Two years ago, the Tri-party Repo Infrastructure Reform Task Force released its final report, including a seven-point roadmap to guide the work still needed to (1) achieve a substantial reduction in the usage of discretionary intraday credit extended by the tri-party clearing banks, and (2) foster improvements in market participants’ liquidity and credit risk management practices.1 At that time, the Federal Reserve announced its intention to embrace this roadmap and to use its supervisory tools to encourage its implementation by market participants.2 Shortly thereafter, both clearing banks—Bank of New York Mellon and J.P. Morgan Chase—announced that they were committed to completing the infrastructure work needed to achieve a settlement regime that was much less dependent on their provision of intraday credit, and would deliver improvements by the end of 2014.
As 2014 begins, progress in achieving industry reform objectives is evident. Both clearing banks have already done much to re-engineer their tri-party repo settlement systems in ways that significantly reduce the amount of intraday credit needed for daily settlement, including ending the daily unwind of cash and collateral for non-maturing trades and redesigning the process for settling maturing trades in a more liquidity-efficient manner, thereby requiring less clearing bank credit. Market participants have also made important changes in their practices and behaviors that have helped to reduce the demand for intraday credit. Repo buyers and sellers are confirming the majority of their trades earlier in the day, providing the clearing banks with better and timelier information, which helps them to run settlement in a more credit-efficient manner.3 Progress has been made by some dealers in extending the tenor and laddering the maturity of their repo books, particularly for less liquid securities, so that maturities are less concentrated on any given day than they were in the past, reducing their need for credit. The Federal Reserve will continue to collaborate with other supervisors and regulators in encouraging dealers to employ robust liquidity management practices that would facilitate an orderly wind-down of their less liquid securities portfolios in the event that secured funding of these assets is withdrawn.
Collectively, these changes in process and practice have already resulted in a sharp reduction in intraday credit usage, from 100 percent of daily volume in late 2012, to about 20 percent of daily volume today. In dollar terms, the two clearing banks are providing over a trillion dollars less in intraday credit to market participants on a daily basis today than in February 2012. By the end of 2014, the Federal Reserve Bank of New York expects that intraday credit usage will reach, and may even fall below, the Task Force’s benchmark of 10 percent of daily tri-party repo volume.
Additional work is still needed, however, to fully realize the objective of a safer tri-party repo settlement process that is more resilient to stress. By the end of this quarter, both clearing banks will have put in place a more automated, centralized and streamlined process for collateral optimization and allocation that will speed these processes and facilitate their interaction with the new settlement infrastructure that has been developed. J.P. Morgan Chase expects to implement all of the changes needed to facilitate its move to extending intraday credit to dealers only on a capped, committed basis by the end of this month.4 The Bank of New York Mellon expects to be in a similar position by year-end 2014.5 Dealers, tri-party repo cash investors and their custodial agent banks will need to adapt their practices to the new settlement regime in order to fully realize its promise. In particular, it will be critical for tri-party repo investors to fund their new trades, and dealers to fund their maturing trades, before end-of-day settlement activity is initiated at 3:30 p.m. ET. Substantial process changes, such as changes to cash netting arrangements, may be required to support the necessary changes in behavior.
It is important to note that one of the goals articulated in the Task Force’s roadmap, namely the full integration of the General Collateral Finance Repo (GCF Repo®)6; settlement into the new tri-party repo settlement process, will not be completed fully by the end of the year. Notably, GCF Repo settlement, which takes place through the tri-party repo platform, is the driver of roughly two-thirds of the intraday credit that is currently extended by the two clearing banks to support tri-party repo settlement on a daily basis.7 The process for settling GCF Repo trades must become more liquidity-efficient, and thus more aligned with the broader tri-party repo settlement infrastructure in order to make the platform truly resilient to stress. While the clearing banks appear to be on track to integrate the settlement of GCF Repo transactions occurring between participants at the same clearing bank into the broader tri-party repo settlement process by the end of this year, it now appears likely that work to integrate GCF Repo transactions occurring between participants at different clearing banks will need to continue into 2015.
A third policy imperative that the Federal Reserve has long highlighted—namely the risk of destabilizing fire sales of repo collateral by tri-party repo investors in the event of a default of a large tri-party repo borrower—is not currently being addressed by industry participants. The risk of post-default fire sales is not unique to tri-party repo, but is a particular concern in the tri-party repo market given the composition of its investor base. Many tri-party repo investors are highly vulnerable to liquidity pressures and credit losses that may cause them to liquidate the collateral of a defaulted counterparty very quickly, even if they must do so at a loss. The ensuing price declines could trigger margin calls and deleveraging well beyond the repo market, spreading instability across the financial system. Unfortunately, no mechanism currently exists or is being developed to ensure that investors will act collectively and in a measured way in liquidating their collateral. Fire sale risk remains a critical policy concern of the Federal Reserve and other members of the U.S. regulatory community. As noted by Federal Reserve Bank of New York President Dudley in a recent speech, in the absence of a market-based solution to this risk issue, regulators may be forced to use the tools they have to take steps to reduce this risk.8
Tri-party repo market participants have made good progress to date in reducing reliance on intraday credit as a source of systemic risk in this market. But more work clearly remains to be done to make this important wholesale funding market more resilient to stress so that the events of 2008 are not repeated. In particular, market participants, together with regulators and supervisors, must work to complete the integration of GCF Repo into the new tri-party repo platform, and to develop new ideas and approaches for mitigating the risk that fire sales of assets could occur in the aftermath of a tri-party repo borrower’s default.
1 This seven-point roadmap can be found on page 3 of the Tak Force’s final report.
3 See the Treasury Market Practice Group’s guidelines for tri-party repo settlement in section 4 of their best practices document.