICC, then the dealer community is holding the risk through the industry utility. It’s all about how the risk is sliced and diced and who’s holding it at any particular point in time.
But keep in mind, even if pushing government tri-party into FICC is the Fed’s goal of tri-party reform, it’s only a reform on paper. It doesn’t address the real fire-sale risk because government securities have very little fire-sale risk during a market crisis.