Authors: Adam Copeland, Darrell Duffie, Antoine Martin, Susan McLaughlin

Citations: 79

Published: 2012-11-01T00:00:00.000Z

Why It Matters

Venue: Federal Reserve Bank of New York Economic policy review. Year: 2012. Citations: 79. Abstract signal: 1. INTRODUCTION During the financial crisis of 2007-09, particularly around the time of the Bear Stearns and Lehman Brothers failures, it became apparent that weaknesses existed in the design of the U.S. tri-party repo m...

Abstract

1. INTRODUCTION During the financial crisis of 2007-09, particularly around the time of the Bear Stearns and Lehman Brothers failures, it became apparent that weaknesses existed in the design of the U.S. tri-party repo market, used by major broker-dealers to finance their inventories of securities. These design weaknesses had the potential to rapidly elevate and propagate systemic risk. Following the crisis, an industry-led effort sponsored by the Federal Reserve Bank of New York was undertaken to improve the tri-party repo market's infrastructure, with the main goal of lowering systemic risk. This article describes some key mechanics of the market--in particular, the collateral allocation process and the process--that have contributed to the market's fragility and delayed the reforms. A repurchase agreement, or is effectively a collateralized loan. A well-functioning tri-party repo market depends on the ability to efficiently allocate a dealer's securities--the collateral in the transaction--to the various repos that finance those securities. In the United States, collateral allocation currently involves considerable intervention by dealers, which slows the entire process. Collateral allocation is also complicated by the need for coordination between the Fixed Income Clearing Corporation (FICC), which clears some interdealer repos, and the clearing bank, which facilitates the settlement of tri-party repos. The length of time necessary to allocate collateral in the tri-party repo market has been a significant obstacle to market reform. Another impediment to reform is the unwind process, the settlement of expiring repos that occurs before new repos can be settled. The unwind creates a need for intraday funding to tide dealers over in the period between when they return cash to investors and when they get new cash from the settlement of new repos. In the tri-party repo market, this intraday financing is provided by the clearing banks. The dealers' reliance on intraday credit is one of the three weaknesses of the market highlighted in a Federal Reserve Bank of New York white paper on infrastructure reform. Such reliance creates potentially perverse dynamics that increase market fragility and financial system risk. The next section offers a brief overview of the U.S. repo market and some of its important segments. In Section 3, we describe the market in more detail and summarize the concerns surrounding it. Section 4 reviews the mechanics of tri-party repo transactions; Section 5 concludes. 2. THE U.S. REPO MARKET A repo is the sale of a security, or a portfolio of securities, combined with an agreement to repurchase the security or portfolio on a specified future date at a prearranged price. Aside from some legal distinctions concerning bankruptcy treatment, (1) a repo is similar to a collateralized loan. Exhibit 1 shows a basic repo transaction. For the opening leg of the repo, an institution with cash to invest, the cash provider, purchases securities from an institution looking to borrow cash, the collateral provider. The market value of the securities purchased typically exceeds the value of the cash. The difference is called the haircut. For example, if a cash loan of $95 is backed by collateral that has a market value of $100, then the haircut is 5 percent. For the closing leg of the repo, which occurs at the term of the repo, the collateral provider repurchases the securities for $95 plus an amount corresponding to the interest rate on the transaction. In most segments of the U.S. repo market, at least one of the counterparties is a securities dealer. (2) Dealers use the repo market to finance their inventories of securities, among other purposes. In some cases, the collateral provider is a client of the dealer that wants to borrow cash. On these repos, the dealer is the cash provider. Repos involve a variety of other cash providers, including money market funds (MMFs), asset managers, securities lending agents, and investors looking to obtain specific securities as collateral in order to hedge or speculate based on changes in the market values of those securities. …