May 13th, 2015
by Antoine Martin and Susan McLaughlin - Liberty Street Economics, Federal Reserve Bank of New York
First in a two-part series. The conventional wisdom about financial innovation is that it is typically undertaken as a way to increase profits. However, financial innovation can also occur as a response to the need to reduce risk. Tri-party repo is an example of such innovation. While tri-party repo ultimately evolved in ways that created and amplified systemic risk (as we will describe in our next post), its origin was as a solution to inefficiencies and risks associated with the repo settlement arrangements prevailing at the time.
In the Beginning . . .
The tri-party repo arrangement was created in the late 1970s by Salomon Brothers, a securities dealer, in cooperation with its Treasury securities clearing bank, Manufacturers Hanover. The problem they were trying to solve was to eliminate the "double" financing costs that Salomon incurred whenever Treasury securities that had been pledged to a repo lender were returned to the dealer too late in the day to be re-delivered as collateral to a new repo lender.
To illustrate, suppose that Salomon borrowed $100 million against Treasury securities from Investor A in an overnight repo yesterday, but Investor A does not want to renew the repo today. To continue to finance these securities, Salomon would look for a new counterparty, Investor B, that would agree to lend it $100 million against the same collateral. To effect the change in counterparty, the securities would have to be delivered to Salomon via the Fedwire® Securities Service by Investor A against repayment of the repo, and then sent to Investor B in a separate movement of securities. If Investor A sends the securities back too late in the afternoon, it may not be possible to deliver them to Investor B before the securities wire closes for the day. In such a case, Salomon would incur a "double" charge: it would still have to pay interest to Investor B, but it would also need to finance the securities it held overnight through a "box loan" with its clearing bank, on which it was also charged an interest rate.
In the tri-party repo arrangement, Salomon - the dealer - and all its potential repo lenders had accounts on the books of the clearing bank, Manufacturers Hanover. Settlement would occur by Manufacturers Hanover transferring cash and securities between the accounts of Salomon and Salomon's lenders on Manufacturers Hanover's books. Under this arrangement, the dealer no longer depended on Fedwire to receive the securities from one lender and to send them to the other lender's account. Indeed, settlement could occur at any time, even after the close of Fedwire Securities.
The Risks That Spurred Tri-Party Repo
Use of tri-party repo arrangements began to grow in the mid-1980s after a spate of defaults on repo contracts by dealer firms caused large creditor losses on "hold-in-custody" (HIC) repo arrangements. HIC repos arose in the 1970s as a way for repo borrowers to avoid the inconvenience of delivering repo collateral; instead of sending the collateral to the repo lender over Fedwire Securities, the dealer would offer to hold the collateral in custody on its books on behalf of the lender. However, the defaults of dealers like Lion Capital Group in 1984 and ESM Government Securities and Bevill, Bresler, and Schulman in 1985 caused large losses for some HIC repo lenders and made it clear that HIC repo arrangements did not adequately protect the collateral pledged to investors. The industry realized that it would be more secure and efficient for an independent third party to segregate and price collateral and to perfect a robust security interest in collateral by the lender through a segregated account in the lender's name. The tri-party repo clearing banks were well positioned to play that role, and tri-party arrangements came to be viewed as a much more effective way to safeguard the collateral of repo lenders than HIC repo arrangements. The safety and cost-effectiveness of tri-party repo led to rapid growth in its usage by government securities dealers in the mid-1980s, amid the expansion of government securities issuance. By the late 1990s, as much as 75 percent of dealers' financing of government securities may have been through tri-party repo (Garbade 2006).
In those early days, tri-party repo was limited to Treasury securities financing and was executed by the clearing banks through a very manual, cumbersome process that was subject to operational risk. In 1987, the Bank of New York invested in automating tri-party settlement to speed up the movement of cash and collateral. This process also included a lockup of cash and collateral to get as close as possible to simultaneous movements of collateral and cash for settlements, further enhancing the safety of the arrangement from the perspective of the repo lender. Security Pacific National Bank automated its tri-party repo settlement process shortly thereafter.
On April 14, 1994, the Fed began charging banks for daylight overdrafts on a minute-by-minute basis. Since delivering securities on Fedwire leads to an inflow of cash to the sender of the securities, it reduces the likelihood of the sender incurring an overdraft charge later in the day. (Mills and Nesmith have shown why this leads to earlier deliveries of securities in this paper.) These incentives led repo lenders to deliver the securities they had received in a bilateral repo early, generating big overdrafts for the clearing banks, which were charged back to the dealers. This development made tri-party repo even more attractive compared with bilateral repos; tri-party repos were generally open and rolled daily, and thus did not involve the cash transfers that generated overdrafts.
By reducing risk and costs associated with the settlement of bilateral repos, the tri-party arrangement made securities dealers more efficient and provided greater safety to their lenders. This innovation reduced the cost to dealers of making markets for Treasury securities, and enhanced Treasury secondary market liquidity. A liquid market for Treasury securities benefits the financial system and taxpayers in multiple ways, most notably by bolstering confidence in and demand for the asset class, thus reducing the government's borrowing costs. In a companion post[link], we document how the efficiencies associated with the tri-party arrangement led to a huge increase in volume and allowed the financing of riskier securities, which contributed to systemic risk.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
About the Author
Antoine Martin is a vice president in the Federal Reserve Bank of New York's Research and Statistics Group.
Susan McLaughlin is a senior vice president in the Bank's Markets Group.