"Puts in the Shadow", a new paper by Manmohan Singh is worth a read

A paper from IMF Economist Manmohan Singh entitled “Puts in the Shadow” was published earlier this month. It is thought provoking and worth a read. We want to focus in this post on what he says about tri-party repo.

Singh’s baseline assumption is that if an entity is deemed to be a SIFI, it will be bailed out by the government. In other words, these are the entities – banks (shadow and traditional), CCPs, insurance companies, etc. – that are too big and interconnected to fail. We imagine that some critics will take offense at this notion. After all, aren’t ”living wills” and other orderly wind-down provisions designed to prevent massive bailouts? But Singh is being practical – if an institution is so large, so inter-connected that its failure will ripple through the financial system, leaving a path of destruction along the way, government will step in. If the alternative is being blasted back to a barter economy, saving the economy’s means of exchange is probably a wise idea. As a result, the owners and other claim holders of SIFIs have, in effect, a put back to the government that protects their interests.

Government puts are not uncommon and Singh looks at FDIC deposit insurance as a prime example. However, he goes further by arguing that FDIC insurance, for example, doesn’t just cover depositors but wraps the entire bank, covering the riskier activity that banks are involved in. In fact, the put could be thought to extend to many of the important clients and counterparts that a bank deals with since their demise will hurt the bank, potentially inflicting a mortal wound. Many of those connected institutions operate in finance’s unregulated shadows and, directly or indirectly, took advantage of the Fed’s programs to bring stability to the banking system during the crisis (e.g. TALF, bank loan bundle guarantees, the MMF Guarantee, etc.). Singh does remind us that the regulators are trying to control this contagion by limits on single counterparty exposure (@ 10%), but it is easier said than done, especially when trading strategies are replicated by multiple clients and/or markets, when under extreme stress, are perfectly correlated.

Singh looks at the impact of Qualified Financial Contracts (QFC) on various markets, including repo. QFC status allows a non-defaulting party to immediately liquidate a contract should one side default. The author notes that this ability creates a class of “super senior” creditors who can avoid long, drawn out bankruptcy proceedings. We have seen analysis that argues QFC status promotes fire sales via quick liquidations. We are not so sure that the alternative (of waiting for long drawn out bankruptcy proceedings to run their course) isn’t worse and wonder if it isn’t better to cut out the malignancy as fast as possible while still acting in a commercially reasonably manner? Singh cites recent academic studies that say QFC status is not justified, but acknowledges it won’t change anytime soon.

The connection to tri-party repo lies in the daily unwind/rewind of exposure. For the time between the unwind and rewind, “…the intra-day exposure remains large and operationally difficult to reduce and the systemic importance of this market may preclude an unwinding of BoNY and JP Morgan…” The Fed has asked for the unwind/rewind to become an “operational moment in time” or in other words, so short as to create no risk. The clearing banks have, in addition to a number of other important reforms, shortened the open period from most of the day to just a couple hours. But they struggle with the process modifications and IT necessary to make the Fed’s demands a reality.

Singh writes,

“…The TPR system in the U.S. can generate systemic risks, however, posing financial stability challenges. Systemic risk originates primarily from the technical daily unwinding of all TPR operations, irrespective of tenor. Every morning, all collateral is returned to the dealers, and cash is credited to lenders‘ accounts with the clearers; the repo is renewed at the end of the day. The intraday funding of the dealers (the latter do not repay cash against the collateral returned) is not subject to any liquidity buffer, or other regulatory safeguards. It is secured by a lien on the collateral returned, but typically with zero margin. Any inability of a dealer to roll over its funding would de facto transfer the risk to the clearer, which would either have to extend overnight credit to the dealer, or try to obtain and liquidate the collateral. From a risk standpoint, the market operates as a de facto overnight credit market, giving cash providers an illusion of liquidity which is not really compatible with funding security for the primary dealers. Indeed, the Fed introduced a special facility, the Primary Dealer Credit Facility (PDCF), to keep the system operating during the post Lehman crisis and prevent a fire-sale of assets by TPR principals or their clearers…” and

“…The magnitude of their exposure makes both BoNY and JPMorgan SIFIs, thus reducing incentives to self-insure. However, the Fed needs to keep TPR clearers in business to meet the needs of its own operations, particularly in light of the large liquidity draining operations that will eventually be needed when monetary policy is again tightened. The dealers are used to the subsidy and do not want to change the status quo…”

So if the tri-party clearing system is so important that the Fed would backstop it under any circumstances, then the clearing banks have a put to the Fed. In effect, they know that tri-party funding mechanisms and access to cash funding (and by extension broker/dealer and client leverage) will be protected with programs like TALF and PDCF.

What are the alternatives? Regulators jumping up and down until the system eliminates unwind/rewind risk isn’t working very well. Yes, the funding mechanism is critical to the system. We are not the first to bring up the plumbing or lubrications analogies, but they ring true. Maybe the clearing system should evolve into a government-sponsored utility? (See Prof. Darrell Duffee’s view and our response here.) There would be some politics to overcome as the fundamentalists insist that the risk needs to be exorcised instead of contained or even mutualized. The clearers might even be happy to have this monkey off their back. If the Fed continues to beat the tri-party drum – and there is no indication they are planning to stop anytime soon – sooner or later they will have to put their money where their mouth is.

A link to the paper is here.

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