Fund managers, broker-dealers, and clearing banks JP Morgan Chase and Bank of New York Mellon are hard at work to reduce the multimillion dollar intraday credit risk the two clearing banks face each day as they process tri-party repurchase agreements.
Their tack? Adopting new standardized electronic messaging and operating procedures.
"We have made substantial progress in promoting matching and auto substitution services and are now working on changing the time clearing banks unwind tri-party repurchase agreements to 3:30 p.m.," said Mark Trivedi, managing director and chief operating officer for JPMorgan's clearance and collateral management group. "We are also coming up with procedures for netting which would reduce the number of times the cash lender must send and receive cash back from the clearing bank."
Trivedi's comments coincide with a recent conference held by the Asset Managers Forum and hosted by the Securities Industry and Financial Market Association, which gave a progress report on implementing recommendations made last year by a tri-party repo task force sponsored by the Federal Reserve Bank of New York.
Among the task force's critical recommendations made last year:
* By February 2011, make it possible for broker-dealers to automatically substitute one type of collateral for another in their tri-party deals.
* By August 2011, have lenders and borrowers match trades prior to settlement.
* Also by August 2011, clearing banks should unwind repurchase agreements no earlier than 3:30 p.m., each day instead of at 8 a.m. each day.
* By October 2011, the clearing banks were originally expected to cap the amount of credit they provide broker-dealers.
Trivedi said that the task force is now considering delaying the October deadline for clearing banks to cap the amount of credit they provide broker-dealers. "There are a number of operational issues which have to be addressed before a cap can be implemented," he explained.
In the United States, fund managers are typically lenders of cash while broker-dealers are borrowers. JPMorgan and BNY Mellon act as agent banks for borrowers and lenders of cash in the $2 trillion U.S. tri-party repo market. Because they are the only two clearing banks for U.S. tri-party repo deals, the New York Fed is worried that they bear huge intraday credit exposure. That exposure could happen if the collateral posted by the broker-dealer isn't sufficient in the event it has to be liquidated in the event of a dealer's default.
Here is how the tri-party repo market currently works:
The fund manager or lender provides cash to the broker-dealer or borrower in exchange for collateral. Regardless of the terms of the trade, the deals are unwound every morning to allow dealers access to the collateral for intraday trading.
Since most dealers are not long cash at the start of the day, the return of collateral is supported by a credit extension from the clearing banks to the broker-dealers. The extension is typically extinguished at the end of the day when the new repos are settled. It is during this window in which the clearing banks are exposed.
The combination of trade matching and delaying the unwinding of repurchase agreements to 3:30 p.m. will reduce the need for, and the amount and duration of, the credit which the clearing banks currently extend to broker-dealers.
Until now, clearing banks have relied primarily on instructions received by broker-dealers, which could occasionally result in a mismatch between the two counterparties in their understanding of the trade details. Neither JPMorgan nor BNY Mellon would discuss the frequency of the errors or costs involved.
The two clearing banks have already implemented matching services, but fund managers may find it hard to use them for legal and technical reasons. For one, fund managers will need to change the terms of their contracts with clearing banks to incorporate the requirement for matching, which could take place through a clearing bank or third-party platform, such as Bloomberg's VCON. Fund managers must also be able to provide trade instructions to the clearing bank or affirm the trade details provided by the broker dealers.
For matching to occur "cash investors must provide and store business identification codes the clearing banks maintain to identify the legal entity transacting the repo. They must also process separate codes provided by CUSIP Global Services for the types of collateral they are willing to accept from the broker-dealer," said John Morik, managing director for broker-dealer services at BNY Mellon. The business identification code would represent either the fund manager itself or a specific fund.
"At issue is whether the fund manager can successfully map the business entity identification code and the collateral codes to internal or dummy numbers," said one operations executive at a fund management firm attending the tri-party repo event.
The clearing banks say that they have made it easier for broker-dealers to begin unwinding repo trades at 3:30 p.m. by implementing auto-substitution services allowing broker-dealers to automatically substitute one type of collateral for another in the repo deal. The securities can remain locked up in the cash investor accounts all day while the banks selectively pull out and replace securities needed by the broker-dealers immediately for other activities, Morik explained.
But for some fund managers waiting until 3:30 p.m.-seven-and-a-half hours later to receive their cash could be a bitter pill to swallow. "Investment managers will need to predict their funding in advance and may need to find alternative sources of funding," Morik said.
Netting also won't be operationally easy for fund managers to accommodate. "Netting requires fund managers to have an appropriate account structure in place with their custodian banks," Trivedi explained. The New York Fed's tri-party repo committee has not recommended the best type of netting that would ultimately allow the cash lender to receive or deliver cash once each day from each of the clearing banks through the Fedwire system.
The clearing bank could offset the dollar of the cash lent by the fund manager with what it expects to receive back from each of its broker-dealer borrowers. Alternatively, the clearing bank could offset the dollar value of the cash lent by the fund manager from all of the broker-dealers using the same clearing bank. Fund managers attending the repo event said they preferred netting the dollar value of the cash lent with each of their broker-dealer borrowers.
