Safest U.S. Debt Likely Only Collateral Covered in Repo Clearing

Treasuries and U.S. government-related bonds are likely be the only collateral covered when financial institutions begin offering centralized trade clearing in the short-term market for borrowing and lending debt.

The securities account for about 85 percent of the almost $1.7 trillion financed daily in the repurchase-agreement market, where banks typically borrow cash for a short time from investors, such as money-market mutual funds, using securities as collateral.

Banks and clearinghouses including LCH.Clearnet Ltd. are close to unveiling centralized systems to minimize risk in the essential wholesale funding mechanism. The Federal Reserve has been pushing banks to decrease the risk that a large dealer default, such as the 2008 collapse of Lehman Brothers Holdings Inc., triggers broad dislocations in the repo market.

“Whatever we clear needs to be liquid, easily priced and manageable in a default,” said David Weisbrod, chief executive officer of LCH.Clearnet LLC, the U.S. unit of LCH.Clearnet. He expects to focus on what are known as Fed-eligible securities, comprised of Treasuries and the debt of federal agencies and government-sponsored enterprises.

LCH.Clearnet Group’s parent company clears repo transactions in Europe. The CME Group Inc. and the Depository Trust & Clearing Corp. through its Fixed Income Clearing Corp. subsidiary, are are among the companies also working to develop U.S. repo clearing structures.

Market Stability

Fed officials have warned that the web of repos remains prone to unravel in a panic, leading to fire sales of assets that could spread losses across the financial system. During the financial crisis, lenders demanded more and higher quality assets and refused to finance new repos as the value of securities held by Lehman plunged.

The movement of repo transactions between banks and investment funds to clearinghouses, which pool capital, would in theory help to ensure losses at one firm don’t harm all trading partners.

“What the market generally wants, and that’s from a regulator perspective as well as a counterparty perspective, is a stable market,” said Jerome Schneider, the head of short-term strategies and money markets at Newport Beach, California-based Pacific Investment Management Co. “One that appreciates the value of overcollateralization and pricing, and with that comes transparency. Steps toward any progress in that regard would probably be well received.”

‘Likely Evolution’

The Fed has sought to strengthen the repo market since the financial crisis by creating new liquidity mechanisms and providing additional support to the primary dealers that trade with the central bank. Reforms have already resulted in Bank of New York Mellon Corp. and JPMorgan Chase & Co, which act as middlemen to process repo in tri-party transactions, to cut hundreds of billions of dollars in excess credit extended to banks.

“We are active in many working groups and see repo clearing as a likely evolution of the market,” said Emily Portney, global head of agency, clearing and collateral management at JPMorgan. “It could provide netting benefits that will help alleviate the balance sheet constraints faced by many dealers as well as more transparency for the market as a whole. It is likely that cleared repo should only cover high quality liquid assets.”

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