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Repo: uncertainty casts a shadow
07 June 2012
While some progress has been made on improving elements of the repo market, concerns surrounding the future direction of clearing and regulation persist. Paul Golden reports
Jaswal agrees that the case for a standalone resolution authority has yet to be proven, but is more supportive of the concept of a central clearing facility. “The role of BNY Mellon and JPMorgan has been questioned and it might be a good option to have a single central party clearer that is closely monitored by the regulator,” he says, adding that repo markets in Germany and Switzerland have made more progress on risk reduction through the influence of product innovation and central clearing.
According to Bruce Tuckman, director of financial markets research think tank at the Center for Financial Stability, there is concern across the repo market regarding the potential for lenders to run from financial institutions in a manner that has systemic implications. The extension of intra-day credit by clearing banks and the fact that clearing happens inside just two major banks in the US are specific issues for tri-party repo. “Not only do these banks have other interests that potentially conflict with their clearing function, but problems at these banks could spill over into the broader repo market. Almost nothing has been done with respect to this issue and that of intra-day credit.”
Tuckman accepts that the Federal Reserve Bank of New York’s Tri-Party Repo Infrastructure Reform Task Force has made significant progress in improving the use of technology to the point that intra-day credit extension by the clearing banks could be significantly reduced and that one of its significant achievements was to collect and publish reliable market data. However, he also suggests that greater use of technology is not being pursued aggressively across the industry and that improving technology so as to effectively eliminate intra-day credit extension in an automated and robust manner is still some way from being achieved.
“A key reason for systematic concerns with respect to the liquidation of collateral in the event of a repo borrower’s default is the illiquidity of some repo collateral,” he adds. “There is very little risk that the liquidation of US Treasury collateral will disrupt markets, but there is risk that the liquidation of certain collateralised mortgage obligations might do so.” A promising method of addressing these concerns, says Tuckman, is to inhibit repo borrowing on illiquid collateral by restrict certainly ing safe harbour protection to the more liquid collateral types.
Safe harbours allow lenders to deal with borrower defaults outside the bankruptcy process by, for example, liquidating collateral. He believes this would ensure repo liquidations no longer posedsystemic threats because only relatively liquid collateral would be put on the market in the event of a counterparty default. “Repo clearing, in the sense of a central counterparty [which includes centralised liquidation] could be useful and risk mitigating for the market if implemented appropriately.
The Depository Trust & Clearing Corporation (DTCC) currently clears many repo trades and its market coverage has been expanding. Forcing repo clearing by legislation, however, would be a mistake. The market and clearing houses are better protected by the process through which the market, perhaps with nudges by regulators, settles on which collateral types are suitable for the outsourcing of risk management and which counterparties are suitable for clearing house membership.”