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Fire sale risk through the U.S. repo market

The Federal Reserve Bank of New York continues to highlight the latent risk of fire sales in the tri-party repo market. The danger arises from an incentive to liquidate collateral in case the solvency of a dealer is in doubt. The risk is enhanced by the vulnerability of the main cash lenders intri-party repos, money market mutual funds and security lenders, to liquidity pressure. Policy tools to contain such an event are limited.

“The Risk of Fire Sales in the Tri-Party Repo Market”, Brian Begalle Antoine Martin James McAndrews Susan McLaughlin, Federal Reserve Bank of New York Staff Report No. 616 May 2013

“Magnifying the Risk of Fire Sales in the Tri-Party Repo Market”, Leyla Alkan, Vic Chakrian, Adam Copeland, Isaac Davis, and Antoine Martin, post July 17, 2013

The below are excerpts from the paper and the post. Cursive text and emphasis have been added

N.B.: In a repurchase, or “repo”, transaction, an investor or dealer borrows cash for a short period from another party, using securities as collateral. A tri-party repo is a repurchase transaction for which collateral selection, payment, settlement, and custody are outsourced to a third party. These agents are custodian banks, i.e. Clearstream Luxembourg, Euroclear, Bank of New York Mellon, JP Morgan and SIS in Europe and Bank of New York Mellon and JP Morgan in the U.S.

Borrowers and lenders in the tri-party repo market

“The tri-party repo market is a particularly large and important segment of the U.S. repo market. At the end of 2012, the tri-party repo market was used to finance close to USD2 trillion of securities. In this market, the collateral providers are the dealer subsidiaries of large, complex financial institutions. Many of these dealers depend on the tri-party repo market as a way to fund their portfolios of securities and those of their clients.”

“Past estimates, based on conversations with market participants, had Money market mutual funds (MMFs), accounting for a quarter to a third of all tri-party repo [cash lending] activity, and security lenders with another quarter.”

  • “MMFs are a class of mutual funds that invests in relatively safe financial assets, with a short maturity. Nevertheless, MMFs can be subject to runs when perceived by shareholders to have worrisome risk exposures, such as when lending cash to a stressed dealer.
  • Securities lending refers to a collateralized loan of a security between two entities. In the United States, these loans are typically collateralized with cash. Securities lenders often hold large pools of cash collateral, which they reinvest in…the tri-party repo market, to enhance their return. Most securities loans in the United States are done on an open maturity basis, which means that the lender of a security has to return the cash collateral whenever the borrower of the security returns it. This arrangement can create liquidity pressures.”

The nature of the fire sale risk

“The risk of “fire sales,” rapid sales of assets in large amounts that temporarily depress their market prices, is a major source of financial instability…Because of the size of the [tri-party repo] market and the fact that some of its participants are vulnerable to runs, fire sales are particularly likely… They can result if a securities dealer defaults and its secured creditors decide to liquidate the collateral—or even in the absence of a formal default if funding becomes difficult to obtain.”

Large dealers’ repo books currently range between USD100 billion and USD200 billion and, in some cases, reached peak levels in excess of USD400 billion prior to the financial crisis. There are currently no external constraints in place to prevent dealer repo books from reverting back to comparable peak levels in the future. For positions this large, even the liquidation of collateral usually viewed as liquid, such as agency mortgage-backed securities (MBS), could prove challenging over a compressed time frame. Additionally, approximately 15 percent of the assets financed in this market, almost USD300 billion at the end of 2012, are private obligations that are not backed by the U.S. government or its agencies and that tend to exhibit significant price volatility and illiquidity when market conditions are strained.”

  • “The first risk, termed pre-default fire-sale risk, occurs when a dealer is under stress, but has not defaulted. A stressed dealer may be forced to sell its securities quickly, an action that likely depresses market prices and creates fire-sale conditions. Tri-party repo investors can aggravate this risk by quickly withdrawing funding from a troubled dealer, and so forcing that dealer to sell even more securities quickly.”
  • “The second risk, termed post-default fire-sale risk, occurs after a dealer default, when that dealer’s investors receive the repo securities in lieu of repayment. Fire sales can then occur if investors attempt to liquidate these securities in an uncoordinated and rapid pace. In this scenario, investors as a group will be trying to sell off a substantial amount of collateral at the same time.”

While fire sales do damage no matter how they arise, the tools available to lessen the harm from the two types…are different.

  • The risk of pre-default fire sales by dealers comes from the fact that dealers perform maturity and liquidity transformation…they cannot expect to liquidate longer-maturity assets as quickly as their short-term funding may evaporate… some tools are available to partially mitigate the impact of pre-default fire sales, such as either regular or emergency lending by the central bank, or capital and liquidity regulation that can make dealers less vulnerable to failure.
  • In contrast, the risk of post-default fire sales by counterparties to a defaulted dealer is posed by the exemption from the automatic stay of bankruptcy that repo contracts enjoy, which means creditors may immediately take possession of collateral in a bankruptcy. While this exemption is very important for the secured funding model, the lack of a process, or mechanism, to ensure an orderly disposal of the assets collateralizing repos across all creditors of a defaulting dealer could lead to rapid sales, price dislocations, and a deleveraging spiral… There are currently no established tools to mitigate the risk of post-default fire sales.

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