Tri-party repo is back in the news. Most of the coverage was driven by a recent FRBNY paper “A Primer on the GCF Repo® Service” (Staff Report 671) authored by a group of Federal Reserve Bank of New York researchers. And on April 28th, JPM issued a press release covered in a Bloomberg article “J.P. Morgan Materially Reduces Intraday Credit Exposure to Achieve Tri-Party Repo Market Reforms”. Is this the end of the story? Well…not entirely.
The issue with tri-party – and the primary focus of the reforms – was the intra-day extensions of credit provided by the clearing banks as part of the unwind/rewind process. The unwind/rewind allowed dealers easy access to collateral around during the day before it was committed to cash lenders later in the day. But the intra-day exposure was enormous and created a huge risk that the regulators were not happy about. More recently, the Fed has added the intersection of fire sale risk and tri-party repo to their list of front-burner securities financing issues.
The operational problem to be overcome was that dealers still need a way to access collateral for settlement purposes during the day. If the paper was always committed as collateral (which would happen without the unwind/rewind), it wasn’t available. Part of the solution was to facilitate intra-day substitution of paper. Further risk reduction is achieved by switching to a “net-of-net” process. From the FRBNY paper:
“…A planned improvement is rolling dealer’s positions in GCF Repo, or switching to a ‘Net-of-Net’ settlement process…The clearing bank then only settles the daily differences. If dealers net GCF Repo positions do not change much from day-to-day, this process could significantly reduce the amount of securities and cash that are required to flow among dealers to settle positions. FICC reports that fully implementing the new Net-of-Net process would result in an average reduction of 76 percent in amounts settled…”
The amount of the intra-day credit extension has been squeezed down (the unwind is now at 3:30pm instead of 6:30am), although maybe not yet to the Fed’s “operational moment in time” standard. This solution was technology driven and enormously complex. The clearing banks have made tremendous progress, as evidenced in Monday’s press release from JPM:
“…J.P. Morgan today announced that it has achieved the reduction of Tri-Party credit set forth in the target end state of U.S. Tri-Party Repo Market Reforms. J.P. Morgan is the first clearing bank to successfully eliminate the unwind as part of the reforms proposed by a New York Fed-sponsored, industry-wide working group, which focused on reducing systemic risk and improving operational efficiency for market participants…”
We imagine that BNY Mellon is pretty close too.
But it is not 100% fixed, especially when it comes to GCF Repo. GCF repo is traded through Inter-Dealer Brokers (IDBs) anonymously between banks and broker/dealers, primarily on US Treasuries and Fannie & Freddie paper. It is centrally cleared through FICC (who approves who can participate) a division of DTCC. It is settled via the tri-party clearing banks. FICC also nets settlements. The process, especially when it involves going across clearing banks, still remains a problem with extensions of credit by clearing banks to FICC.
From the paper:
“…Although the clearing banks have made progress on reducing dealers’ reliance on intraday credit, most of these improvements have been aimed at the settlement of tri-party repo trades, and not GCF Repo trades. Specifically, GCF Repo trades are still settled under a system that heavily relies upon unlimited intraday credit in order to be able to function…”
“…The concerns over clearing banks extending unlimited and uncapped credit continue to exist with the settlement procedures of GCF Repo…”
“…The clearing banks also extend intraday credit to FICC to settle GCF Repo positions. For the end-of-day settlement in the intrabank and interbank cases, as well as during the morning unwind for the intrabank case, the clearing banks extend frictional credit to FICC…”
Yes, the risk reduction strategies – “net-of-net”, active substitution, reducing the tine between unwind and rewind — do work and have gotten the market most of the way. But…
“…Relative to the intrabank case, less progress has been made on the interbank case. The current settlement system for interbank GCF Repo positions still requires the extension of non-frictional credit to FICC…”
There are some improvements coming here too.
“…For these interbank cases, a planned improvement with regard to settlement is to partially, rather than fully, unwind in the morning. Under the pre-reform system, securities are unwound to the repo dealers, and cash is returned to the reverse repo dealers. Under the new proposed arrangement, securities will be unwound to FICC and the repo dealer will access its securities through a collateral-substitution mechanism…”
So instead of broker/dealers getting the intra-day credit, FICC will.
“…This proposed settlement change impacts the nature of the intraday credit extended by clearing banks, but not the amount…”
However, as the paper noted, the clearing banks extending credit to FICC may be a better option than extending it to dealers. Not perfect, but a major improvement. FICC has been deemed a systemically important financial market utility and under the watchful eye of the regulators.
Still we wonder if a new architecture isn’t warranted? Would a blank slate have resulted in the same market structure? Could the clearing banks be replaced altogether with something that looks more like centrally cleared OTC derivatives, with FICC (or the Fed?) as the CCP market utility? The issues that come up – substitution for example – start to make the head swirl. For everyone hoping for a CCP structure for securities lending trades (including us), the intricacies of tri-party GCF trading and risk management may be a cautionary tale on how complex a problem this really is.