Earlier this week, we sent clients an assessment of new recommendations from the Committee on the Payment and Settlement System (CPSS) on the repurchase-agreement (repo) market. Although sometimes confused with repos as in “I’ll take that trailer now,” repos in the financial markets are anything but simple. Although little remarked upon in the press, they are a vital part of financial-market infrastructure. Thus, we think repos are sure to be fingered as a systemic-risk activity once the FSOC gets down to work. The new repo regulatory regime will have far-reaching impact on both clearing banks – at considerable strategic risk in the short term – and on the financial system – poised for renewed crises if the repo rules aren’t right.

Size alone would dictate systemic treatment. At its peak, the U.S. tri-party repo market clocked in at $2.8 trillion – and that’s just one part of the whopping global repo arena. To be sure, the Dodd-Frank Act tells regulators not to judge systemic activities solely by size. However, repos played a major role in the Lehman debacle because the market had – and sadly still has – few internal checks to corral counterparty flight when a major financial firm falters. And, when the repo market freezes, the rest of us get frostbite. One reason global finance went catatonic in the fall of 2008 was the sudden collapse of the repo market, which forced all of the players in it to cover bets with funds that otherwise would have supported liquidity throughout the global financial system.

The CPSS report is an important guide to what might be done to the repo market in the U.S., the heart of this market. For big players – the largest U.S. clearing banks – the critical strategic issues in the repo proposals are eerily reminiscent of those over which public furor raged in the OTC-derivatives reform debate: central clearing and bank conflicts of interest.
In the OTC market, reform will bite hard into profitability. It could of course do the same for the big clearing banks in the tri-party repo market, but we don’t think their fate here is in any way sealed. Threatened, yes. Sealed, not yet.

Why? First, central counterparties (CCPs) are no slam-dunk to end systemic risk. Unless carefully structured, they in fact exacerbate it, especially in the repo market. Unlike trading in OTC derivatives – bet for counter-bet – trading in repos is backed by collateral. Who owns it, where it is pledged, how it is reused and whether it is worth what’s been represented all complicate clearing. For a CCP to work for tri-party repos, it at the least has to have the capacity to claim, track, value and seize collateral. It remains to be seen if trying to build a CCP is a more effective route to systemic-risk reduction than enhancing the power of clearing banks. The CPSS paper outlines several ways this could be done – new collateral facilities, for example. Should the U.S. go towards clearing banks, not CPPs, the biggest banks will take on an even more powerful role in this vital market.

Of course, this won’t be a free ride. The big clearing banks are also subject to new systemic regulation, which won’t come cheap. The second repo-specific issue – potential conflicts of interest – will also be answered, and not in the big bank’s favor. In concert with their look at repo infrastructure, regulators in the U.S. will take an unsympathetic look at recent efforts by the clearing banks to enhance the equity, transparency and strength of their repo operations. Were the Fed inclined to go easy, the FDIC will kick back. Its new systemic-resolution powers and the “living wills” required under it give the FDIC considerable power to mandate separation between repo activities and insured depositories – a game changer for clearing banks depending on how this is done.

Thus, the repo market and the huge players in it can’t rest easy. Dissatisfied with private reform efforts to date, the U.S. regulators are sure to act on the toughest of the CPSS recommendations, using Dodd-Frank’s formidable powers to wreak their will.

 

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