June 18, 2014 4:40 pm

Regulatory tussle centres on ‘repo’

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In the spring of 2008, financial regulators at the Federal Reserve Bank of New York watched in shock as money market fund managers rushed to pull back billions of dollars in short-term loans they had made to Bear Stearns.

It was a classic bank run. But this time, instead of retail depositors queueing outside Northern Rock or another high street bank, the panic played out among professional investors in one of the shadowy recesses of the financial system.

The “repo market” was long viewed as one of the stodgiest corners of finance, a place where banks could raise cheap financing by pawning their assets to investors in exchange for short-term loans.

But in 2008, investors and regulators learned that the repo market was anything but staid and innocuous. When repo lenders suddenly pulled back their cash, Bear Stearns was left scrambling and was eventually forced into a sale to JPMorgan Chase. Months later, Lehman Brothers, which had used repo trades to borrow money and enlarge its balance sheet, collapsed following a similar retreat.

The repo market has since emerged as a crucial battleground of global financial reform. The market’s complex web of transactions is, in the words of Lord Turner, formerly a top UK regulator, potentially very risky because of the “cat’s cradle” of interwoven relationships it creates.

Much of the sector has been reformed, especially in the part known as the “triparty” repo market. There, regulators have largely eliminated the temporary credit provided to other banks by JPMorgan and Bank of New York Mellon, the two triparty clearing banks.

But a fight is brewing between rulemakers who want to revamp the market further to make it safer and bankers who say that a dramatic clampdown on repo could threaten the plumbing of the entire financial system by starving banks and the real economy of cash.

New leverage ratio rules that require banks to hold more capital against all of their assets are expected to force significant changes because they make it more expensive for banks to borrow through repo and to facilitate repo trades for other market participants.

Bankers have warned that such rules could hit other securities in an unintended way. While the repo market is prone to sudden runs, it is also a source of credit that lubricates the financial system.

US regulators, most notably Daniel Tarullo, Fed governor, are also considering whether to slap additional capital charges on banks that rely on large amounts of short-term secured funding, including repo.

“It’s going to box it in to some extent, because you’re not going to see institutions be able to get as levered as Lehman,” said one repo trader at a large bank.

Even as banks begin to retreat from the market, other entities are waiting in the wings to take over a potentially lucrative activity from Wall Street.

Some hedge funds are dabbling in lending out their assets, while others are creating new units that aim to directly connect repo borrowers and lenders.

As the bank repo trader said: “There’s been a lot of talk about peer-to-peer relationships disintermediating guys like us and matching off between each other.”

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