Four months ago, New York bankers issued a 43-page report on the tri-party repurchase, or “repo”, market, which solemnly described some of the sector’s shortcomings. The New York Federal Reserve then issued additional comments – and called for reform.*
Both reports almost immediately vanished from public view. They were not, for example, mentioned in all the US Congress summer debates. Indeed, the Dodd-Frank bill barely touches them at all. And, this month, as European and US regulators have marked the second anniversary of the collapse of Lehman Brothers by unveiling new financial reforms, the issue has barely cropped up at all.
Perhaps this is unsurprising: after all, until 2008 the workings of the repo market – or the part of finance where banks raise short-term loans backed by collateral – seemed distinctly dull. But in many ways this silence is shocking. After all, the sector is huge: the total volume of so-called “tri-party repo contracts” – or those arranged via a third-party broker – in the US peaked at about $2,800bn in early 2008 and is now at about $1,700bn.
Moreover, the repo market was central to the dramas of 2008. One of the main reasons why entities such as Lehman Brothers collapsed, after all, was that investors fled from repo deals, because they became frightened about counterparty risk. They also feared that the collateral backing these deals was losing value, particularly in relation to mortgage bonds, which represented 37 per cent of collateral.
However, this did not hurt just Lehmans, but other banks too. Most notably, the structure of the tri-party market is so closely entwined that it creates a contagion risk as bad as anything seen in the derivatives world. But while this contagion issue is now prompting politicians to push derivatives activity on to a clearing house, there have not been similar demands in the repo world.
Does this matter? Thankfully, not right now. In 2008, the repo market froze in the US (and, to a lesser extent in Europe), but since then, activity has resumed and in Europe the market is now even bigger than in 2008. That is partly due to a general improvement in financial market sentiment. However, the industry has also started implementing some sensible micro-level reforms, which – as laid out in that recent 43-page report – aimed to make the sector more transparent and improve risk management.
However, the core vulnerability that was exposed during the Lehman shock has still not gone away. The key problem is that there is still no neutral, third-party platform to underpin deals – and guarantee that they are honoured – if disaster strikes. Before 2008, nobody used to worry about this, since the short-terms loans were backed by collateral. Moreover, in the US deals are generally struck via two giant clearing banks, JPMorgan Chase and Bank of New York. And the whole point of the “tri-party” structure is that a third party is supposed to stand in the middle to broker and clear trades.
But in 2008 investors, in effect, lost faith in the ability of the system to net and clear deals and started to worry about whether they could sell collateral. They also started to panic about the health of counterparties, including those two giant clearing banks. If another crisis occurs, such fears might well erupt again.
Ironically, some bankers suspect that the current improvements in transparency, valuations and risk management might cause investors to withdraw at an even faster pace, if a crisis hits, because there is more pressure to act.
Is there a solution? Some observers, such as Viral Acharya, a New York-based economist, argue that what is needed is a type of neutral clearing house or resolution mechanism. This would, in effect, guarantee to complete deals in a crisis and thus avoid any damaging firesales of collateral. It would also avoid the need for the government to provide an implicit backstop for JPMorgan and BNY as the private sector clearing banks (which is what they are basically doing right now since they cannot afford for these to fail).
That sounds extremely sensible. But it seems most unlikely to happen anytime soon. Indeed this idea is not even properly discussed in those May reports. One reason is that JPMorgan and BNY have a vested interest in maintaining the status quo, since it gives them enormous informational power. The other problem is that there is little political appetite right now in the US or Europe for any more upfront, explicit state guarantees to the financial sphere. Unless a repo resolution mechanism is backstopped by, say, a central bank, it is unlikely to be credible. Little wonder, then, that silence rules. Right now it is easier for everyone to keep crossing their fingers – and pray that JPMorgan and BNY remain bulletproof for years to come.
*Tri-party Repo Infrastructure Reform; The Federal Bank of New York, May 17 2010; Task Force on Tri-Party Repo Infrastructure; May 17 2010
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