Draining the Swamp: The Fed's Tri Party Repo Machine

A triparty repo transaction is a transaction among three parties: a cash lender acting on behalf of all holders of dollars (the Fed), a borrower that will provide collateral (dodgy debt holder in shaky financial condition), and a clearing bank, most likely a primary dealer like J.P. Morgan, which is only too happy to collect its fees as an agent of the Fed.

The triparty clearing bank provides custody (agency) accounts for parties to the repo deal and collateral management services. These services include ensuring that pledged collateral meets the cash lenders’ requirements, pricing collateral, ensuring collateral sufficiency, and moving cash and collateral between the parties’ accounts. What if any liabilities the clearing bank such as J.P.Morgan might obtain for the mispricing of risk remain undisclosed, but are probably negligible at worst.

This is the method of obtaining toxic assets from the books of non-primary dealers, and providing stability and liquidity from the aggregate value of all dollar holders to cover the misdeeds of diverse financial institutions and other favored parties.

In other words, the Fed is draining the financial debt swamp and toxic waste dumps into your basement, if you hold Federal Reserve Notes. Your IRA's, your 401k's, your savings, as long as you hold Federal Reserve Notes, which are claims on their balance sheet loosely backed by the Treasury. When the Fed's balance sheet contained nothing but Treasuries and explicity backed agencies that relationship was firmer. Now, we are into the realm of make believe and Timmy's credibility.

The Fed pledges Morgan assure them that there will be no radioactive material in the sludge pond headed your way, and levels of carcinogenic and toxic contamination will be within levels that they believe are adequate based on the non-binding estimates.

In practice the Fed has a defaults account on its book for the shortfalls from fat valuations due to the toxic debt it has already assumed on your behalf.

The source and composition of the sludge will remain a secret among the bankers, without oversight. This seems like taxation without representation, at least for holders of dollars that are US citizens, since the Fed is engaging in the expenditure of public money without hearings, votes, public oversight, or controls. The Fed seeks to become a financial Star Chamber, dispensing 'justice' as it pleases.

WSJ
Tri-Party Repo Could See 1st Round Of Reforms By Year-End
By Deborah Lynn Blumberg
NOVEMBER 30, 2009, 5:20 P.M. ET.

NEW YORK (Dow Jones)--Progress is being made in reaching agreement on a first round of reforms for the crucial tri-party repo market and details could be revealed as early as the end of this year, according to people familiar with ongoing discussions.

The reforms, which focus on margin requirements and intraday credit, are a first step in making security repurchase transactions more secure and preventing this $4.3 trillion over-the-counter market, where firms raise cash against collateral, from becoming a source of instability for the broader financial system.

They also come at a time when the repo market will be in the spotlight as the Fed plans for the day when it will start to pull the massive amounts of cash it has extended to markets from the system. The Fed is planning to use reverse repo operations--selling dealers securities such as Treasurys for cash with the agreement to buy them back later at a higher price--as one tool to achieve that goal.

The drive to reform the repo market--whose smooth functioning is key to the health of the financial system--has recently gained traction, in part due to the expiry of the Fed's primary dealer credit facility in February 2010. The facility serves as the current borrowing backstop for the big banks that deal directly with the central bank. Without it, the banks will have to rely more on repo for funding, which adds to the need to strengthen its functioning.

According to one person involved with the talks, the New York Fed-sponsored Tri-Party Repurchase Agreement Infrastucture Task Force could issue a progress report on repo reform discussions and seek feedback from the broader market as early as December.

The New York Fed was unavailable for comment.

The reforms will focus on the tri-party repo market, which makes up the biggest chunk of the repo market. In this market, a clearing bank stands between the borrower and the lender, holding collateral and facilitating the trades. The two dominant clearing banks in the U.S. are J.P. Morgan Chase & Co. (JPM) and the Bank of New York (BK).

In a first step, reform will focus on steps that market participants can address without outside input: standardizing margin requirements and tackling the issue of the intraday extension of credit in the market. Longer-term reforms to reduce systemic risk in tri-party repo are still being debated.

Standardized, or minimum margin requirements, would add security for the two clearing banks. Higher margins could be required for certain types of securities, such as commercial paper, or high-yield debt, or for riskier banks.

Intraday credit has also been a top concern. Currently, for operational efficiency, the two clearing banks extend intraday credit on term repos, or repos longer than overnight, meaning they return cash to the lender and securities to the borrower each day even though the contract continues to run. That leaves the clearing bank on the line should either counterparty falter.

One possible solution is to bring the U.S. term repo market more in line with overseas markets, by not allowing term repos using less liquid securities, such as corporate debt, to unwind every day. Other transactions, such as those using the more liquid Treasury securities, would still unwind every day.

The need for repo reforms has been apparent to policymakers for years, but was paid greater heed after severe disruptions in the market during the recent financial crisis.

Borrowers, lenders, clearers, industry groups and the Fed came together in September to form the repo task force and have been meeting every few weeks since then. Members have been working on crafting an initial set of reforms that would help to protect the tri-party repo market from future financial market disruptions.

The Fed and Those Money Market Funds Redux

There is quite a bit of speculation on the reasons why the Fed is eyeing the shadow banking system, aka the Money Market Funds, as a target for the reverse repos when they see the need to drain liquidity from the system.

The following chart shows that as the Fed expanded the monetary base, the liqudity was not being accumulated across the financial system proportionately.

There was a quite obvious parabolic increase in excess reserves held at the Fed as one would expect from a balance sheet expansion, for which the Fed is now paying interest.

From the look of the institutional money funds, one might surmise that beginning with the first failures of major banks, there were heavy flows of liquidity into the institutional money market funds from a variety of sources, with less into the retail funds, and very little change in demand deposits at commercial banks. This would have been consistent with a flight to safety in 'cash.'

Why is the Fed eyeing the money market funds? Two reasons perhaps.

First and most simply because, as notorious criminal Willy Sutton once said, that is where the money is. And if it stays there, the Fed must find a way to affect it to drain liquidity while mitigating the effects of their actions on specific institutions and sectors of the financial system.

Secondly, there is a strong possibility that the Fed's initial attempts to drain will not only involve reverse repos, but also an increase in the interest rate which it pays on the excess reserves.

As you know, one of the reasons the Fed wished to pay this interest rate is as a means of putting a 'floor' under short term rates during a period of significant quantitative easing. If the Fed is paying .15 percent on reserves, for example, it is unlikely that short term rates will fall below .15 percent, without regard for the tranches of liquidity it may be adding to shore up the balance sheets of the banks.

Conventional open market operations tend to become sluggish, if not unmanageable, as one approaches zero rates. Therefore Benny 'got a brand new bag.'

Since the Money Market Funds do not place their excess reserves with the Fed, there is an obvious need to somehow tie them into the process, if one intends to manage it gracefully, not tilting the real economy in one direction or the other, as we are sure our Maestro Ben wishes to do.

It was a bit of an eye opener for us to see this comparison of the Funds with the Banks, and the overall expansion of the Base in the period of fiancial crisis.

Granted, wherever the Fed drains there will be at least a temporary 'crowding out' that needs to be managed carefully. Goldilocks and all that.

No doubt the Banks who own the Fed are keenly interesting in making sure that no additional advantage is being given to the Funds in their ability to attract capital, and invest in even short term paper which might prove advanageous in a recovery. The Vampire Squid and its Merry Band of Lame-os do not like competition.

It is also interesting to note the hints being dropped by various Fed heads for the need to draw the regulation of the Funds under their purview, away from the SEC.

And the SEC is contemplating tougher rules on required reserves for the retail and institutional funds, as well as stricter guidelines on what they may hold on their books.

Sometimes the simplest, most straightforward possiblities are the best. And until additional data may prove otherwise, it does not appear that the Fed wishes to 'dump toxic assets' on the Money Market Funds. Rather, it looks to be all about financial engineering, and a desire to attempt to manage the downstream effects more carefully.

Financial engineering is quite possibly a quagmire, and the Fed in fairly deep within it.