Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Intra day exposures once again

No, I am not talking about my obsession with intra-day risks (see here and here), but about the New York Fed’s uncharacteristically blunt criticism of the big clearing banks on this issue:

… the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged.

These structural weaknesses are unacceptable and must be eliminated.

… the Task Force [of the clearing banks] … has not proved to be an effective mechanism for managing individual firms’ implementation of process changes

The Fed’s response is to step in directly to ensure that practices change:

… the New York Fed will intensify its direct oversight of the infrastructure changes

Ideas that have surfaced and could be considered include restrictions on the types of collateral that can be financed in tri-party repo and the development of an industry-financed facility to foster the orderly liquidation of collateral in the event of a dealer’s default.

Nor is the criticism restricted to the banks; the Fed is equally critical of the non bank participants in this market:

Ending tri-party repo market participants’ reliance on intraday credit from the tri-party clearing banks remains a critical financial stability policy goal.

The Federal Reserve and other regulators will be monitoring the actions of market participants to ensure that timely action is being taken to reduce sources of instability in this market.

The background to all this is the strange way in which the tri-party repo market operates in the US. Leveraged investors in various securities finance their positions using overnight repos which can be regarded as a form of secured borrowing. The securities in question are not however pledged directly to the lenders but with the clearing bank (hence the name tri-party). Next day morning, the lender gets the loan back, but the borrower does not repay the money. What happens is that the clearing bank lends the money intra-day. Over the course of the day, the borrower drums up a new set of borrowers to lend against its securities that night, and the bank again ends the day without any exposure to the borrower.

The weakness here is that the repo lenders are relying on the clearing bank to get their money back in the morning; the bank is relying on the repo lenders to get its money back in the evening; and both could become complacent about the risks involved. It is a little like two people passing a hot potato back and forth to each other, and pretending that there is no longer any hot potato to worry about. (It is actually worse than that because while the potato would cool in a few minutes, the securities underlying the repo may take years to mature – assuming that they do not default in between.) Of course, everybody wakes up at times of stress, and then the clearing bank is in the position of having to decide each day whether to throw the borrower into bankruptcy by refusing to clear its repos. This is hardly the way to organize such a large and systemically important market.

We should all be happy that, for once, the Federal Reserve seems to be taking things seriously instead of succumbing to regulatory capture.


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