And it's hard to overstate how important the repo market is to modern American finance. The short-term loans, which dealers usually get by putting up U.S. government debt as collateral, serve a crucial role in day-to-day trading on Wall Street. Not only do repos support liquidity in the $14.1 trillion Treasury market, but the financing they provide also helps grease the wheels of trading in assets as varied as stocks, corporate bonds and currencies.

“A single point of failure in the U.S. government-collateralized repo market, which is huge and is essentially the liquidity engine for the country, is a little bit unnerving just in itself,” said Adam Dean, managing director at Square 1 Asset Management. “It's not an ideal situation.”

Recall that it was widespread panic in the repo market that helped lead to the collapse of Lehman Brothers Holdings Inc. and imperiled the financial system a decade ago. While the Federal Reserve has spearheaded efforts that have greatly reduced systemic risks in tri-party repo, having just one clearing bank has the potential to leave U.S. markets more vulnerable to everything from natural disasters and computer glitches to terrorism and cyberattacks.

Brian Ruane, who oversees BNY Mellon's securities clearance and tri-party collateral business, says the firm is leaving nothing to chance.

The bank, which had over 80% of the market even before JPMorgan decided to exit the business, has spent $100 million in recent years beefing up its technology, which included upgrades to enable three-way trade confirmations and the automatic substitution of collateral within repo agreements, to meet the Fed's tougher requirements.

'Important Role'

That sum doesn't include the “very sizable” investment the bank made to replace its three-decade-old clearing and settlement platform. And since JPMorgan's announcement last year, Ruane says BNY Mellon has spent even more on improvements, without saying how much.

“We understand the important role we play in the marketplace and are preparing ourselves to take on this greater capacity,” Ruane, a 22-year veteran at the bank, said in an interview from BNY Mellon's office in downtown Manhattan. “A key focus is on building resiliency, by investing more in back-up, capacity, technology, processes and people.”

There's also plenty at stake for BNY Mellon itself. Fees from clearing accounted for 12% of revenue last year, according to the bank.

For years, regulators have prodded players in the industry to come up with ways to prevent potential troubles in repos (which still play an important role in the shadow banking system) from turning into a contagion that threatens broader financial markets, as they did in 2008.

Clearing banks ended the practice of extending intraday credit, which regularly exceeded a trillion dollars. Repo dealers now have to set aside more capital to protect themselves against potential losses. More contracts are now backed by government debt rather than mortgages or other risk assets.

Fire Sales

Nevertheless, the Fed says work still needs to be done to eliminate fire sales, which was a key risk during the financial crisis. Dealers and investors are still vulnerable to the kind of rapid, wholesale dumping of assets that sank Lehman, and the repo industry has yet to implement a solution.

Now, JPMorgan's impending exit is once again calling attention to the stability of the repo market.

“In this day and age when we are looking for risk mitigation across a wide range of institutions, it's much healthier for the marketplace to have numerous clearers involved,” said Christian Rasmussen, the global co-head of repo trading at UBS Group. “It mitigates any concentration risk.”

For its part, BNY Mellon recently set up a unit called BNY Mellon Government Securities Corp. to oversee its repo business and bolster governance. It will have a separate board that includes a number of independent directors.

“We recognize the systemic importance of this market and welcome the steps that Bank of New York Mellon has taken,” Fed Governor Jerome Powell said last month. The Fed “will continue to have heightened expectations for Bank of New York Mellon as it becomes the sole provider of settlement services.”

Better Off?

The process hasn't been easy. Because of the legal and technical complexities, Ruane says the bank has taken its time getting new clients up and running to ensure that everything runs smoothly. As of late July, BNY Mellon had moved just four of JPMorgan's clients onto its platform. And for the time being, JPMorgan will still safeguard their collateral, though both banks expect a majority to make the switch to BNY Mellon in the future.

Nobody is suggesting that the current state of affairs is bulletproof. In the event where one clearing bank goes down, it could still take weeks for the other to pick up all the slack.

“It's not like a firm can just flick a switch and move from one to the other,” said Jeff Kidwell, the director of funding and direct repo at AVM, a broker-dealer in Boca Raton, Fla.

Darrell Duffie, a Stanford University finance professor who has written extensively on the repo market, says that because of issues like its high fixed costs, clearing is one business that just might be better off as a monopoly. Having a single player do all the back-office work could increase efficiency and liquidity. That would be a positive in the Treasury market, which critics say has suffered as post-crisis rules have made it tougher to trade.

“Fewer pipes required in the plumbing of the repo market should make things cheaper,” he said.

However, Duffie added one small, but important caveat. That's all “assuming it doesn't cause clearing fees to go up,” he said.

Bloomberg News

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