BofE's Tucker may turn the tri-party repo market upside-down

On Monday we wrote about the speech given on April 27th by Paul Tucker “Shadow banking:  thoughts for a possible policy agenda.” Mr. Tucker is Deputy Governor of the Bank of England with a remit for financial stability and this was an important speech. While there are many points and comments to make here, in this post we want to focus on just one sentence: “Financial firms and funds should not be able to lend against securities that they are not permitted or proficient enough to hold outright.” This sounds simple enough. How could financial firms take collateral – which they might have to own one day if their counterparty defaults – that they aren’t allowed to otherwise own outright? Um, wait a second.

In Finadium’s July, 2011 research paper “The New Face of the Repo Market for Investors, Dealers and Clearers” (a link to a synopsis is here) we wrote about the problem of tri-party cash lenders ending up with assets they weren’t allowed to otherwise own. We said, “…(do) money market funds or other investors who were maturity constrained with regard to what they own, fully appreciate that if the cash borrower defaulted, that they were going to have to own assets which they otherwise may not have been permitted to own — and then have to liquidate this paper to get their money back? Cash investors say that the collateral question may be one that no one really wants to ask regulators. The fear is that the answer will be painfully simple: do not take collateral in tri-party that the cash provider could not otherwise own, leading to another level of monitoring and risk management….” Paul Tucker just asked the question, and its unlikely to go away on its own.

In the last official round of U.S. money market fund reform, as of January, 2010 (link to SEC press release is here), 2a-7 funds have the following limitations:

  • Restricting the maximum weighted average life maturity of a fund’s portfolio to 120 days.
  • Restricting the maximum weighted average maturity of a fund’s portfolio to 60 days.

The trouble is, the collateral they take in on tri-party repo isn’t necessarily that short, but it may have to be if this rule is adopted globally. This could profoundly impact the way dealers can fund themselves and their leveraged clients. Beyond the extra layer of complication, where will the longer paper go for funding? The answer will be unsecured cash borrowings by the banks — a market that is more prone to market shocks.

One wonders if the ECB was listening to the speech? The pandora’s box of paper they hold, including the LTRO securities, might not qualify under Tucker’s rules. No one can argue with the concept of “know your collateral”. But be wary of distortions created by these rules. Short liquid paper will be in high demand in repo markets, longer or more complicated securities — not so much.

The New York Fed publishes data on the tri-party market by type of security (see a link here) but we wonder what it would look like if sorted by collateral maturity? This brings up a much bigger question: if investors can’t buy repo backed by collateral that they wouldn’t otherwise own, what would happen to all that underlying paper?

The burden may fall to the tri-party clearing agents to filter out ineligible collateral. This may require a level of security granularity that is not yet available.

A link to Tucker’s speech is here.

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