As the concerns about the U.S. housing market escalated in 2007, participants in the tri-party repo market became increasingly concerned about the liquidity and credit risks that they faced. The clearing banks became uncomfortable with their large intraday exposures to their tri-party securities firm customers. After all, if a securities firm were to fail suddenly, the clearing banks could be stuck with huge loans to these counterparties, secured by securities that were not necessarily high quality and liquid. Thus, as the condition of the most troubled securities firms deteriorated, there was a risk that one morning a clearing bank might decide not to unwind a firm’s tri-party transactions in order to avoid a large intraday exposure. 6  The problem was particularly acute for those firms with large securities trading and over-the-counter derivative businesses operated outside of depository institutions. In the United States, even those securities firms that were part of bank holding companies were vulnerable because Section 23A restrictions in the Federal Reserve Act that govern transactions between the bank and the nonbank affiliates as part of a bank holding company complex sharply limited what assets the securities firm could pass through to the bank and on to the Fed’s discount window facility. 7  In the unwind, cash was transmitted back from securities firms to wholesale investors each morning, to hopefully be reinvested and returned back to the securities firms by the end of the day to finance their inventories of securities.

The securities in asset-backed commercial paper (ABCP) conduits serve as collateral for the issuance of asset-backed commercial paper, while repo conduits fund in the repo market. Most conduits are so-called single-seller conduits that only serve individual banks or finance companies. Multi-seller conduits provide funding for asset pools of multiple institutions. Conduits are backed by credit lines from commercial banks, which allow the conduits to have a credit rating. Asset-backed commercial paper conduits are also defined in “Shadow Banking: A Review of the Literature”. Federal Reserve Bank of New York Staff Reports, no. 580, (October) 2011. www.newyorkfed.org/research/staff_reports/sr580.pdf. 2  BIS central bankers’ speeches  Because the boom years resulted in strong earnings, low price volatility and few credit losses, firms were able to operate at extreme levels of leverage. When the housing bubble started to deflate, the vulnerabilities of this type of business model soon became apparent. Heavy reliance on short-term wholesale funding exposed the system to a series of intertwined downward spirals in asset and funding markets. This spread in waves, beginning in the market for asset-backed commercial paper (ABCP) issued by off-balance-sheet conduits, and spreading via auction-rate securities, to the repo, money market and financial commercial paper markets that formed the core financing for market-based financial intermediation. Initial declines in asset prices forced leveraged holders with maturity mismatches to sell assets. This increased price volatility and reduced the value of the assets that collateralized other firms’ borrowings.