Tri-party repo taskforce to disband without delivering key reform

The New York Fed's concerns about intra-day credit should be tackled by JP Morgan, BNY Mellon and DTCC, an industry taskforce concludes

Tri-party reforms fall down

Market participants will explain why they have not been able to make key changes to the tri-party repo market in a report due later this month, setting up a showdown with the Federal Reserve Bank of New York, which has been pushing for reform. Bankers involved in the project had previously told Risk they feared a failure by the industry to radically overhaul the market could spur the New York Fed to intervene in a more aggressive way, forcing the market – the biggest single source of financing for US banks – to shrink.

The tri-party repo taskforce was set up in September 2009, in response to regulatory concerns that the market could become a source of systemic risk. Despite making a series of changes to the market, the group has failed to reduce the amount of intra-day credit extended to dealers by the two main clearing banks, BNY Mellon and JP Morgan – and the taskforce argues it should now be left to these institutions, along with the Depository Trust & Clearing Corporation (DTCC), to resolve the issue.

After releasing the report, the taskforce will disband. Darryll Hendricks, head of investment banking strategy at UBS in New York and chair of the group, says the process of reforming the market turned out to be more complicated than expected.

"Articulating the precise operational prerequisites to fully achieve our original objectives, in conjunction with other important constraints, proved more complicated than originally thought," he says.

The tri-party repo market – which stood at $1.67 trillion in late January – allows a bank to borrow cash from investors, secured by collateral, with a clearing bank standing in the middle. A key characteristic of the market is the daily unwind of repo trades, which allows dealers to access the assets they had posted as collateral so they can deliver those securities that have been sold to other buyers. The clearing banks then typically extend credit to the dealers, enabling cash to be returned to investors during this period.

Technically, it's not that challenging for the clearing banks to implement a cap on intraday credit. However, we respect the fact that decision would have repercussions on our clients and the market-place

This ensures investors are covered until the collateral is returned and the repo trade is renewed later in the day, but means the two clearing banks are massively exposed to the dealers.

Regulators want to see this extension of intra-day credit replaced with committed credit facilities, capped at 10% of current credit exposures. The taskforce had hoped to achieve this before the end of 2011, but participants say it proved much more difficult than anticipated.

"When we started this process two years ago, the taskforce just couldn't fully predict the scope and complexity of the steps required to get there – that knowledge emerged over time through implementing the steps already completed," says Mark Trivedi, chief operating officer for global clearing and custody at JP Morgan in New York.

As a result, there has been a realisation that other things have to change before the issue of intra-day credit can be resolved, says Trivedi. "Technically, it's not that challenging for the clearing banks to implement a cap on intra-day credit. However, we respect the fact that decision would have repercussions on our clients and the market. So in the interests of our clients, a wider degree of operational change is going to be required," he says.

The upcoming taskforce report is expected to recommend a number of new measures that must be taken before the intra-day credit extended by clearing banks can be safely reduced. These include steps to make the process of unwinding and settling trades more transparent and efficient, such as the removal of non-maturing trades from the daily unwind and the introduction of a rules-based process for determining the order in which repo trades should settle. The taskforce will also stress the need to make the reformed market interact properly with the interdealer tri-party repo market.

Much of the work required to enact the changes in the new report will fall squarely on the two clearing banks, as well as the DTCC, which acts as a central counterparty for interdealer tri-party repo trades through its general collateral finance facility.

While the taskforce has been a useful forum, the task of reconfiguring the market is better left in the hands of the three firms, says UBS's Hendricks. "The taskforce itself is not planning on regular meetings going forward, so in that sense it is concluding. But there's plenty more work to do to implement the things the taskforce has identified as necessary to fully solve the issue of intra-day credit exposures," he says.

Although regulators are not pleased with the failure to address intra-day credit, he defends its work. Under the taskforce, the timing of the daily unwind of tri-party repo trades has been dramatically altered. Whereas trades used to be unwound at 8.30am, this has now been pushed back to 3.30pm, reducing the length of time dealers and clearing banks are exposed to each other. A process of auto-substitution has also been put in place, meaning dealers can substitute collateral from tri-party repo deals without having to unwind the entire transaction. And tri-party repo trades are now subject to a process of three-way confirmation between investors, dealers and clearing banks.

"Many of the members of the taskforce and the clearing banks believe there has been a meaningful reduction in risk associated with moving the unwind to the afternoon and the advent of three-way trade confirmation," says Hendricks.

Regulators recognise there has been some progress. In a February 2 speech on the progress of financial reform, US Treasury secretary Timothy Geithner cited the tri-party reforms as a key achievement, but the New York Fed is understood to be frustrated by the failure to address the issue of intra-day credit. This frustration is likely to be made clear in a response that will follow the taskforce's upcoming report.

According to taskforce participants, the two clearing banks have laid out different timetables for completing the remaining work. JP Morgan's Trivedi says the bank has "an appropriately aggressive plan" to enact the changes outlined within the next two years.

BNY Mellon and the DTCC refused to comment on their timetables for implementing the changes.

"We have taken meaningful steps to support the recommendations of the taskforce and help meet the reform goals for the industry. We will continue to support industry efforts moving forward," says a spokesman for BNY Mellon in New York.