The tri-party repo market is an important part of the U.S. financial system. However, as observed during the recent financial crisis, the tri-party repo market's infrastructure exhibits significant structural weaknesses that undermine market stability in a stressed environment. The Federal Reserve was forced to take extraordinary policy actions beginning in 2008 to counteract the effect of these flaws and avert a collapse of confidence in this critical financing market. These structural weaknesses are unacceptable and must be eliminated.
The Task Force was formed to develop options to address three fundamental areas of concern identified by policymakers at the Federal Reserve: (1) market participants' overreliance on intraday credit from tri-party clearing banks, (2) risk management practices that are vulnerable to procyclical pressures, and (3) the absence of an effective and transparent process for the orderly liquidation of a defaulted broker-dealer's collateral. The Task Force released a set of recommendations in May 2010 to modify industry operations and practices to sharply reduce the market's dependency on intraday credit provided by clearing banks. At that time, the Task Force indicated that the industry would complete the recommended operational changes in 2011. This goal was not achieved.
Based on the recommendations of the Task Force, market participants have made a number of important changes to the tri-party repo settlement process in the past year, all of which are prerequisites for reducing market participants' reliance on intraday credit provided by the two tri-party repo clearing banks. Among these improvements are the establishment of automated collateral substitution functionality for most trades in the market and the implementation of a 3-way trade confirmation process for all tri-party repo transactions. The Task Force also improved transparency in the tri-party repo market by publishing a monthly report on market size, collateral composition and margining practices on its website. These accomplishments could not have been realized without the concerted effort and dedication of the clearing banks and the Fixed Income Clearing Corporation (FICC), as well as the borrowers and lenders that actively participated in the Task Force.
Despite these accomplishments, the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged.
When significant obstacles arose in the industry's work last year, senior executives from firms on the Task Force met to enumerate a shared vision of the processes and practices needed to achieve the goal. Their vision, outlined in the Task Force's report, reflects lessons from the 2010-2011 implementation effort and input from the New York Fed regarding the characteristics that a future settlement infrastructure for tri-party repo must satisfy.
The clearing banks and FICC have submitted new plans and timelines for the work needed to achieve this vision, and the New York Fed has instructed them to begin work on refining and implementing the plans immediately. As the Task Force's report indicates, some systemic risk reduction is likely to be achieved later this year with the elimination of non-maturing trades from the daily unwind process by at least one clearing bank. However, a multi-year effort will be required to achieve all of the changes needed to realize the Task Force's vision for the entire tri-party repo market. The clearing banks and FICC are expected to provide clear communication to the public on the timing of deliverables in order to help ensure that all market participants have adequate time to prepare for and adjust to the changes.
Given the expanded timeline for the industry's work to reduce reliance on intraday credit, and the fact that this work may not substantially strengthen market participants' credit and liquidity risk management practices and mitigate the risk of fire sales of assets in the event of a large dealer's default, the Federal Reserve is making two changes in its approach to tri-party repo reform going forward.
First, the New York Fed will intensify its direct oversight of the infrastructure changes that the clearing banks and FICC are undertaking in order to reduce market reliance on intraday credit. While the Task Force has been an essential forum for generating and developing ideas, it has not proved to be an effective mechanism for managing individual firms’ implementation of process changes.
Second, the Federal Reserve is escalating its efforts to explore additional policy options to address the remaining sources of instability identified in the New York Fed's May 2010 White Paper. The Federal Reserve will pursue this work in parallel with the industry efforts to reduce reliance on intraday credit and will consult with other regulators and tri-party repo market participants as ideas are further developed. Ideas that have surfaced and could be considered include restrictions on the types of collateral that can be financed in tri-party repo and the development of an industry-financed facility to foster the orderly liquidation of collateral in the event of a dealer's default.
Ending tri-party repo market participants' reliance on intraday credit from the tri-party clearing banks remains a critical financial stability policy goal. While the bulk of the work on operational changes will fall to the clearing banks and FICC, borrowers and investors in the tri-party repo market will also need to modify their credit and liquidity risk management practices to realize the promise of these operational changes. As highlighted in the Task Force's May 2010 recommendations, dealers should be taking steps to reduce their reliance on short-term financing and investors should be taking actions to ensure their credit risk management policies and practices are robust to stress events. Such actions can help to ensure that market participants better internalize and price the costs associated with the credit and liquidity risks they bear in tri-party repo transactions. The Federal Reserve and other regulators will be monitoring the actions of market participants to ensure that timely action is being taken to reduce sources of instability in this market.