A recent paper authored by Darrell Duffie, Finance Professor at Stanford GSB is worth taking a look at. “Replumbing Our Financial System: Uneven Progress” was presented at the Fed conference “Central Banking: Before, During and After the Crisis” held in Washington, D.C. on March 23-24. If ever there was a paper that touched so many topics near and dear to us, this is it. Duffie looks at tri-party repo, CCPs, re-hypothecation, money funds, prime brokerage, and foreign exchange. In this post we are going to focus on what Professor Duffie has to say about tri-party repo. Duffie’s approach toward tri-party repo is that the clearing banks should be replaced with a “dedicated regulated utility”.
A common theme in the paper is that Dodd-Frank makes it more difficult to bail out financial institutions in trouble, especially non-banks, thus raising the risk of failure. In the case of tri-party, the settlement apparatus is far too systemically sensitive to be associated with institutions that could, however unlikely, fail. A robust tri-party clearing utility could also, says Duffie, better withstand the shock of a dealer failure than the current system.
Duffie writes, “…Given the systemic importance of tri-party clearing agents, and given their high fixed costs and additional economies of scale, tri-party repo clearing services for U.S. dealers and cash investors should probably operate through a dedicated regulated utility. Although this would likely increase operating costs for market participants, it would enable investment in more advanced clearing technology and financial expertise, allowing greater resilience of the tri-party repo market in the face of financial shocks such as the default of a major dealer. The moral hazard associated with lending of last resort to a dedicated utility is much reduced relative to the case of a financial institution with a wide scope of risk-taking activities…”
Duffie reminds us that the tri-party still can transmit systemic risk. Reliance on short-term funding makes the market vulnerable to sudden shifts in confidence, potentially causing dealers to fail and the collateral sold at fire sale prices. And at the risk of sounding like a broken record, the unwind/rewind process is far from being fixed, “…In extreme scenarios and in the absence of sufficient transparency, cash investors could become concerned that a clearing bank could be destabilized by its intra-day secured-lending exposure to a dealer. A run of these intra-day demand deposits could indeed destabilize the balance sheet of a clearing bank in the worst case…”
We think that as the Fed grows ever less patient with the market’s reform efforts and, in particular the clearing banks difficulty in resolving the unwind/rewind problem, the chances of a forced shift to a utility model increases. It will not be easy for anyone. But we wonder, somewhat rhetorically, won’t Congress be equally suspect about a tri-party utility that, in Duffie’s words will be “too important to fail”?
The author does acknowledge that Basel III liquidity requirements (e.g. LCR) “…are likely to be effective at forcing regulated financial institutions to maintain a reduced dependence on short-term repos for financing their securities inventories.” But Duffie then takes the regulation argument one step farther “…Some consideration should be given to parallel regulatory requirements for non-bank systemically important wholesale cash borrowers…”
It’s rare that one paper can connect so many dots without descending into hard-core econo-speak and pages of formulas. It certainly deserves a read.
A link to the paper is here.