Within the next few weeks, the Depository Trust and Clearing Corporation’s (DTCC) subsidiary Fixed Income Clearing Corporation (FICC) intends to officially file a rule with the US Securities and Exchange Commission (SEC) and Federal Reserve to provide central clearing for the institutional tri-party repo market.
Currently, FICC provides central clearing for dealers in tri-party repo, but now, the firm plans to extend the service to registered investment funds in order to “to help to prevent another squeeze in tri-party funding such as the one observed in 2008,” says Murray Pozmanter, managing director and head of Clearing Agency Services at the DTCC, who spoke with Global Custodian recently to discuss the details of the proposal. Much of the operations would be the same though, and the current tri-party repo custodians would continue to serve as the custody banks, just with FICC as a counterparty.
As Pozmanter explains, a remaining concern amongst the Fed is the risk of a fire sale in the tri-party repo market, either as a result of a firm nearing default or one that actually does default. In a pre-default scenario, there could be a large flight in the market, thereby causing liquidity crunches, and in a post-default scenario, as related parties try to liquidate assets, there would be large price dislocations.
“We feel that by bringing a good portion of the $1.6 trillion in institutional tri-party that's out in the market right now into a clearing structure, we can help address both the pre-default risk and post-default risk,” says Pozmanter.
The pre-default risk would primarily be mitigated because the clearinghouse would be acting as a credit intermediary for the institutional lenders. “While this doesn't guarantee there won't be a flight from the market in the event of a market stress, we think it will make the market a lot stickier than it is in the bilateral basis,” says Pozmanter. “In a post-default scenario, we think the benefits are even larger in that the clearinghouse would be conducting a centralised liquidation of a much larger portion of the dealer's overall portfolio (compared to investors trying to liquidate on their own)." Plus, the clearinghouse can offset positions in many cases as a result of other trades that it clears.
In order to incentivise institutional investors to participate in the structure, which does add a small cost to both the lenders and borrowers, FICC is creating a limited-purpose membership for tri-party repo that will allow '40 Act funds to become direct members of the clearinghouse. As limited-purpose members, these funds would only be able to access the clearing services of FICC for tri-party transactions where they're the cash lender, and because of this setup, most of the margin put into the clearinghouse would come from the dealers, with the lenders only putting up a minimal amount of margin.
While lenders will put in less margin, the liquidity needs of the clearinghouse will go up if the buy side joins, “because there's a larger portfolio of securities that needs to be financed while we execute the liquidation” in the event of a default, explains Pozmanter. To offset this change, FICC is including a rules-based liquidity facility in its proposal, so that in the case of a default, the '40 Act funds who participate in the clearinghouse are obligated to lend FICC for a five-day term for the same amount they had lent the dealer for the trade.
If the fund needs the cash during the five days, though, the structure would follow that used in DTCC's mortgage-backed securities, where members can have a loss allocation, rather than mutualising losses amongst the clearing members.
One benefit of this structure, says Pozmanter, is that it makes sure the fund’s incentives are still properly aligned to diversify their lending base, even though the trades are all going to be novated to the clearinghouse.
Once FICC officially files a rule with regulators in the coming weeks, the rule will go out for public comment, and the organisation hopes to get final approval by Q2.