Tuesday, October 1, 2013

Repo is Far from "Unregulated"


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

Repo is very much in the news lately, even coming up on the radar screen of the New York Times' Gretchen Morgenson. Morgenson penned an article in the Times' September 14, 2013 issue, After a Financial Flood, Pipes Are Still Broken, in which she worries that despite new rules on derivatives, the repo market remains largely unregulated.

And yet, for all the new regulations governing derivatives, mortgages and bank holding companies, a crucial vulnerability remains. It’s found in our vast and opaque securities financing system, known as the repurchase obligation or repo market. Now $4.6 trillion in size, it is where almost every financial crisis since the 1980s has begun. Little has been done, however, to reduce its risks. Morgenson indulges in some journalistic hyperbole to make her point, but she is not the only one concerned about the risks associated with the wholesale funding market.

Some government officials have also voiced concerns recently about risks in the repo market. William C. Dudley, president of the Federal Reserve Bank of New York, referred to the issue in a February speech and Ben S. Bernanke, the Fed chairman, discussed the problems with wholesale funding in a speech in May. The Securities and Exchange Commission published a bulletin in July on the vulnerabilities in the repo market as they relate to money market funds. Ms. Morgenson is also not the only one worried about the tri-party repo market's reliance on just two repo clearing banks, Bank of New York Mellon and JP Morgan Chase. In 2008, the Fed took extraordinary policy actions intended to avert a collapse of confidence in the tri-party repo market, partially because of repo participants' overreliance on intraday credit from the two tri-party clearing banks. The Fed's restriction of free intraday credit in tri-party repo have since that time affected broker-dealer and bank customers who now experience increased collateral costs and requirements. In addition, like other market segments, tri-party repo has experienced a huge demand for quality collateral, a trend that can be expected to last for awhile. The new demand for high quality collateral in the repo and other markets has had the unintended consequence of creating more demand for repo. This is because the increased need to transform lower quality collateral into higher quality collateral is pushing even more securities into the tri-party repo system in order to secure cash or other quality collateral.

Despite this feedback loop resulting in the even greater importance of repo to financial markets, Morgenson's feeling that not enough has been done to control the risks associated with repo may be misplaced.

Beyond the OTC derivatives reforms proposed or already on the books globally, regulators are still interested in looking into repo, and are currently proposing to manage repo risk by governing leverage ratios, and implementing central clearing.  According to the Wall Street Journal, "Regulators said reforming the repo market remained a top priority, and that they would give markets sufficient time to adapt and avoid disruptions," and "Regulators are also trying to address the problem of lack of data on the repo market, Fed Chairman Ben Bernanke has said."  

A new rule, known as the supplemental leverage ratio, is being proposed by the Federal Reserve and considered globally by regulators. In addition, the Financial Stability Board is examining the feasibility of central clearing for repo, though such a central clearing house would itself be a too-big-to-fail entity. Outside of regulatory reforms, the two tri-party repo clearing banks have undertaken major initiatives to both reduce risk in the repo market and make repo transactions more transparent to both participants and regulators.  


This includes:

  • Stopping the daily unwind of of non-maturing term repo trades, eliminating its intraday credit exposure for these transactions.
  • Implementing operational and technology changes that will ultimately eliminate the intraday credit that BNYM provides to dealers against privately-issued, nongovernment securities that settle through the Depository Trust Company (DTC). 
  • Improving the timeliness of tradematching. 
  • And a whole host of other process, reporting, and procedural reforms

The repo markets may not have been center stage in the financial meltdown, but they certainly played a role. That said, they haven't escaped regulatory scrutiny. And with the reforms proposed and already in place, and the considerable efforts taken by the clearing banks, the well collateralized repo market is far from the, "$4.6 trillion arena operating on trust, which can disappear in an instant" Gretchen Morgenson says it is.  

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