A recent New York Fed study, “Key Mechanics of the U.S. Tri-Party Repo Market,” provides a primer on the issues and key mechanics that have contributed to the market’s fragility and proved an obstacle to industry reform efforts.
In the report, the authors explain how the collateral allocation and “unwind” processes pose systemic weakness and are hindering reform efforts. These problems stem in part from the intervention by dealers to allocate collateral and their reliance on intraday financing to unwind, or settle, expiring repos.
The collateral allocation process currently requires a considerable amount of time, and is further complicated by the need for coordination between several parties. As a result, the time required to allocate collateral makes it difficult to settle new and expiring repos simultaneously and reduce dealers’ reliance on credit from their clearing banks.
The time gap between the daily unwind and rewind of repos drives much of the demand by dealers for intraday credit from their clearing banks, contributing to the fragility of the market. The gap leads to a twice-daily transfer of exposure from a dealer’s investors to its clearing bank, and vice versa. This “handoff” can create a perverse dynamic if the dealer comes under stress, as both the cash investor and the clearing bank may want to be the first to reduce exposure to the dealer.
The report concludes that improving the collateral allocation process and eliminating the time gap between the unwind and rewind of repos could help reduce weaknesses in the market and the amount of risk in the financial system.
The study was authored by Adam Copeland, a senior economist at the New York Fed; Antoine Martin, an assistant vice president at the New York Fed; Susan McLaughlin, a senior vice president at the New York Fed; and Stanford University Finance Professor Darrell Duffie. It can be read in full in the latest Economic Policy Review.Key Mechanics of the U.S. Tri-Party Repo Market »
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