What Too Big to Fail Means in the Tri-party Repo Market

What happens if a major issuer of repo defaults? This question comes up as the November Federal Reserve tri-party data remind us that the repo market is highly concentrated. For non-investment grade corporates (aka high yield debt or junk bonds) for example, the top three dealers have 51.7% of the market. Granted, this asset group comprises only 1.6% of tri-party repo, but walking through the implications of a potential failure by a major dealer shows significant implications for money market funds and other repo buyers.

The Fed’s statistics cite several asset groups with 8% median margin as compared to Agency MBS and US Treasuries that are almost no risk at 2% median margin. This means that these products, including equities, CMO Private Label Investment & Non Investment Grade and Corporates Non-Investment Grade, are concerning enough that cash providers want an additional 6% margin on average over an effectively risk-free margin rate. Together, the riskiest repo products make up 8.1% of the US$1.66 trillion tri-party repo market. This is arguably a small drop in the big bucket of repo, but it could become a major headache if not managed well.

Any systematic trouble would arise from the failure of any one of the major dealers of less liquid repo products. Operationally, a failure would mean that the collateral underlying the repo, either term or overnight, becomes the property of the cash provider who took on the repo in the first place. These investors are going to want their money back fast. While not a lot of assets will be affected relative to the total market size ($27 billion in high yield debt compared to a $1 trillion market), a forced sale of these collateralized assets will destabilize the least liquid products, especially on top of the failure of a major financial institution. As another example, equities make up 4.2% of repo by asset group and total $72 billion. While $72 billion seems like a small figure in the face of a $50 trillion global equities market, what happens when sellers must liquidate into a market in freefall? We’ve seen this story before.

As repo provides a fundamental building block of modern finance, the possibility of a major dealer failing with outstanding repo would create a major jolt to all markets. Both Bear Stearns and Lehman Brothers were felled by a lack of access to the repo markets. Our scenario is not that repo investors would pull away from certain issuers but that these issuers would default with the repo outstanding, making the collateral the problem of the investor. This situation becomes more likely with the growth of term repo in place of overnight issuance. A rush to sell potentially illiquid collateral would mean that other repo market participants would be unlikely to see their illiquid repo bought up that week, effectively shutting down the market and creating negative spin-off effects to other financial institutions.

Repo risk is remote but still real enough for investors to need to know what they are holding, and raises the issue of what too big to fail means in the repo market. Not all repo is created equally, and there are significant potential liquidation differences between equity-backed repo that typically produce greater returns than US Treasury-backed repo. Who the issuer is also matters, as does whether the repo investment is overnight or structured for a fixed term. Investors should take care in the repo market especially as new Dodd-Frank regulations create more structure about what too big to fail will mean in the future counterparties.

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