Avi Cohen had a good comment on the recent post about repo transactions (here), pointing out that triparty repo custodians face some intraday risks. It is indeed an important issue and should be discussed.
Repo markets have functioned well for decades. However this recent paper published by the NY Fed (below) outlined potential systemic risks in the tri-party markets that became apparent in 2008. The concerns are not with the repo market itself or the lenders/borrowers under the contract, but with the clearing banks that facilitate triparty repo transactions.
Both lenders and borrowers under the repo agreement often prefer for a third party to hold collateral and arrange settlement. This is similar to using an escrow account when two parties don’t fully trust each other. Not surprisingly triparty repo usage has been increasing since the financial crisis and particularly when dealing with Eurozone banks (see discussion).
The risks the NY Fed discusses in their paper are posed by the clearing banks such as BoNY and JPM who handle some $100bn+ in repo each on a daily basis. Specifically the issue is with the exposure these custodians have on an intraday basis when repo transactions are unwound.
Consider the following scenario. On a quiet Friday morning a lender under the repo agreement informs her borrower that she wishes to unwind the repo loan and asks the borrower to return the money. The custodian (clearing bank) is told that the repo trade is closed. The clearing bank then transfers the funds to the lender, expecting to get that cash from the borrower upon the end of day settlement. But when the clearing bank, in the process of returning collateral bonds to the borrower, tries to settle, the borrower fails to make payment and the securities go back to the custodian (via DTC).
Now the clearing bank, stuck with these bonds, is forced to start selling. But it is Friday late afternoon and there are few buyers out there willing to even look at the bonds. The custodian bank goes into the weekend still holding the securities. On Sunday the media picks up the news that this particular borrower has failed. By Monday morning markets are in disarray and other repo lenders to the troubled borrower are stepping out of their repo, all forcing the clearing bank to liquidate more collateral. At the same time the other large clearing bank is doing the same. Now lenders to unrelated institutions are also spooked by this event and decide to step out of their loans as well. A panic ensues. Clearing banks are forced to liquidate billions in collateral that is declining in value. All of a sudden one of the clearing banks fails to make payment and the situation rapidly spirals out of control as all triparty lenders try to get their money out at the same time. It’s a run on the repo clearing banks that forces credit markets globally to freeze.
This scenario, though quite remote, could be catastrophic. It was a serious enough concern for the clearing banks in 2008 that one very large custodian chose to liquidate collateral without waiting for the end of day settlement – which landed it in court later. But at the time it was the rational thing to do.
NY Fed: – Bear Stearns and Lehman Brothers, during the financial crisis of 2007-09 highlighted the fact that the two tri-party clearing banks are not only agents, but also the largest creditors in the tri-party repo market on each business day. This daytime exposure is associated with the unwind of repos, a process by which the clearing banks send cash back to investors and collateral back to dealers, regardless of whether a repo is expiring.
Between the time of the unwind and the time at which new trades are settled near the end of the business day, dealers must finance the securities that serve as repo collateral. During this transition period, the clearing banks provide financing to dealers, collateralized by the dealers’ securities. This provision of intraday credit creates multiple risks.
To deal with the risks posed by the clearing banks in 2008, the Fed set up its own “clearing bank” to make sure repo markets continue to function. It was called the Primary Dealer Credit Facility (PDCF). It’s obviously no longer used, but this intraday settlement gap continues to pose some risks to the financial system (discussed in the paper).
These risks however have diminished since the financial crisis. Collateral haircuts are now higher, particularly for the less liquid bonds. Lenders restrict bond size/concentration that can be in the collateral pool to make sure they are able to liquidate them. And the bulk of the collateral handled by clearing banks these days is comprised of treasuries and agency bonds.
NY Fed on Triparty Repo
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