The U.S. Federal Reserve has asked an industry task force of leading banks and investors to work on a plan to scale back systemic risk in the repo funding market that was at the center of the financial crisis and reduce trader dependence on the two clearing banks, JPMorgan Chase (NYSE:JPM) and Bank of New York Mellon (NYSE:BK).
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The changes would aim to bring greater automation to the $1.6 trillion tri-party repurchase market, but could increase financing costs for other banks. In the repo market, banks pledge securities as collateral for short-term loans from money managers and other investors.
The issue raises questions about the ongoing vulnerability of JPMorgan and BNY Mellon, the two so-called clearing banks in the market, and their power over the Wall Street community in general. Many Fed officials believe that such a role should be played by a public sector body rather than a private institution.
“The incentives are different for a private sector institution when under pressure,” said one senior Fed official. “There are conflicting objectives and when stresses rise, the banks may behave badly. The desire for security or collateral can be debilitating.”
The task force — made up of investors and leading banks, including JPMorgan and BNY Mellon — met earlier this month to discuss additional reforms to prevent a repeat of th turmoil that characterized the repo market in 2008. Early next year, the task force is expected to publish a final report on its investigation, the focus of which has been the reduction of the role of the two clearing banks, which extend temporary credit late in the day to Wall Street dealers when repo trades are unwound and reconstituted.
As it now stands, if a repo-market borrower were to run into funding problems and were unable to obtain credit from either of the two clearing banks, policymakers worry that market volatility would increase, raising the specter of repo securities being liquidated en masse, potentially harming other investors.
Regulators are pushing for a real-time settlement process for new and maturing repos that would sidestep the need for intraday credit from the clearing banks. However, with the Fed pushing for fundamental reform, creating a real-time system is a potentially costly and difficult technology project, said bankers. It would also result in higher charges for those dealers using repo as a financing tool.
The industry had hoped to shift 90 percent of the intraday credit from the two clearing banks by August 2011, but the deadline passed as the industry realized the huge scale of the undertaking.
“A road map to real-time auto confirmation would be a huge step, but achieving that is problematic as there are differences in the operational capacities of dealers and cash investors,” said Peter Nerby, senior vice-president at Moody’s.
Furthermore, “it is not easy for market participants to agree on measures that enhance financial stability when this goal conflicts with commercial and business interests,” said William Dudley, president of the New York Fed.
But any delay in resolving the issue risks punitive measures from regulators who want this potential source of systemic risk eliminated, and are waiting for results. “If the private sector falls short in this instance, public authorities may need to intervene and impose more forceful regulatory solutions,” said Dudley.
If the tri-party market should fail to satisfy regulators, then a centralized clearing house might be established to oversee the lending process without the pressure of making profits.
“Reducing the vulnerability of the tri-party system entails either increasing the number of clearing banks beyond BNY Mellon and JPMorgan or replacing them with a centralized counterparty that is a utility and thus has fewer conflicting incentives than a clearing bank,” said Anshuman Jaswal, senior analyst at Celent.
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