When Timothy F Geithner spoke at the Economic Club of New York on June 2008 he was president and chief executive officer of the Federal Reserve of New York. Little did we know that he would be chosen as 75th Secretary of the Treasury by President Obama. What brought a shiver through my spine was one remark he made: “We have begun to review how to reduce the vulnerability of secured lending markets, including triparty repo by reducing, in part, the scale of potentially illiquid assets financed at very short maturities.”
In the early 90s, the American investment banks brought a new product to Europe called triparty. Triparty is based on the technique of bilateral repurchase transactions but provides additional collateral management tools. The legal framework commonly known as the GMRA (Global Master Rate Agreement) opened possibilities for secured financing. The diversity of collateral like government bonds, corporate bonds, equities and ABS/MBS securitisation programs would have been unmanageable without collateral agents. Currently four major triparty providers are known – Euroclear, Clearstream, BONYMellon and JPMorgan Chase. Triparty is used by wholesale banking participants, hedge funds, money funds and increasingly also by central banks. The triparty agents have an additional legal document supporting the outsourcing of collateral management by the users to the triparty agents.
Only last year the Eurosystem (the ECB and the National Central Banks of the euro area) agreed in principle to avail of all market techniques in the reform of what is commonly known as CCBM (Collateral Central Bank Management). CCBM is used by the Eurosystem as an internal system for collateral management. The current CCBM has some drawbacks as there is a lack of standardisation across countries, which materially impacts on the usability as it adds to administrative burdens for the users, particularly in a cross-border context. It is in that context that the market took note of the intention of the Eurosystem to develop the next version of the internal collateral bank management commonly called CCBM2. It would harmonise all country specific practices regarding cut-off times and order execution and obviously open possibilities for more advanced collateral management with the Eurosystem. The short-comings of the current system have been especially noticeable with the un-abating credit crisis particularly after the failure of Lehman Brothers.
Structuring the markets
The European Repo Council wrote to the ECB on December 18th 2007 highlighting the efficiency gains and mitigation of operational risks of the triparty product. The letter highlighted in particular the benefits performed through this mechanism such as matching of transaction details, collateral screening, collateral transfers, collateral valuation, custody and reporting services. After many discussions in various working groups the Eurosystem accepted the integration of external collateral management systems, which would enable the use of existing collateral management solutions provided by (I)CSDs and the eventual integration of other triparty collateral management services into CCBM2.
In the context of the above, it is easily understandable that eyebrows regarding Mr Geithner remarks were raised. Why?
Triparty is extensively used in the US markets but the infrastructure of the market is dominated by BONYMellon and JPMorganChase only. A large percentage of financing in the triparty programs is for overnight transactions only, hence the alarming remark from the Federal Reserve of New York.
In Europe the concentration in triparty financing is rather different as shown in the most recent repo survey conducted by ICMA’s European Repo Council. The European triparty product has shown to be a flexible tool catering for the wide and diverse government bonds allowing the creation of different baskets that allow users to switch collateral in and out of these when sovereign states have been downgraded lately. An increasing share of collateral used in triparty is the non-government bond sector. The recent crises have demonstrated what was known for a long time, pricing of less liquid bonds can be problematic. All triparty agents are increasing their efforts and similar to other efforts in Europe like the European Securitisation Forum solutions are currently been worked out. As Europe’s capital market matures the secured market through a flexible approach by the users and providers will be able to continue to prosper.
There is little doubt in my mind that the market volume of triparty will increase with the increased use of central counterparties as pushed by the regulators. It will make this product even more attractive to all, although continuous improvements to the product are obviously needed. The crisis has shown a weakness in the evaluation of the various types of collateral used and a decrease of non-government bonds has been witnessed. But that does not mean that triparty is a dangerous product, I call it “garbish in – garbish out”. All triparty agents are spending a lot of attention and money to improve the daily collateral evaluations. A clear distinction needs to be made between the triparty process and the type and complexity of securities used in triparty.
Collateral to be had
Europe’s secured financing market has a wide range of collateral available in various currencies. The triparty products allow cross-currency transactions and has been beneficial to market participants in the credit crisis, allowing the posting of European collateral versus US dollar liquidity provided through the Federal Reserve to the ECB.
The 16th ERC repo survey shows the value of repo contracts that were still outstanding at close of business on December 10, 2008. The total value of repo contracts outstanding on the books of the 61 institutions who participated in the latest survey was €4,633bn, compared to €6,504bn in June 2008.This is the most severe reduction in the headline number since the survey began in 2001, reflecting the acceleration of de-leveraging by banks since the collapse of Lehman Brothers in September 2008.
The growth of electronic trading continued, reaching a record 28 percent from 24.4 percent in June 2008. There was a dramatic increase in the share of outstanding repo contracts that were negotiated anonymously on an ATS and settled with a central clearing counterparty (CCP) to a record 17.6 percent from 12.7 percent in June 2008, confirming the importance attached by the market to the creditworthiness and automatic netting facilities of CCP. However, the share of tri-party repos fell back to 9.4 percent from 10.1 percent.
The trend decline in the use of government bonds as collateral was reversed. The share of government bonds increased to 83.6 percent, compared to the record low of 81 percent in June 2008. The share of government bonds in tri-party repos fell back from a corrected 47.3 percent in June 2008 but remained historically high at 41.7 percent.
The seasonal need of banks to lock in term funding over the year-end was evident in a significant increase in business with remaining terms of one to three months. This may have disguised an underlying reduction in duration, which was reflected to some extent in a reduction in short-dated transactions to 55.4 percent from 61.3 percent. The maturity profile of triparty repos continued to shorten dramatically, with transactions with one day remaining to maturity jumping to 46.4 percent from 29.1 percent in June 2008, largely at the expense of transactions with remaining terms of between one week and one month. This means that turnover in triparty repos will tend to appear healthier than outstandings would suggest.
Discussions ongoing
Market participants are currently engaged in discussions with the Eurosystem on yet another form of collateralisation, namely credit claims (bank loans). Initially introduced by the Eurosystem to help widen the pool of collateral availability for central bank purposes, it is now widely acknowledged that a huge untapped market exists in the bilateral market. When the current credit crisis abates the central banks will scale down the liquidity provided through regular auctions. The increased use of secured financing for an ever wider range of different types of products, in particularly pushed by the regulators through the use of Central Counterparties will without any doubt increase the pressure on the need to find more collateral. Credit claims are one such product but because of the numerous amounts of individual loans the triparty product will be crucial for efficient and well managed collateral provisions. European policymakers and market participants have also worked on the establishment of a common identification tool on a cost recovery basis that would harmonise the framework. The European Repo council, the Euribor ACI Money Market & Liquidity working group and the European Banking Federation are in discussions with the ICSDs to provide a common data base. This needs to be complemented by a common legal framework made possible as the Financial Capital Directive has been extended to accept credit claims as financial collateral for both central bank and wholesale bank purposes.
Triparty in Europe differs to some extend from triparty market practises in the US markets. Although repo markets are global, local “flavours” make a difference as highlighted in this article. As we expand the territory of the product in emerging markets, efforts of the G20 to solve the credit crunch will force us to look beyond the current framework of collateral management. In this respect it is crucial that we as professional wholesale market participants contribute to consultations with the regulators and express the needs we have to optimise the product with the infrastructure providers. At the same time we have to satisfy the regulatory requirements. It will be a huge effort from all involved, but the ultimate rewards will also be important as repo and triparty contribute to stabilise and rebuilt the financial markets.
