In Anticipation Of A Run On The Tri-Party Repo System

A week ago the FRBNY's Task Force On Tri-Party Infrastructure came out with an exhaustive must read report discussing its concerns about the massive $1.7 trillion US tri-party repo market, and specifically proposing several ideas that could prevent a bank run on a shadow market that is second in size only to the money-market $2+ trillion US money market. Incidentally, both markets were on the verge in the days after Lehman. Their day of reckoning may be coming again soon, and with the FRBNY task force's explicit attention on Tri-Party repos, all is probably not well. In fact even Moody's today agreed that until the proposed fixes are implemented (likely many months, if not years away), the tri-party repo "market will remain a major source of systemic risk, especially given the current market volatility and the fact that the Federal Reserve’s primary dealer emergency lending facilities are no longer in place." This should be another bright red flashing warning to those who still have to realize that the liquidity situation from a month ago and now are diametrically opposite.

For those interested in the cliff notes on Tri-Party repos, we present Moody's abridged thoughts on the matter. Others may read our previous observations on the topic here.

Tri-party repo is similar to bi-lateral repo except for the involvement of a third party – a tri-party agent (Bank of New York Mellon or JPMorgan Chase, the two major clearing banks), which provides custody, valuation, and settlement services for the exchange of cash and collateral between the borrower and the cash investor. Nearly 40% off its peak size in 2008, at $1.7 trillion the tri-party repo market remains a key source of funding for primary dealers (Exhibit 2). The collateral funded in this market (Exhibit 1) is mostly treasuries and agencies. At $320 billion, less liquid collateral is still a large portion, although down 65% since the start of the financial crisis.

An “unwind” occurs every morning, when the tri-party agent returns the collateral to the dealer-borrower and the cash to the cash investor. Until the transaction (whether a term repo or a rolling overnight repo) is “rewound” in the afternoon, it is the tri-party agent that is lending to the dealer on a secured basis. The purpose of the unwind is to allow the dealer access to the securities in its collateral pool to settle sales, which occur throughout the day. Such intra-day credit extension, while normal, is not guaranteed in the clearing agreement and can be withdrawn at any point, particularly if the dealer’s creditworthiness deteriorates.

In order to reduce the gigantic amount of intra-day credit extended by the clearing banks, the Task Force proposed developing an “auto-substitution” functionality. This would allow dealers to access and substitute their encumbered collateral, thus facilitating settlement without the need for the daily unwind. Any remaining intra-day credit would be extended under well-defined bi-lateral agreements between dealers and the clearing banks. While this is a sensible solution for both the dealers and the clearing banks, its implementation is only targeted for June 2011.

In the meantime, the market remains structurally vulnerable to a repo run. First, many cash lenders (primarily, money market funds) continue to make lending decisions based on the counterparty’s credit rather than quality of collateral. And second, the market as a whole has a tendency for pro-cyclical haircuts – that is, lower haircuts when liquidity is abundant, and higher when liquidity is scarce. If cash investors pulled away in a stressed environment, the clearing banks would be faced with a choice (as they were several times in 2008) of taking on large secured credit exposure to dealers or severely constraining intra-day credit to them. Such market mechanics can exacerbate the effect of a systemic and/or a dealer-specific crisis.

Until the remaining issues in the tri-party repo market are resolved, the risk of a repo run remains in place. Risks could be exacerbated by the Fed’s quantitative tightening program draining available liquidity.

And to loosely paraphrase Troy McClure, now that you know how fragile the Tri-Party repo market is, try to not to panic too much.