In 2012, the New York Fed released a report on Tri Party Repo Reform to address potential systemic risk concerns associated with the infrastructure supporting the tri-party repo market. The roadmap to reform's goals were to substantially reduce the amount of intraday liquidity needed to facilitate settlement, and foster improvements in market participants' liquidity and credit risk management practices. In a new post on its Liberty Street Economics blog entitled, "Don't Be Late! The Importance of Timely Settlement of Tri-Party Repo Contracts," the NY Fed gives a status update on reforms and explains "cash investors' role in the settlement process, and highlight how their current practice of sending principal payments late in the day disrupts the timely settlement of tri-party repo contracts." The piece was written by Adam Copeland, research officer in the NY Fed's Research and Statistics Group, and Ira Selig, senior associate in the Financial Institutions Supervisory Group.

To reduce the amount of intraday liquidity, the New York Fed's Tri-Party Repo Infrastructure Task Force called for changing the settlement process so as to end the "unwind" for non-maturing trades and allowing trades to roll without a need for intraday credit. Further, the "unwind" was moved to 3:30 p.m., with the end-of-day settlement process kicked off shortly thereafter. They write, "Before the recent reforms, all outstanding tri-party repo contracts were unwound at 8:30 a.m. -- with cash returning to the lender and collateral to the dealer. The end-of-day settlement process was run at approximately 6 p.m., settling all outstanding and new contracts. Because dealers are highly levered, they required intraday liquidity between the maturation or "unwind" of tri-party repo contracts in the morning and the end-of-day settlement."

The blog continues, "Tri-party repo contracts are settled on the books of the two clearing banks -- JPMorgan Chase and Bank of New York Mellon. The clearing banks provided unlimited intraday credit to dealers to enable the "unwind" on a discretionary basis. Given the very sizable securities positions that the larger dealers financed using tri-party repo, the clearing banks extended enormous amounts of intraday credit, both in terms of absolute dollars and relative to their respective capital bases. Such actions raised the risk that a clearing bank would not be able to absorb the impact of a failing dealer and so would itself be destabilized, leading to the interruption of a number of financial services provided to other clients (with potentially disastrous results)."

To date, significant progress has been made meeting the Task Force's intraday credit recommendations. "The amount of intraday credit extended by the clearing banks to dealers has fallen from 100 percent of tri-party repo volume to below the Task Force's recommendation of 10 percent. An essential element of the Task Force's roadmap was the requirement that the intraday credit the clearing banks choose to provide to dealers be on a capped and committed basis. The size and terms of each dealer's credit line would be negotiated between the dealer and the clearing bank, subject to a cap of no more than 10 percent of a dealer's total tri-party repo book. Initial indications from market participants suggest that these lines may currently be below the 10 percent threshold."

JPMorgan Chase transitioned to capped and committed intraday credit in March 2014. The Bank of New York Mellon recently announced that it will operate its tri-party repo settlement process with only capped and committed intraday credit by the end of the first quarter of 2015, stated the article. It says, "In addition to committed credit provided by the clearing banks, dealers may source intraday credit from an affiliated company, or from a third party. Using the available sources of intraday credit, dealers will need to ensure that they can provide enough liquidity to fund their maturing obligations by 3:30 p.m. If a dealer is sourcing this funding outside its clearing bank, it will be expected to pay back its liquidity provider upon the completion of the tri-party repo settlement window at 5:15 p.m. and all funds must be repaid prior to the close of the Fedwire Funds Service at 6 p.m. (Fedwire Funds is the main wholesale cash-payment settlement system used by financial institutions.)"

Cash investors are integral to the smooth settlement of tri-party repo contracts, they assert. "Just as dealers need to provide enough intraday liquidity to facilitate the unwind of maturing obligations at 3:30 p.m., clearing banks need to pay out maturities to investors, and investors need to send their cash payments to clearing banks shortly after 3:30 p.m. to ensure an efficient and timely settlement of tri-party repo contracts," the blog tells us.

The authors conclude that late arriving payments are disruptive, saying, "The timely arrival of incoming cash from investors, then, is an integral component of the settlement of tri-party repo contracts. Currently, much of the cash provided in new trades arrives quite late in the day. Using data from the clearing banks, we estimate that in the first half of 2014 only 13 percent of investors' incoming cash arrived at the clearing banks before 3:30 p.m. About 65 percent of investors' incoming cash arrived after 5 p.m. The late arrival of investors' incoming cash will disrupt and delay the settlement schedule of tri-party repo contracts. Settlement delays increase the risk of fails, and can create disruptions for a broader set of late-day payments activities in which the clearing banks are involved. Given the importance of tri-party repo as a source of funding for dealers and an investment tool for investors, market participants should work toward ensuring the earlier arrival of investors' incoming cash payments."

In other news, the estate of the bankrupt Lehman Brothers Holdings Inc. and JP Morgan and Co. continue their legal battle stemming from a financial crisis-era dispute related to tri-party repo, according to The Wall Street Journal. In the article, "Lehman Brothers, J.P. Morgan Lawsuit Over Repo Market Resumes, the Journal writes, "In a filing made late Wednesday with U.S. District Court in New York, lawyers for Lehman and its creditors said J.P. Morgan used its "life-or-death leverage" as Lehman's primary clearing bank to force Lehman into handing over virtually all of its remaining liquidity to "create an $8.6 billion slush fund." In its own filing Monday, J.P. Morgan's lawyers said the Lehman account was "a fable" and Lehman, following the holding company's bankruptcy, tricked it into believing it would be repaid some $70 billion advanced to keep Lehman's broker-dealer business afloat in the days surrounding Lehman's historic bankruptcy filing and the sale of the business to Barclays PLC."

The article continues, "The bank provided cash advances of up to $100 billion a day to Lehman to facilitate overnight repurchase, or repo, agreements.... Like other Wall Street broker-dealers, Lehman depended on the tri-party repo market to fund its business. In a typical tri-party repo, a bank like J.P. Morgan acts as the middleman between money-market funds lending cash and a broker-dealer like Lehman.... The dispute sheds some light on opaque repo markets, which financial firms use to lend one another trillions of dollars each day. That funding dried up in the uncertainty that followed Lehman's collapse, worsening a market panic and alerting regulators to the fact that repos could be a major financial-system vulnerability. Since then, the Federal Reserve and other regulators have moved to tighten the screws on repo activity. The Federal Reserve Bank of New York has pushed J.P. Morgan and Bank of New York Mellon Corp., the other main bank clearing tri-party repo trades, to reduce the same-day credit they provide. Separate Fed rules adopted since the crisis now force banks to ensure they have enough safe assets to convert to cash if they can't tap the repo markets for credit."

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