One of our favorite blogs, the FRB NY Liberty Street Economics site, has a new post on the risks of tri-party unwind/rewind. The author, Antoine Martin, makes a great point about the two potential errors that come out of the current daily unwind/rewind system:
1.) that the clearing bank could refuse to roll over a broker/dealer when, in fact, they have adequate collateral, forcing the broker/dealer into default and bankruptcy or 2.) the opposite: that the clearing bank unwinds a broker/dealers positions when they don’t have adequate collateral to refinance themselves, and the clearing bank ends up exposed, Martin’s point is that by eliminating the unwind/rewind process, the clearing bank isn’t in a position to have to make the decision and the system is better off. The post is, in reality, a reminder to the tri-party clearers and industry task force that their reform work isn’t done.
The impact of removing the unwind/rewind is pushing the collateral risk to the cash lenders. As Finadium noted in their July 2011 report “The New Face of the Repo Market for Investors, Dealers, and Clearers” that removing the unwind/rewind, the tri-party cash investment is converted from an 16 hour trade where the clearing bank pays the cash investor out early in the morning to a 24 hour trade that is unwound when the financing trades are rolled over or the broker/dealer has the cash to pay it off. Finadium said, in part, (by eliminating the unwind/rewind) “The collateral risk stays with the cash lender for the term of the trade but there are some consequences to this change that need to be considered. First and foremost is the question of how collateral would be liquidated. How practical is it to expect dozens of cash lenders, many of whom are short-term money funds with limited experience in trading longer-term assets, to be able to efficiently dispose of collateral while avoiding fire sale prices? Cash lenders in tri-party have a history of benign neglect when it comes to the collateral. The problem will not be the US Government or GSE guaranteed paper – it will be everything else.Tri-party cash lenders, facing a 24-hour trade, may begin to differentiate between US Government or GSE guaranteed paper and all else, in particular noninvestment grade assets and equities. Will cash lenders simply turn off the flow for non-US Government or GSE guaranteed paper, raise haircuts and spreads, or do nothing unless a crisis hits them square in face? Is the handful of extra basis points worth the additional liquidity risk? If history is any guide, they may not act on a particular class of securities until it is too late.”
As cash lenders gain an increased appreciation of the reforms and the additional risks they will shoulder, they ought to think more seriously if they are set up to liquidate the collateral if it comes to that and if they want to impose more granular restrictions on the types of paper they accept.