Faced with an unruly child, an exasperated parent will often impose a “time out”.
That is one strategy some think could help calm the next major episode of a bank running into trouble in the “repo market”, where financial institutions pawn their assets in exchange for trillions of dollars’ worth of short-term loans.
The financial “time out” was one proposal from a Federal Reserve Bank of New York conference last week attended by leading players in the $2tn tri-party repo market, so-called ground zero for the runs on Bear Stearns and Lehman Brothers in 2008. Others include wresting control of the tri-party market away from the two banks which currently dominate it: Bank of New York Mellon and JPMorgan Chase.
In the five years since the crisis, regulators have endeavoured to strengthen the workings of tri-party repos by weaning the industry off intraday credit provided by BNYMellon and JPMorgan, who help facilitate repo agreements in the wider market.
But regulators remain concerned about the repo market’s tendency towards “fire sales”, where the assets underlying loans are sold off in a way that sparks a rapid pullback from other securities and funding.
“All the aspects of repo that make it a low-risk transaction for lenders historically, is what also makes it risky for borrowers,” says Martin Hansen at Fitch Ratings.
A repo resolution authority would allow lenders in the tri-party market to liquidate, or sell off, the collateral which secures their loans to a troubled bank or other financial institution. The idea is to give lenders and borrowers some extra time, with backing by regulators such as the Federal Deposit Insurance Corporation or the Fed.
Such an authority would mimic how major banks dealt with the near collapse of Long Term Capital Management in September 1998, as opposed to the chaos which surrounded the failure of Lehman Brothers a decade later.
Banks with exposure to LTCM pooled their resources and took over the hedge fund, giving the market breathing room to unwind trades and avoid fanning the flames of an asset fire sale. In contrast, Lehman failed after market participants rapidly pulled away their repo financing to the bank during the crisis.
Lehman’s estate is still wrangling over $8.6bn of cash and collateral which it says JPMorgan, its tri-party custodian, wrongly demanded in late 2008. Instead of helping to administer its repo agreements, JPMorgan helped cause Lehman’s collapse by asking for billions of dollars’ worth of extra security, the estate claims.
“When you have different lines of business with market participants that are involved in repo there’s a conflict of interest in that repo is ‘mission critical’ and could be used as a leverage point,” says Darrell Duffie, a professor at Stanford University and consultant for the Lehman estate who spoke at the conference.
The creation of a repo resolution authority, however, strikes at the heart of how the market has functioned down the years; namely that a lender can liquidate collateral immediately instead of waiting several weeks, months or even years to get the securities back by engaging in a long and complex bankruptcy process.
“From a practical standpoint, any solution that requires changes in the bankruptcy status of repo is a non-starter,” says Scott Skyrm, a former repo broker who attended the NY Fed conference.
However, government authorities have been contemplating tweaking the bankruptcy code to eliminate the provisions which exempt repo assets from the “automatic stay” which usually prevents securities from being seized during a bankruptcy. In July, Senator Elizabeth Warren suggested striking the relevant parts of the code as part of a wide-ranging bill aimed at improving the financial system.
An alternative proposal to a resolution authority is transferring the complex infrastructure which underpins the tri-party market from BNYMellon and JPMorgan to create a repo “clearing utility”. Such a utility, again backed by the Fed, would in theory help resolve alleged conflicts of interest and work to cushion the market.
However, that proposal is likely to meet with opposition from the two tri-party banks, and from others in the market who warn that it risks creating another “too big to fail” entity.
Mr Skyrm says: “Both the repo resolution authority and clearing utility have one thing in common, they’re camouflage for access to the Fed’s [lending].”
The real issue, says Mr Skyrm, is that while banks can tap the Fed for extra financing in times of market stress, other repo market participants like money funds, broker-dealers and hedge funds do not have the same recourse.
Few think that further reform of the tri-party market will be swift to come, as the vast array of characters involved in repo continue to make their case to an increasingly fed-up Fed. Says Mr Duffie: “There are winners and losers in almost everything that was brought up.”
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