An industry task force sponsored by the US Federal Reserve is working on a plan to scale back systemic risk in the funding market at the centre of the financial crisis and to reduce trader dependence on JPMorgan Chase and Bank of New York Mellon.
In the repo market, banks pledge securities as collateral for short-term loans from money managers and other investors.
While the issue is technical, it raises questions both about the ongoing vulnerability of the two so-called clearing banks in the market, JPMorgan and BNY Mellon, and their power over the Wall Street community in general.
Many officials at the Fed believe that such a role may not be appropriate for private institutions and that a public sector body may be more appropriate.
“The incentives are different for a private sector institution when under pressure,” said one senior Fed official. “There are conflicting objectives and when stresses rise, the banks may behave badly. The desire for security or collateral can be debilitating.”
The task force – made up of leading banks, including JPMorgan and BNY Mellon, and investors – met earlier this month to discuss additional reforms to prevent a repeat of the turmoil that characterised the repo market in 2008.
A final report by the task force is expected to be published early next year.
Its focus is the reduction of the role of the two clearing banks, which extend temporary credit late in the day to Wall Street dealers when repo trades are unwound and reconstituted.
Policymakers worry that market volatility could increase significantly if a repo-market borrower ran into funding problems and were unable to obtain credit from either clearing bank.
That would raise the spectre of repo securities being liquidated en masse, potentially harming other investors.
The regulators are pushing for a real-time settlement process for new and maturing repos, which would alleviate the need for intraday credit from JPMorgan and BNY Mellon.
With the Fed pushing for fundamental reform, creating a real-time system is a potentially costly and difficult technology project, said bankers.
It will also result in higher charges for dealers using repo as a financing tool.
The industry had hoped to shift 90 per cent of intraday credit from the two clearing banks by August using existing systems, but the deadline was missed as the industry belatedly realised the huge scale of the undertaking.
“A road map to real-time auto confirmation would be a huge step, but achieving that is problematic as there are differences in the operational capacities of dealers and cash investors,” said Peter Nerby, senior vice-president at Moody’s.
Any delay in resolving the issue of intraday credit potentially runs into the heavy hand of regulators who want this potential source of systemic risk eliminated and are waiting for results.
“Experience suggests that it is not easy for market participants to agree on measures that enhance financial stability when this goal conflicts with commercial and business interests,” said William Dudley, president of the New York Fed, earlier this year. “If the private sector falls short in this instance, public authorities may need to intervene and impose more forceful regulatory solutions.”
The most likely outcome, should the tri-party market fail to satisfy regulators, might take the form of a centralised clearing house, which would oversee the lending process without the pressure of making profits.
“Reducing the vulnerability of the tri-party system entails either increasing the number of clearing banks beyond BNY Mellon and JPMorgan or replacing them with a centralised counterparty that is a utility and thus has fewer conflicting incentives than a clearing bank,” said Anshuman Jaswal, senior analyst at Celent.
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