Triparty Repo: Implementing a More Effective Approach. Author Aman Arora

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1 Triparty Repo: Implementing a More Effective Approach Author Aman Arora 1

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3 Contents Executive Summary 4 Introduction to Repo 4 Triparty Repo 5 Triparty Repo Implementation General Approach 5 Proposed Approach to Triparty Repo Implementation 7 Advantages of the Proposed Approach 8 Key Challenges in Recent Times 10 Summary 13 References 13 History of Repo Market 13 Market Size 14 Links for Further Reading 14 3

4 Executive Summary The financial crisis of 2008 revealed serious issues with the financing instrument commonly known as Triparty Repo. Following the crisis, a Task Force prompted by the Federal Reserve Bank began spearheading an effort to reform the way these transactions are managed.* This white paper reviews the current approach to executing Triparty repo transactions, proposes a new and more effective approach, delineates some of challenges facing borrowers, lenders and clearing banks and, finally, posits that the proposed approach would help address many of the Fed s current and emerging recommendations. Although this paper reviews some core concepts of the Triparty repo market, for the most part it assumes that the reader is knowledgeable about Triparty repo and problems incurred during the financial crisis of * The Task Force was formed in September 2009 under the auspices of the Payments Risk Committee (PRC), a private sector body sponsored by the Federal Reserve Bank of New York ( the NY Fed ). Introduction to Repo In a repo transaction also known as RP or sale and repurchase agreement a buyer of a contract delivers cash as loan to the seller of a contract, who then uses securities as collateral. The seller of the contact needs to buy back the securities from the lender (that is, the buyer of the contract) at some point in the future. That buyback typically occurs within a single day but may span up to six months. The seller pays the buyer of the contract some amount as interest in lieu of the amount taken as cash; this is known as the repo rate. Although the asset has been sold, a fall (or rise) in value during the term of repo will be a loss (or profit) to the seller, who will have to buy it back at the price fixed at the start of the repo. The seller of the contract is liable for any coupon made on the securities during the term of repo. However, the repo counterparty (that is, the buyer of the contract) can also reuse the assets during the term of the repo selling them outright, repurchasing them or pledging them to a third party. The market value of the securities kept as collateral is reduced by an amount considered as margin (also known as haircut ). Haircut is generally decided based on the credit worthiness of the seller, the quality of collateral and the term of the repo. Repo is considered similar to a money market instrument; that is, it generally is used to fulfill short-term cash needs of the seller. A repo transaction generally takes place overnight. 4

5 Triparty Repo While a bilateral repo involves just two parties, a more common type of repo is a triparty repo. As the name suggests, this repurchase transaction involves three parties: The cash borrower is the party who sells its assets with an agreement to buy them back at a specific date. This party gets the cash against the collateral kept and must pay interest on the cash. The cash lender/investor lends cash to the borrower and then receives interest on the cash given. It keeps collateral in the form of securities. The clearing bank is responsible for the administration of the transaction including collateral allocation, verification of collateral quality and adequacy, marking to market and substitution of collateral. In the US, the two principal triparty repo agents are The Bank of New York Mellon and JP Morgan Chase. The clearing bank charges fees to both the lender and the borrower of the cash. Thus, the triparty repo service provided by Bony Mellon and JP Morgan Chase can be seen as a way of reducing the operational costs and administrative burdens of the repo product. The parties in a triparty repo transaction agree to the terms and conditions of the transaction outside the triparty repo environment. Following the agreement, both sides instruct the designated triparty agent to process, collateralize and service their transaction within the triparty repo environment during the transaction lifecycle. Triparty Repo Implementation General Approach Today, many US financial institutions follow the same general approach to triparty repo implementation. This approach is not completely automated and therefore requires manual intervention at various stages. Current Approach 1. Cash borrower shares its portfolio with the clearing bank. 2. The clearing bank allocates the portfolio with the cash lenders. The allocation logic lies at the clearing bank s end. 3. Based on the terms negotiated earlier with the borrowers, lenders pay cash to the clearing banks. Securities re then delivered to the respective *Depo accounts of lenders. 4. The clearing bank pays this cash back to the respective *nostro accounts of the borrowers. 5. The clearing bank provides reporting to both parties at the end of the day. These reports inform both parties about the allocations that happened during the day. 6. The lender and the borrower update their data sources based on the clearing bank s reports. 7. An is sent from borrower to lender to inform them about the amount that will be borrowed for the day. This amount is within the threshold defined when laying out terms. 5

6 Triparty Repo (continued) Shortcomings of the Current Approach Borrowers are not doing optimal allocations of the portfolio available to them. In essence, they pass this responsibility to the clearing bank, which determines what can and cannot be allocated. This approach lacks an effective backup system for failure in allocation logic. At both ends, this approach requires a lot of manual effort to keep systems updated. This approach does not resolve disputes that may occur (regarding collateral quality or margin, for instance) over various securities across different asset classes in the portfolio. *Explanation of Depo and Nostro: Tri-party Repo Implementation General Approach 6

7 Proposed Approach to Triparty Repo Implementation How can triparty repo be implemented with greater effectiveness? What kind of process could help optimize the draw down for the borrower? How can the issues that may arise between the counterparties and the clearing bank be prevented? The solution proposed below seeks to address those and other opportunities for improvement. It uses technology to replace much of the manual effort required under the current approach: 1. Borrowers can develop software that applies an optimization algorithm when generating trades. The optimization algorithm works on the allocation of assets to various lenders account. Borrowers can use the communication layer of their software to send these trades to the clearing bank. 2. Based on collateral quality, terms of the deal and margin, the clearing bank allocates these securities to the mentioned counterparty in the trade. The clearing bank also takes care of collateral quality. The quality of the asset is mentioned beforehand in the reporting, which the clearing bank provides. Using this reporting and considering a T+1 portfolio, a real-time projection will help avoid any discrepancies that may happen on T. 3. Based on the trade s status, the clearing bank sends real-time updates to both the borrower and the cash investor. 4. Using this information, the borrower and the cash investor update the database. Again, this update occurs in real time. Consequently, the portfolios are updated in real time for the borrower. In the event the borrower is running short of collateral, the borrower can make appropriate arrangements. For example, if the borrower has additional collateral sitting in the Depository Trust Company (DTC)*, that excess collateral can be allocated to fetch more cash. 5. The cash investor and the borrower inform/instruct the depo account about the cash with the bank and securities movements, respectively. 6. The clearing bank provides end-of-day reports to both the cash investor and the borrower who use these reports to reconcile data in their automated systems. *Info on DTC: 7

8 Triparty Repo (continued) Advantages of the Proposed Approach The proposed approach offers a number of advantages over the commonly used approach: The allocation logic present at the borrower s end has optimization logic (which actually reveals all trades that would be created for allocation/deallocation and also highlights which counterparty should be traded with to get more cash in return of securities). Such insights help the cash borrower to identify at the beginning of the day what can be allocated in triparty deals. The borrower can then plan to use other securities accordingly. In short, this helps the borrower determine the maximum cash drawdown that would be fetched with minimum cost. The optimization algorithm runs and allocates the same securities to different accounts and suggests allocations that will maximize the drawdown. Because of the difference in deal terms among lenders, the drawn-down cash is different in different accounts. Since the optimization spans the complete portfolio, the borrower is able to see the total drawdown per lender. In case of failed trades, the clearing bank updates the cash borrowers on a real-time basis ensuring adequate time for the borrower to make adjustments for a successful trade. With real-time information flowing at both ends, most of the systems can then be updated in real time. This information can be used dynamically for various other purposes; for example, the securities not allocated can be lent to other counterparts for generating cash. If there are any issues over collateral quality and margin, these issues can be communicated to borrower and lender in real time giving them sufficient opportunity to resolve them. Repo trades can be simulated for T+1 and T+2 based on estimated portfolio on T+1 and T+2. In the past, the sent from the borrower to the lender has been a manual process that does not involve the clearing bank. With automation, the can be sent from the borrower to the clearing bank and then to the lender. The clearing bank will receive the acknowledgement from the lender and send it back to the borrower. This occurs before the allocation process starts, thereby improving transparency between lender, borrower and clearing bank. This process more commonly known as three-way confirmation has been suggested by Fed as one of the improvements in triparty repo systems. 8

9 Tri-party Repo Implementation Proposed Approach 9

10 Key Challenges in Recent Times In 2008, lenders stopped lending money to cash borrowers primarily because mortgage-backed securities (MBS) were being kept as collateral for borrowing cash. At that point, MBS were not considered as collateral. The lenders started withdrawing repo contracts; in other words, they started asking for money from borrowers. Such requests can drive repo borrowers into bankruptcy and was a key factor in banks, such as Lehman Brothers, plummeting toward insolvency. In essence, this call on loans could well be compared with the Bank Run of 1907, in which depositors lined up outside banks and demanded all their deposits back. In the following section, we examine the issues that came to the fore during and after the 2008 financial crisis. We visit them one by one and, for the challenges of intraday credit limit, we also explain the solution. Finally, we discuss how the proposed automated system would help in achieving the Fed s suggestions. Indeed, the Fed has been actively working to enhance the resiliency of the triparty repo market. This instrument facilitates borrowing by banks, money market funds, insurance companies and other key players in the market. Since the 2008 financial crisis revealed flaws in triparty repo trade execution, the Fed has been working to address the shortcomings. As part of that effort, a Task Force was formed in September 2009 under the auspices of the Payments Risk Committee (PRC), a private sector body sponsored by the Federal Reserve Bank of New York ( the NY Fed ). The Task Force identified the following areas of improvement Challenge: Intraday Credit As the name suggests, triparty repo is an instrument wherein the borrower takes a secured loan from the lender. The third party (that is, the clearing bank) provides the infrastructure for the execution of the trade (refer to page 3 for further details). In a triparty repo trade, each day the securities given by the borrower are exchanged for cash given by the lenders. The securities are delivered in the lender s account maintained by the clearing bank, and the cash is delivered to the borrower s account. This activity is known as winding of trades and occurs every evening. Every morning, all triparty trades are deallocated by the clearing bank. This means the cash is returned to the lender s account every day and the securities are returned to the borrower. The clearing bank, protected by a lien on the securities, provides funding for the collateral during part of the day. This unwind, which is reversed at the end of each trading day with a rewind, permits borrowers in the triparty repo market (generally securities dealers) to have full and unimpeded access to their securities inventory for routine operational purposes. Thus, almost the entire value of this market is funded each day through the extension of intraday credit by a clearing bank. If, after the mornings unwind, a giant borrower defaulted during the day, it could put one of the world s largest financial institutions in danger, threatening the entire triparty market and beyond. What is more, based on the financial viability of a borrower, the clearing bank can stop unwinding trades for it. Such a decision by a clearing bank can further push an organization toward financial instability and, eventually, a default. Through the practical elimination of intraday credit extended by the clearing banks, any potential threat (however remote) to the solvency of a clearing bank due to this exposure is likewise removed. This measure alone is a substantial mitigation of systemic risk. Based on the proposed approach, market participants need to make some crucial changes to their systems. Among these improvements is the establishment of automated collateral substitution functionality for most trades in the 10

11 market. Reducing intraday credit risk is one of the Fed s most significant goals moving forward. To reduce intraday credit risk, clearing banks have instituted a rule against unwinding. This rule reflects the clearing bank s need to have some kind of collateral for any kind of securities returned back to the borrower. The clearing banks now want to automatically substitute such DTC-based collateral as common stocks. (This requirement is not applicable for Fed collateral such as savings bonds and Treasury bills, notes and bonds. For example, assume the borrower has gone into a triparty repo trade with a lender by giving XYZ stock as collateral to borrow cash. Historically, during a deallocation, the borrower would get back the securities and the lender would get back the cash. For a day, the clearing bank would sit on intraday risk as explained above. To avoid this risk, the clearing bank now requires that if securities are released back to the borrower during the day, then the borrower needs to substitute this with some other collateral. This collateral can be stocks of some other company or can be substituted with cash, thereby eliminating intraday credit risk to the clearing bank. The Fed suggests that this process be automated making automation of the base system even more critical. Let s explore how we can leverage the proposed solution to our advantage. The approach this paper proposes would help borrowers to substitute securities in case they want to fetch securities after unwind. Using the proposed approach, a borrower can easily substitute collateral and thus obtain the required securities from the clearing bank. This would not be different from other collateral pledged by the borrower. This exchange occurs in real time, and the borrower would send the replacement collateral (such as cash and securities) to get back the allocated securities. The borrower then gets back collateral from the clearing bank and, at the same time, must allocate collateral in another form. On receiving the securities, the borrower can reuse them or generate cash by lending them to other counterparties through the securities lending market. With the current approach, if the borrower operates a manual system, it would not be able to automatically substitute and thus would be unable to take out the collateral pledged in a deal. * Source: part-1-tri-party-repos-problems-are-deep-andunresolved/ Challenge: Dealers/ Borrowers Risk Management Triparty repo activity must be an essential focus for liquidity risk management. Dealers should not assume that secured financing is inherently stable. Since cash investors are at risk if dealers default, dealers should realize that some cash investors may reduce and/or eliminate funding as the credit quality of the dealer deteriorates. This can occur even when there is collateral. As such, dealers should account for the loss of secured funding within their liquidity risk management plans and liquidity stress tests. What is more, dealer liquidity buffers should be sized accordingly. Had such an approach been consistently in place across the industry during the crisis, it is much more likely that illiquid collateral would have been matched by a corresponding liquidity buffer, limiting the potential systemic impact of the loss of that financing. Dealers should lengthen and stagger the maturity profile of their financing, seek to combine shortterm and long-term financing with the same counterparty and should continue exploring 11

12 Key Challenges in Recent Times (continued) alternatives and mechanisms that may be able to achieve more durable financing of certain types of securities. The Task Force supports the increased emphasis on liquidity risk management by supervisors and regulators. Challenge: Margining Practices After failing to anticipate how much the market can worsen, cash lenders did not set the margins accordingly and ended up with losses. The Task Force has suggested that market participants undertake statistical analysis and stress testing of collateral price movements allowing them to assess the potential for losses at different levels of margins and to make decisions based on their appetite and capacity to absorb such losses. Margin agreements should avoid precipitous and unanticipated increases in margins. Challenge: Contingency Planning Cash investors should develop liquidation plans for the management and liquidation of repo collateral in the event of a dealer default. a collateral liquidation manager service that would be made available to a broad range of market participants on a voluntary basis, as well as tools that will legally support offsetting of secured exposures related to the defaulting party. Challenge: Transparency There was insufficient transparency with respect to many aspects of the triparty market, including its aggregate size and composition, the extent of concentrations and typical levels of margin. The Task Force also improved transparency in the triparty repo market by publishing a monthly report on market size, collateral composition and margining practices on its website. *Source: nyfrb_triparty_whitepaper.pdf These plans should cover both practical aspects, such as custodial arrangements, as well as stress tests of potential losses due to collateral price movements and stress tests of possible liquidity needs. Exploration of additional liquidity tools and mechanisms by cash investors should also be considered. Cash investors should regularly review their liquidation plans with their senior management and boards as appropriate depending on the nature of the organization. Cash investors should be able to demonstrate that potential stress scenarios on their single largest repo counterparty will not lead to destabilizing losses, even when associated collateral valuations are subjected to reasonably severe stress tests. Additionally, the DTCC and/or other interested providers should explore the development of 12

13 Summary: Triparty repo has been a key contractual type for the world of financing. Following the devastating events of the financial crisis of 2008, the Fed has introduced reforms that are being implemented by various clearing banks and counterparties. The current approach for triparty repo systems, still used by many financial institutions, leads to wider gaps and greater risk of failure. The solution proposed in this paper is a step in the right direction avoiding not only manual effort but also better preparing triparty repo players to adopt the changes suggested by the Fed-created Task Force. References History of Repo Market In the US, repos have been in use since 1917, when wartime taxes made older forms of lending less attractive. What follows are some key milestones and events that have fueled the growth of repo markets: Federal Reserve banks first extended credit to member banks when wartime tax made commercial paper less attractive. 1920s. The New York Fed extended credit to nonbank dealers to encourage the development of a liquid secondary market for bankers acceptances After disuse during Great Depression and WWII, repos reappeared after the Federal Reserve gained control of monetary policy s The repo market expanded due to successive new heights in short-term interest rates, a high level of volatility in short and long interest rates (risk management), and growing marketable Treasury debt. 1980s. The triparty repo structure developed in the mid-1980s in response to the desire by cash investors to have collateral held by a third party agent. At peak levels in 2008, more than $2.8 trillion in securities were being financed through the US triparty repo market. 13

14 References (continued) Market Size The US Federal Reserve and the European Repo Council (a body of the International Capital Market Association) both try to estimate the size of their respective repo markets. At the end of 2004, the US repo market reached US$5 trillion. The European repo market has experienced consistent growth over the past five years, from 1.9 billion in 2001 to 6.4 trillion by the end of 2006, and is expected to continue significant growth due to Basel II, according to a 2007 Celent report entitled The European Repo Market. Especially in the US and to a lesser degree in Europe, the repo market contracted in 2008 as a result of the financial crisis. But by mid-2010, the market had largely recovered and, at least in Europe, had grown to exceed its pre-crisis peak. (* Source: Other countries including Chile, India, Japan, Mexico, Hungary, Russia, China and Taiwan have their own repo markets, though activity varies by country, and no global surveyor report has been compiled. Links for Further Reading Video Introduction to Triparty Repo and Explanation of Financial Crisis: Latest on Repo Market: Description of Depot and Nostro: settlements-main.pdf 14

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