In Market That Ensnared Lehman, Risk of Debt Fire Sales Lingers

  • Fed pushing for fix to stamp out threat of dumping collateral
  • Push for central clearinghouses yields little progress

After four years of efforts, regulators and the financial firms with the most at stake have failed to extinguish systemic risk in a crucial short-term lending market that greases the wheels of trading in U.S. Treasuries.

There’s a consensus on how to further safeguard the $1.6 trillion tri-party repurchase-agreement market, which almost collapsed amid the financial crisis. The plan is to move most repo transactions onto central clearinghouses, which would prevent a default by a dealer from pushing counterparties into abruptly dumping repo collateral. Such fire sales, which the Federal Reserve has been highlighting as a threat, helped sink Lehman Brothers Holdings Inc. in 2008 and forced the central bank to step in to keep credit flowing.

QuickTake The Repo Market

Yet the firms at the forefront of developing or expanding central clearinghouses for repos -- CME Group Inc., the Depository Trust & Clearing Corp. and LCH -- have been unable to figure out a structure that aligns participants’ interests and builds the needed cash backstop. Nor has the Fed shown it’s willing to serve as lender of last resort to a central counterparty clearinghouse, known as a CCP. That backing might speed the creation of a CCP.

The result is a state of gridlock that leaves the financial system vulnerable and may point to further contraction in repos, where dealers turn for overnight financing, often using Treasuries as collateral. The tri-party repo market has shrunk almost 50 percent since 2008 as banks stepped back because of post-crisis capital requirements and leverage mandates.

Withering Effect

“It seems that either the Fed or the industry isn’t trying hard enough or doesn’t want this badly enough to figure out a way for the CCP to get the needed committed cash in the extreme event of a member’s failure,” said Darrell Duffie, a Stanford University finance professor who co-authored a 2011 paper on repos with Fed researchers. “Something has got to give, or the repo market is going to keep withering.”

The Fed’s 23 primary dealers use repos for financing, with money funds among key cash providers. In a tri-party arrangement, a third party, one of two clearing banks -- JPMorgan Chase & Co. or Bank of New York Mellon Corp. -- facilitates transactions and holds the collateral.

Overnight general collateral Treasury repo rates closed at 0.37 percent Thursday, according to ICAP Plc.

Four Years

Since the Fed in 2012 took on a greater role in overseeing efforts to bolster the repo market, it’s prodded the industry to stamp out risk resulting from potential fire sales of repo collateral, and the consensus has coalesced around a CCP. A clearinghouse pools member resources to ensure losses at one firm don’t harm all trading partners. Most over-the-counter interest-rate swaps contracts were moved to this model because of post-crisis regulations.

One challenge is the amount of money involved. In repos, the liquidity backstop for a CCP needs to be larger than for swaps clearing systems because the full notional principal amount of repo deals is exchanged at the beginning and the end of trades. In swaps, it’s only a fraction of the value.

The DTCC, through its Fixed Income Clearing Corp. unit, has been trying to expand the central clearing it does between dealers to include counterparties such as asset managers. FICC clears Treasuries and other government-related securities.

DTCC Proposal

One idea DTCC proposed in the past month to investors and regulators is to have asset managers, for a fee, pre-commit to take in the collateral of a CCP member that defaults, according to a person with knowledge of the talks who requested anonymity because discussions are private. That approach would ease the burden on the clearinghouse.

The challenge with all central-clearing efforts has been to hammer out specifics, said Jerome Schneider, head of short-term portfolio management at Pacific Investment Management Co., which oversees $1.5 trillion.

“The devil has always been in the details,” Schneider said from Newport Beach, California.

Collateral Question

“For example, extra consideration needs to be given in any pre-committed repo program, including what type of collateral you are getting,” such as whether it will be newer or older Treasuries, he said. “That matters a lot as it’s one thing trying to sell benchmark Treasuries and a whole different discussion having to sell off-the-runs or other less liquid collateral types.”

“DTCC is in active conversations with regulators and market participants on ways to continue to improve the risk management capabilities of its clearing services for the benefit of the industry,” said Murray Pozmanter, the company’s head of clearing agency services.

CME, operator of the world’s biggest futures exchange, has been working on its own plan. In an April earnings call, officials mentioned efforts to develop a repo clearing platform, without giving specifics or a timetable.

“CME Group is preparing a cleared repo offering that will leverage the existing market structure,” Agha Mirza, global head of interest-rate products at Chicago-based CME, said via e-mail. We “are making significant progress on important considerations such as accounting, risk, default management and liquidity.”

European Model

LCH, which clears repo transactions in Europe and owns the world’s largest interest-rate swap clearinghouse, is trying to frame a U.S. repo clearing alternative around its swaps clearing structure.

Liz Bruce, a New York-based spokeswoman for LCH, declined to comment, as did Andrea Priest at the New York Fed.  

For Duffie at Stanford, without a solution that revives the repo business, it may undermine trading in the world’s biggest bond market.

“The Treasury market is supposed to be a bulwark of liquidity to the global economy and it’s much less reliable,” he said. “It may be that the Fed is OK with allowing the repo market to get less vibrant and less liquid, with the trade-off being financial stability.”

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