Financial institutions in the almost $2 trillion a day market for borrowing and lending debt are close to unveiling centralized trade clearing systems to minimize risk in the essential wholesale funding mechanism.
The Federal Reserve has been pushing firms to decrease the risk that a large dealer default, such as the collapse of Lehman Brothers Holdings Inc., triggers broad dislocations in the repurchase-agreement market, where banks typically borrow cash for a short time from investors using securities as collateral. The movement of repo transactions to clearing houses, which pool capital, would help ensure losses at one firm don’t harm all trading partners.
“A central clearing solution for repo is much more imminent now, with it likely just some quarters away,” said Darrell Duffie, a finance professor at Stanford University, who with the Federal Reserve Bank of Chicago, organized an April 10 symposium on clearing in Chicago. “This would improve transparency, create minimum standards and improve loss distribution because there would be more market participants that would share in counterparty losses should they occur.”
In 2008, the Fed was forced to create liquidity mechanisms to prevent the rapid dumping of debt, known as fire sales, and support its primary dealers. The inability to secure cash via the repo market was a catalyst for the demise of Bear Stearns Cos. and collapse of Lehman that sparked a near credit freeze.
The Depository Trust & Clearing Corp. said in October it was seeking regulatory approval to provide central clearing for government-related securities in the $1.66 trillion tri-party market. The Fixed Income Clearing Corp., a DTCC subsidiary, would guarantee securities such as Treasuries and mortgage securities backed by Fannie Mae and Freddie Mac.
“We continue to work closely with the industry working groups and discuss the proposal with the regulators,” Bari Trontz, a DTCC spokeswoman in New York said on April 10.
While the Fed has already succeeded through work with industry members to reduce the trillions in intraday credit that the tri-party market’s two clearing banks had previously extended daily to dealers, the potential for fire sales leaves the market still vulnerable, central bank officials including New York Fed President William C. Dudley have said.
JPMorgan Chase & Co., which serves as one of the two tri-party repo clearing banks, is working with participants and infrastructure providers to create a central counterparty clearing house model that would provide benefits from both lenders and borrowers of cash, according to a person familiar with the work, who asked not to be identified because the system isn’t complete or yet public.
After the 2008 crisis highlighted the threat posed by financial companies’ exposure to swaps, regulators including the Commodity Futures Trading Commission moved to require that most trades be guaranteed at clearinghouses including those owned by LCH.Clearnet Group Ltd., and CME Group Inc. Both are working on guaranteeing repo trades through their own clearing frameworks, according to two people familiar with each the development.
One of main concerns about setting up a central counterparty for repo is whether it is possible to ensure that clearinghouses would have sufficient resources to meet a sudden surge in demand for cash upon a member default, possibly crippling its own ability to function. The resilience of CCPs, as the clearing houses are known, to withstand such extreme stresses has been the focus of regulators scrutiny this year.
“Central clearing doesn’t worsen the repo fire-sale risk, but so far there isn’t full clarity on how liquidity would flow into a CCP in the event that a lot of collateral needed to be liquidated quickly,” said Duffie, who is also a Bloomberg View contributor. “The Fed has not indicated it would be a lender of last resort to that market -- so you need private industry sources of liquidity. This is probably the biggest design problem to be overcome.”