The Federal Reserve Bank of New York said risks of rapid asset sales in the repurchase agreement market aren’t being adequately curbed, and regulators may need to step in to shore up such wholesale funding.
The potential for fire sales, or forced selling of securities used as collateral in the $1.6-trillion-a-day tri-party repo market in case of a large default, “is not currently being addressed by industry participants,” the New York Fed said in a note posted on its website today.
Since the 2008 financial crisis, the central bank has tried to strengthen the tri-party repurchase agreement market, which nearly collapsed amid the demise of Bear Stearns Cos. and bankruptcy of Lehman Brothers Holdings Inc. The Fed took over efforts to improve functioning of the market in 2012 after the private-sector Tri-Party Repo Infrastructure Reform Task Force, sponsored by the Fed in 2009, disbanded.
“There has been good progress on infrastructure reform,” Darrell Duffie, a finance professor at Stanford University’s Graduate School of Business in Stanford, California, wrote in an emailed response to questions. Yet, “we are at a standstill on reforms to address fire-sale risk.”
Repos are transactions used by the Fed’s 22 primary dealers for short-term funding and typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender, typically a money-market mutual fund.
In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. (JPM) and Bank of New York Mellon Corp. (BK) serve as the industry’s clearing banks.
“Fire sale risk remains a critical policy concern,” the New York Fed said. “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.”
Increased use of equities collateral may heighten regulators’ focus on the risks of rapid asset sales disrupting financial markets, Fitch Ratings said in a statement this week.
Repos backed by equities rose 40 percent during the year ended Jan. 10, according to Fed data. Rising equity-collateral usage combined with a slide in repos backed by government securities pushed equities share to 9.6 percent of the $1.55 trillion tri-party repo market in January, up from 5.7 percent a year earlier, Fitch said in a report published Feb. 11.
The New York Fed statement today said “progress in achieving industry reform objectives is evident.”
Still, “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 New York Fed said.
“The ensuing price declines could trigger margin calls and deleveraging well beyond the repo market, spreading instability across the financial system,” the Fed district bank said.
The central bank created liquidity mechanisms to prevent fire sales and support its primary dealers in 2008. Fed officials backstopped the market through the Term Securities Lending Facility, for loans of Treasuries to Wall Street dealers, and the Primary Dealer Credit Facility for cash loans to the firms.
The risk of post-default sales, from money market mutual funds and other counterparties that hold the securities used as collateral for the repos, persists because such transactions are exempt from a bankruptcy regulation that typically prevents creditors from immediately taking possession of assets. These investors would likely quickly sell the securities, the New York Fed said in a May 2013 report.
“I would also add to the NY Fed’s list the issue of what to do about the too-important-to-fail aspect of the two banks that clear tri-party repo,” wrote Duffie, who co-authored a paper in July 2011 with New York Fed researchers Adam Copeland, Antoine Martin, and Susan McLaughlin titled “Policy Issues in the Design of the Tri-Party Repo Markets.” “That, and fire sales, remain serious issues to address.”
New York Fed President William C. Dudley said at an Oct. 4 conference at the bank on the topic of fire sales that “current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales, whether by the dealer itself, or by the dealer’s creditors following a default.”
“Industry participants have yet to fully embrace the role they must play in finding a solution to this problem,” Dudley said. “If industry is unable to play its role in achieving a holistic solution, regulators may find themselves forced to employ the specific policy tools at their disposal in their respective purviews to address the fire sale risk.”
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