DTCC’s Institutional Tri-party Repo Clearing: Great Idea…Maybe

A recent proposal by the Depository Trust & Clearing Corp. to serve as the middleman for a large chunk of the institutional tri-party repo market through its subsidiary Fixed Income Clearing Corp. might sound like a great way to reduce counterparty risk and the potential for fire sale of collateral, but with so few details unveiled thus far fund managers are having a hard time embracing the idea.

From what operations directors at several US fund management shops tell FinOps Report, DTCC is touting the merits of funds joining the FICC as “limited participants” as a no-brainer. Yet until the US Securities and Exchange Commission publishes the DTCC’s request for a rule change, fund managers have only the preliminary concepts the DTCC has floated through a recent press statement and what officials have told media outlets — too little to know how exactly the new membership category will operate or what it will cost.

DTCC declined to respond to emailed questions from FinOps Report seeking elaboration on the merits of the proposal for fund management firms, referring FinOps to a press statement. That statement doesn’t offer any cost-benefit analysis or enough information to project it. Cost is is a critical selling point for the risk conscious, yet budget-savvy fund management shops. “We’re waiting for details on the expense involved,” one East Coast fund management operations director tells FinOps.

An operations manager at another East Coast fund management firm took an even less interested stance. “It’s an admirable idea, but we see the two main risks that would drive us to to use any central counterparty service as pretty unlikely.” Those risks are the potential for a borrower default and a fire sale of the collateral resulting in its devaluation.

The Federal Reserve Bank of New York has been trying to “reform” the sagging tri-party repo market since the financial crisis of 2008 and in February 2014 announced that it was pleased with the results. However, the New York Fed insisted that the institutional tri-party repo market remained vulnerable to a fire sale of collateral. Liquidity pressures and credit losses stemming from a bankrupt bank or broker dealer borrower counterparty could prompt lenders to act en masse to rapidly liquidate collateral backing deals,driving prices lower and triggering margin calls. The ramifications could go far beyond the repo market, according to the regulatory viewpoint.

The DTCC needs approval from both the SEC and Federal Reserve Board before it can implement the new service through its FICC subsidiary. The New York Fed and DTCC have reportedly been in talks for over a year on the matter, so the DTCC is moving forward with the New York Fed’s blessing. The DTCC is promoting the FICC’s proposed expanded reach of its tri-party repo services — previously only available to broker-dealer and banks —  to fund management firms as protection for  buy-side players who are cash lenders in the deals. They won’t have to worry should a broker-dealer or bank borrower go bust. And fire sales wouldn’t happen because FICC would ensure a centralized “orderly sale” of collateral.

In a repo transaction, the borrower sells securities to a cash lender in exchange for buying them back at a future date at a higher price. The tri-party repo deal simply adds an administrator or third party in the middle to ensure the movement of cash and securities between borrowers and lenders. BNY Mellon and JP Morgan Chase, who were unavailable for comment at press time, control the US market for institutional tri-party repo deals through their operational work and by extending broker-dealers and banks intraday credit to protect them against the default of any cash lenders between the time a repo deal is unwound to the time another one is begun. It is widely presumed that such intraday credit would no longer be necessary under the FICC’s institutional tri-party repo clearing service, but BNY Mellon and JP Morgan would retain their administrative roles.

In expanding services to fund managers who are lenders in tri-party repo deals, FICC’s Government Securities Division (GSD) would allow easier financial terms than broker-dealers or banks who are full-fledged members. “Such a limited participation would likely mean that fund management firms would not have to contribute to the FICC’s default fund as do other bank and broker-dealer participants,” says Michael Barrett, vice president for financial services consultancy Genpact in New York. “It is also likely that the limited participation would narrow any risk a fund management firm absorbs to a bilateral one — only for the particular transaction affected — and not mutualized or applied to the default of another unrelated counterparty member of the FICC’s GSD unit.”

Money market funds, many of which have recently left the institutional tri-party repo market in favor of participating in the New York Fed’s reverse repo service, might be lured back into the fold by the FICC’s new service, predicts Barrett. The New York Fed apparently thinks that money market or other fund management cash lenders may find it comforting to deal with the FICC as the middleman — or counterparty — rather than their current practice of a direct counterparty or borrower.

But will fund management firms buy in? The jury is still out. Fund management firms don’t do business with just anyone so it is likely they would already be interacting with a financially stable bank or broker-dealer. Of course, participating in the FICC’s service will enable them to expand their pool of potential borrowers.

“Fund management firms which serve as lenders might be happy and the overall tri-party repo market would be stabilized,” suggests Aman Arora, a manager at Sapient Global Markets, a financial services consultancy. However, as he acknowledges that with the additional costs for the limited participation at GSD unknown it’s hard to quantify the benefit.

One US fund operations specialist observes that the expanded service doesn’t exactly open the doors to the entire fund management world. In addition to only being available to firms which are lenders in the deals, the service requires fund management firms to be registered registered with the SEC, which shuts out all but the largest players.

That leaves the biggest remaining question of whether the FICC’s service actually affects the risk of fire sales in real terms. “The new expanded service only affects tri-party repo services for which US government securities are used as collateral,” says a collateral management consultant who considers the Fed’s concern a bit overblown. “Given the highly liquid nature of such securities, it is unlikely their price would be affected by a so-called fire sale. The risk for price fluctuation is far greater with equity, corporate and private-label mortgage securities.”