Repos are transactions generally used by the Fed's 22 primary dealers—consisting of Wall Street's biggest banks, including Morgan Stanley and Bank of America Corp.—for their day-to-day financing needs. In one example of a repo agreement, a dealer borrows money from a money-market fund in return for collateral, often Treasury bills or notes.

The dealer agrees to repurchase the securities as soon as the next day for the principal value plus interest. The collateral itself is held on behalf of investors by JPMorgan Chase & Co. and Bank of New York Mellon Corp., which serve as the designated clearing banks in what the industry calls tri-party repo transactions.

The repo market accelerated the fall of both Bear Stearns, which was taken over by JPMorgan in 2008 after an emergency bailout orchestrated by the Fed, and Lehman, whose collapse in September that year plunged financial markets into their worst crisis since the Great Depression.

Investors who perceived the firms might not pay repo loans or be able to post adequate collateral because of their exposure to the plunging value of subprime mortgages demanded more and higher-quality assets and refused to finance new repos.

The funding squeeze triggered sales at Lehman and Bear Stearns as the New York-based firms unloaded assets at any price to stay solvent.

Collateral Guarantee

While Wall Street firms have taken steps to curtail risk-taking in the repo market since the financial crisis, the potential for contagion remains. The Federal Reserve Bank of New York said in a statement published Feb. 13 that forced selling of repo collateral if a dealer defaults still risks “spreading instability across the financial system.”

“The ensuing price declines could trigger margin calls and deleveraging beyond the repo market,” the Fed said.

To address the Fed's concern, repo participants are now gravitating toward proposals that would have the Fixed Income Clearing Corp. (FICC), an industry body that processes repos between dealers, guarantee the most-liquid assets used as collateral between dealers and investors in the tri-party system, said the people familiar with the discussions, who asked not to be identified because the talks were private.

The guarantee would cover securities such as Treasuries and mortgage securities backed by Fannie Mae and Freddie Mac, which make up about 85 percent of daily repo transactions, they said.

Such an arrangement would eliminate the need for repo investors to rely solely on the creditworthiness of one dealer by providing a backstop with broad industry support.

“FICC doing the tri-party clearing would be a possible solution,” Scott Skyrm, the former head of repo and money markets for New York-based Newedge USA LLC and author of the book “The Money Noose: Jon Corzine and the Collapse of MF Global,” said in a telephone interview on Feb. 26. “They have the infrastructure set up to liquidate a failing counterparty.”

Bari Trontz, a spokeswoman for the New York-based Depository Trust & Clearing Corp. (DTCC), which owns the FICC, said it's too early to speculate on next steps.

“DTCC is examining ways in which safeguards can be created to better protect the U.S. tri-party repo market from systemic risk,” Trontz said by phone on March 7. “We continue to work closely with our members and other interested constituencies.”

Liquidation Protocol

The DTCC won approval from the U.S. Securities and Exchange Commission (SEC) in January to let registered investment firms, including some mutual funds, become members of its government securities division, a sign to Skyrm the group may be planning to set up a central clearing body for tri-party repos.

For riskier repo collateral that wouldn't be guaranteed, including structured notes and mortgage securities without government backing, industry organizations are working on guidelines, or best practices, that would include ensuring investors are equipped to price, trade, or liquidate the assets in an orderly matter after a dealer default, the people said.

Investment funds that may have difficulty liquidating such collateral during times of distress would be able to enter into pre-arranged agreements with those firms with the ability to do so efficiently, based on the proposals, they said.

Some academic researchers such as Stanford University's Darrell Duffie have suggested the repo industry needs more drastic changes to effectively prevent fire sales, especially for illiquid and harder-to-sell collateral, from inflicting losses across financial markets.

Not Enough

Duffie, who co-authored a paper in July 2011 with Fed researchers titled “Policy Issues in the Design of Tri-Party Repo Markets,” proposes a highly-regulated utility that could liquidate assets in periods of market stress.

“You need someone to give bids for these less-liquid assets in the event that money funds need liquidity upon a dealer default,” Duffie, who presented his vision at a Fed conference on repo fire sales in October, said in a telephone interview on March 5. “Some pre-arranged source of liquidity for those assets would of course be a positive development.”

Such far-reaching proposals would require an investment that few repo participants would be willing to sign onto and take even more time to implement, Skyrm said. The centralized guarantor system in the over-the-counter swaps market, mandated by the Dodd-Frank Act, has already proven to work, he said.

“We certainly recognize the risks and believe it needs to be a market-wide solution, and are working to see what the best way to do that is,” Robert Toomey, the New York-based managing director at the Securities Industry and Financial Markets Association (Sifma), said in a telephone interview on Feb. 27. “We also realize there may be different solutions for different asset classes within the tri-party market.”

Sifma, the main trade association for dealers, banks, and money managers in the U.S., has in the past few years been among the groups to look at the implications of fire sales.

While repo participants have already succeeded in reducing the use of intraday credit—one of the other systemic risks the Fed identified—regulations designed to shore up bank capital and boost liquidity have contributed to a market contraction.

The tri-party repo transactions have declined 18 percent in the past year to an average $1.61 trillion in outstanding securities each day as of February, from $1.96 trillion in December 2012, data compiled by the Fed show.

Conversation Topic

Any reforms that help mitigate the remaining risks in the repo market may ultimately increase participation, according to Chester Spatt, a finance professor at Carnegie Mellon University in Pittsburgh, who was formerly the chief economist at the SEC.

The Fed may use the repo market to eventually drain reserves and guide interest rates higher. The central bank has conducted what's called reverse repos with dealers and a list of counterparties, including hedge and money market funds, since 2009 to test its ability to tighten policy. The Fed Bank of New York drained $71.89 billion yesterday from the banking system through the reverse-repo facility.

“Fire sales remain a topic of conversation” for the Fed, Robert Grossman, managing director of macro credit research at Fitch Ratings, said in a telephone interview on March 6. “This will therefore be on the market's radar screen.”

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