Once considered the poster child for systemic risk, the repo market is set to play a starring role in derivatives contracts.
On June 22, a working group convened by the Federal Reserve Bank of New York selected the Secured Overnight Financing Rate (SOFR) – a broad index of US Treasury repo trades – to replace Libor as the reference rate for roughly $70 trillion notional of US dollar interest rate swaps.
That’s a remarkable vote of confidence in a market that, only four years ago, was being pilloried by regulators as a threat to financial stability. “We have not come close to fixing all the institutional flaws in our wholesale funding markets,” New York Fed president William Dudley said in a speech on February 1, 2013. “The tri-party repo system and the money fund industry that plays a crucial role financing collateral through it are both still exposed to runs.”
A year earlier, the New York Fed disbanded an industry task force it established in 2009 to fix systemic weaknesses in the tri-party repo market after it failed to achieve the desired results. Regulators spent the next few years imploring banks to reduce their reliance on overnight repo funding. Volumes dwindled as a result.
So what’s changed since then?
For one, following the overhaul of Bank of New York Mellon’s (BNY Mellon) settlement process for tri-party repo trades in 2015, the market is no longer reliant on the extension of vast amounts of intraday credit from a clearing bank to function – greatly reducing the spillover effects of a dealer default.
Second, the US Securities and Exchange Commission’s money market fund reforms, which took effect in October 2016, drove investors to transfer an estimated $1.5 trillion from prime funds that invest in commercial paper into government MMFs, which lend cash in the repo market.
Daily average volume in the dealer-to-client tri-party repo market for US Treasuries has exploded as a result, from $771 billion in June 2016 to more than $1 trillion in the same month this year – the most since regulators began collecting this data in 2010.
It’s not all good news, though.
The Depository Trust & Clearing Corporation’s (DTCC) interbank repo clearing service – which allowed dealers that cleared through JP Morgan and BNY Mellon to trade with each other – was suspended in July 2016 after a proposed overhaul to eliminate intraday credit risk within the service fell apart. That prompted JP Morgan to exit the business, leaving BNY Mellon as the sole clearing bank for tri-party repo transactions.
The cleared market could shrink further if DTCC presses ahead with a proposal to implement a so-called capped contingent liquidity facility, which has riled members and seen some threaten to leave the clearing house.
At the same time, the opaque market for non-cleared bilateral transactions executed between cash lenders and collateral providers – whether dealers or end-borrowers such as hedge funds and insurers – is said to be growing. These privately negotiated deals are difficult to trace, and are excluded from the SOFR calculation.
The Fed’s outsize role in the market is another worry. The central bank is the largest repo counterparty to MMFs qualified to use its reverse repo programme.
At quarter-ends, when banks shed repo balances to window dress their leverage exposure numbers, it accounts for well over half of MMF volumes. These trades are also excluded from the SOFR, and some fear the benchmark could be starved of liquidity if MMFs opt to trade exclusively with the Fed during a crisis.
There is a silver lining to these repo clouds, however. In June, the DTCC launched a pair of new clearing programmes for the buy side. The central cleared institutional tri-party (CCIT) service is aimed at institutional investors, such as corporates, hedge funds and insurance companies. Citadel and Morgan Stanley executed the first CCIT trade on July 29.
A separate sponsored access facility for registered investment companies, including MMFs and mutual funds, was also introduced in June. Goldman Sachs Asset Management and Federated Investors used the service to clear a combined $10.2 billion of repo trades over the course of June and July.
A move to central clearing of buy-side trades should enhance transparency and stability, while minimising the risk of destabilising runs and fire sales in a stress scenario. But many more firms will need to follow in the footsteps of Citadel, Federated and Goldman before confidence in the repo market is fully restored – a quality that now matters as much to the derivatives market as to repo participants.