By Karen Brettell
NEW YORK (Reuters) - Participants in the $5 trillion repurchase agreement market need to work harder to develop solutions that reduce the risks the market poses to financial stability, or regulators may need to intervene, New York Federal Reserve Bank President William Dudley said on Friday.
The NY Fed hosted a conference on Friday to discuss ways to reduce the risks from fire sales in repo, which can happen when a dealer comes under stress and dumps assets in a bid to shore up its liquidity. When this occurs, falling asset values can hurt other firm that also hold them, creating a chain of selling.
"Significant work remains to be done" to reduce the risks of fire sales in repo, Dudley said.
In repurchase agreements lenders, such as money funds, make short-term loans to banks or other borrowers and receive collateral such as Treasuries or other bonds to back the loans. Banks then often make similar loans to leveraged investors such as hedge funds that money funds won't lend to, in what they term a "matched book."
Those hedge funds often use the loan to enter a highly leveraged trade, which can exacerbate a fire sale if one of these funds comes under stress. Worries over a fire sale of collateral against repos at Long Term Capital Management (LTCM) when it almost defaulted in 1998 led to a group of banks having to purchase the fund and then slowly unwind the firm.
Dudley said industry participants have "yet to fully embrace" their need to develop solutions, and warned that if they are unable to reduce the risks, regulators may have to use other tools to address the problem, a move that he noted could also have unintended consequences for the industry.
Federal Reserve governor Jeremy Stein, speaking at the same event, said that regulators have a number of tools they can employ to help shore up liquidity at individual companies including banks, including risk-based capital, liquidity and leverage requirements. He noted, however, that none are a comprehensive solution to the problem.
Stein added that reform of money funds is also key to reducing the risks of fire sales of repo collateral, saying that the funds may withdraw financing from banks that come under pressure, even if the collateral underlying the loan is stable.
Dudley also said that efforts to reduce the extension if intraday credit in tri-party repos are accelerating, with loans that rely on intraday credit from clearing banks declining to around 70 percent of the market. It will likely fall to less than 10 percent by the end of next year, he said.
In tri-party trades, JPMorgan Chase & Co or Bank of New York Mellon Corp act as intermediary banks for lenders and borrowers and arrange for the settlement of the loans and the collateral behind them.
These firms extend intraday credit to loan counterparties, which helps smooth the process. But that also means that the two clearing banks remain heavily exposed to the risk of a failure by a large counterparty and that the other participants in the market remain heavily exposed to the financial health of JPMorgan and BNY as intermediaries.
(Additional reporting by Steven C. Johnson; Editing by Chizu Nomiyama)