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Repo Program Too Reliant on Clearing-Bank Credit: Report

The settlement of securities in Fixed Income Clearing Corp.’s program for dealers to borrow and lend U.S. government debt is overly reliant on credit extended by the industry’s two clearing banks, according to a report prepared by staff at the Federal Reserve Bank of New York.

While reform proposals scheduled to be completed will mitigate risks, “how the clearing banks will handle the intraday credit extensions to the FICC” to settle interbank general-collateral finance repo trades has not been determined, the report posted on the New York Fed website said.

Since the 2008 financial crisis, the Fed has sought to strengthen the tri-party repurchase agreement market, which almost 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. The amount of daily securities financed in the tri-party repo market was $1.57 trillion as of March 11, Fed data show.

FICC, owned by the Depository Trust & Clearing Corp., in 1998 introduced the GCF Repo service as a means for eligible members to exchange cash and securities.

Repos are transactions used primarily 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, which in the tri-party market is typically a money-market mutual fund.

Counterparty Risk

Securities dealers, primary among the more-than 100 entities eligible to participate in GCF repo, negotiate repo and reverse repo transactions anonymously through interdealer brokers. In this arrangement, firms don’t face counterparty risk because the FICC serves as the central counterparty while also providing netting services, allowing repos to be offset by reverse repo trades where similar securities used as collateral.

“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,” Paul Agueci, Leyla Alkan, Adam Copeland, Isaac Davis, Antoine Martin, Kate Pingitore, Caroline  Prugar and Tyisha Rivas wrote in the report released this month.

Tri-Party Settlement

Dealers participating in GCF repo are required to post collateral into the clearing fund, which protects the FICC against the risk of a dealer default. Firms must also meet eligibility requirements laid out by the FICC to become GCF members. GCF repos are cleared and settled through the tri-party platform run by Bank of New York Mellon and JPMorgan Chase & Co.

Securities that can be borrowed at interest rates close to the central bank’s target rate for overnight funds are called general collateral. GCF repo transactions are limited to 10 general asset classes for collateral.

The average daily trading in GCF repo was almost $500 billion with average daily netting services of over $250 billion in the first quarter of 2013, the authors wrote in the report.

On Feb. 13, the New York Fed said in an update on the tri-party reform efforts that progress had been made by the industry, while still more needed to be done to reduce systemic risk in this wholesale funding market.

“GCF Repo 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,” the New Fed’s statement said.

Fire Sales

Changes in settlement procedures through repo reform efforts to date have already cut by about $1 trillion the intraday credit extended by the tri-party clearing banks, and include setting up three-way trade confirmation and automatic substitution of collateral within repo agreements.

A primary risk remaining to the stability of the financial system is from potential fire sales, where cash lenders rapidly sell collateral of a defaulted counterparty or one at risk of such an event, the Fed said in the Feb. 13 update.

Fed staffers in the April report saw relatively less risk of fire sales in the FICC’s GCF repo structure relative to the tri-party market overall.

“We argue that fire-sale risks in GCF Repo are substantially mitigated by the role of the FICC as the central counterparty,” the report said. “An important assumption underlying this argument, however, is the ability of the FICC to adequately manage dealer defaults.”

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