William C Dudley: Key developments in the tri-party repo market
Introductory remarks by Mr William C Dudley, President and Chief Executive Officer of the
Federal Reserve Bank of New York, at the Workshop on "Fire Sales" as a Driver of Systemic
Risk in Tri-Party Repo and Other Secured Funding Markets, Federal Reserve Bank of New
York, New York City, 4 October 2013.
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Good morning. I am pleased to have the opportunity to open this workshop and discuss key
developments in the tri-party repo market. In my remarks, I would like to give a brief overview
of some of the problems that surfaced in this market during the financial crisis of 2008,
recognize the improvements that have occurred since then, and most importantly, highlight
significant vulnerabilities that still persist despite the progress we have made. While we can
feel proud of the enhancements that are currently underway in the tri-party repo market,
today I want to underscore the fact that significant work remains to be done.
The tri-party repo market constitutes a vital component of the U.S. financial system. It plays
an important role in providing financing for broker-dealers that make markets in Treasury and
agency securities, and is an important mechanism that supports dealer intermediation of
credit. The market also provides a secure investment vehicle for those that manage large
amounts of liquidity and need an investment vehicle to park these monies. We care about the
health and stability of the tri-party repo market both because of our interest in promoting
stable and liquid financial markets and because we use it to implement monetary policy.
The recent financial crisis showed us that the tri-party repo market was inherently unstable
due to deficiencies in the settlement infrastructure. Prior to 2008, there was limited
recognition of the ways in which adverse developments in this market could quickly transmit
risk to other parts of the financial system with unforeseen consequences. We now know, with
the benefit of hindsight, that the market was overly reliant on massive extensions of intraday
credit by the clearing banks to the broker-dealers, that market participants did not adequately
appreciate the magnitude of the risk embedded in the role played by the clearing banks, and,
as a result, market participants underpriced risk in ways that undermined the market's
resiliency during periods of stress.
These vulnerabilities were made apparent in the spring of 2008 when the events surrounding
Bear Stearns demonstrated the run risk that existed more broadly in the tri-party repo
market, prompting the Federal Reserve to intervene in order to restore confidence and
market functioning. This intervention took the form of the creation of a Primary Dealer Credit
Facility in March 2008, and a subsequent expansion of the facility in September 2008. The
scope and scale of the market disruption were clearly very troublesome.
As many of you are aware, the Federal Reserve Bank of New York published a white paper
in May 2010 that highlighted three critical sources of instability associated with practices in
the tri-party repo market: (1) the market's excessive reliance on intraday credit from the
clearing banks; (2) weaknesses in the liquidity and credit risk management practices of cash
lenders and clearing banks that left them vulnerable to stress environments; and (3) the lack
of a mechanism or process for liquidating collateral during periods of stress in a manner that
did not destabilize other segments of the financial system.
After the crisis, we asked the industry to help develop a plan to reengineer the tri-party repo
settlement infrastructure to mitigate these risks. The industry responded by identifying key
changes that could be made to the platform to eliminate market reliance on intraday credit,
thereby removing a key source of fragility observed in 2008. This process was challenging at
times, and ultimately required our intervention as a supervisor to move forward. But the
industry successfully developed a roadmap for reform that is the basis for the changes now
being implemented. The clearing banks are making substantial investments to reengineer
their tri-party repo settlement processes, while lenders and borrowers are making
adjustments to their business practices and technologies to ensure they are ready for
changes that are occurring in the market. When completed at the end of next year, we
expect that these changes will substantially improve the stability of the market. Indeed, the
work completed to date has already reduced the amount of activity being financed on an
intraday basis from 100 percent to about 70 percent, and we project that intraday credit
usage will decline to no more than 10 percent by the end of next year. By removing the
clearing bank from the role of substantial intraday lender, and making tri-party repurchase
exposures truly bilateral, we expect that market participants will have better incentives to
manage their liquidity and credit risks more prudently.
While these changes represent positive developments that will enhance the stability of the
triparty repo market, an important challenge remains. Current reforms do not address the risk
that a dealer's loss of access to tri-party repo funding could precipitate destabilizing asset fire
sales, whether by the dealer itself, or by the dealer's creditors following a default. Industry
participants have yet to fully embrace the role they must play in finding a solution to this
problem. As a result, I would urge industry participants to begin work on this issue without
further delay. In fact, this is one of the motivations for convening today's workshop - to start
the dialogue.
As several of the speakers will discuss in greater detail today, when fire sales occur they can
undermine the stability of other markets beyond the tri-party repo market. The transmission
of instability typically occurs as a consequence of increased margin calls and mark-to-market
losses that strain firms' liquidity and capital positions and put additional pressure on firms to
further deleverage. Such scenarios can have material adverse repercussions on other
market segments and market participants.
It is vital that we take steps to address this risk now, during a period when markets are
functioning without stress, in order to improve the resiliency of this market before the next
crisis occurs. This is especially important in light of the heightened threshold established by
the Dodd-Frank Act for future central bank interventions in the event of a market disruption.
Even if this constraint did not exist, the experience of the recent financial crisis has served to
strengthen our resolve to ensure that the market is structured in a way where risk is
accurately priced and resilient to stress on a day-to-day basis, without the need for official
sector intervention as a first resort.
As many of you know, the Federal Reserve has been calling for action on this issue over the
past two years, and all three Financial Stability Oversight Council annual reports have
highlighted this as a significant issue worthy of our attention. However, the diversity of
participants in the tri-party repo market has made it difficult to move forward quickly with a
market solution that addresses the risk I have outlined. Industry leadership is absolutely
critical to overcoming these challenges. If industry is unable to play its role in achieving a
holistic solution, regulators may find themselves forced to employ the specific policy tools at
their disposal in their respective purviews to address the fire sale risk. While such an
approach may indeed enhance the overall stability of this market, it could also lead to
unintended consequences that include reducing the efficacy of the critical role played by this
market in supporting the broader financial system.
I am glad that you are all here today to work with us to begin to identify the best solutions to
the problem of fire sale risk in the context of the tri-party repo market. I urge you to
participate actively and express your ideas candidly. I am confident that we will come up with
the best solution to this problem by working together.