Money Markets & Derivatives
Both derivative and repo markets have been blamed for contributing to the recent financial crisis. But appropriate policy responses require differentiation across the variety of what actually trades in these markets and attention to the details of how these markets work in practice.
Flash: Tri-Party Repo Infrastructure Reform
The Tri-Party Repo Infrastructure Reform Task Force released its final report, with an accompanying statement by the Fed. Read CFS views with respect to the accomplishments of the task force, current state of the tri-party repo system, and current thinking of the Fed... Read More
Federal Liquidity Options: Containing Runs on Deposit-Like Assets without Bailouts and Moral Hazard
CFS Director of Financial Markets Research Bruce Tuckman proposes a bold and innovative approach for the US Government to contain runs on deposit-like assets, such as repo and money market funds, without resorting to ad hoc liquidity facilities and bailouts.
Specifically, Bruce advocates that the Fed auction new instruments called Federal Liquidity Options (FLOs) as the exclusive means of providing liquidity to nonbanks in a crisis.
Having issued FLOs that encompass a sufficient quantity and breadth of collateral, authorities will be able to claim, with credibility, that no additional emergency lending programs or bailouts will be required to safeguard the viability of solvent nonbanks. Consequently, moral hazard will drop significantly. Read More
Update: The Clearing Mandate in Dodd-Frank, Systemic Risk, and Competition
Regulatory rule making is often poised on a knife-edge: insufficiently restrictive rules do not fully fulfill the intent of underlying legislation, while overly-restrictive rules spawn a host of unintended consequences. Implementation of the clearing mandate in Dodd-Frank (DF) is no exception...
Some Concerns with the Derivatives Legislation
Steven Lofchie (Non-Resident Senior Fellow) releases a new paper entitled "Some Concerns with the Derivatives Legislation." Steve is critical of the absence of procedures relating to regulated entities and is fearful of unintended ill consequences from the legislation. He poses questions for legislators and regulators as well as recommendations for improving the legislation. We encourage and welcome comment. Read More
Amending Safe Harbors to Reduce Systemic Risk in OTC Derivatives Markets
Read this paper for a practical and easy-to-implement policy change that will make derivatives markets more robust. The key is that all derivatives markets are not the same and the right incentives can motivate market participants to improve transparency and safety.
Systemic Risk and the Tri-Party Repo Clearing Banks
Explore the hidden risks in the repo markets that fueled the crisis. The author recommends major changes in the operation and supervision of this vital but not well understood market.
Opinions and Editorials
How to Contain a Financial Crisis without Bailouts
March 22, 2012
Today Forbes published an essay by Bruce Tuckman, Director of Financial Markets Research at the Center for Financial Stability. He argues for the creation of a new instrument - the Federal Liquidity Option - to contain periodic liquidity crises.
Four years after the fall of Bear Stearns our fallback policy in a crisis is just as it was in 2008: rely on emergency, ad hoc lending by the Fed. We should not settle for this approach.
To view the Op-Ed.
To read more about Federal Liquidity Options.
Straight Talk from a Practitioner: Notes from Under the Wall
Steven Lofchie writes "Straight Talk from a Practitioner: Notes from Under the Wall." The report covers his thoughts on Dodd-Frank one year after passage and was just published in the Harvard Business Law Review Online.
Survey of Two Dodd-Frank Problems: the Effective Date and the Definitions
At the CFS, we seek to offer a nonpartisan and independent forum to discuss the implementation of Title VII in Dodd-Frank. Input from practitioners, academics, and officials is essential. Hence, we seek comment on the following questions...
With respect to derivatives, precisely which types of contracts caused trouble in the crisis? It is difficult to argue that vanilla interest rates swaps and even credit default swaps on corporate bonds turned out to be much of a problem, while the same can certainly not be said about credit default swaps on illiquid and complex mortgage securities.
On the other hand, many details of market practice across all derivatives were ex ante causes of concern in the crisis and have not yet been fully addressed. Aggregate derivative exposures of financial entities to one another did not seem readily available either to regulators or to the financial entities themselves. While the net derivative exposures of counterparties to one another might have been reasonable, the gross or notional amounts, which become important in the event of bankruptcy and liquidation, were staggeringly large. Financial relationships and transactions across entities of the same company were extremely complex in ways that did not matter for the conduct of day-to-day business but that mattered a lot in a stressed environment. Finally, unwind or liquidation procedures that had been adequate in processing the failures of relatively small financial institutions were not confidence inspiring during the crisis.
With respect to repo markets, many were surprised at the amount of stress arising from the operational details of the tri-party repo system. A recent CFS policy paper explains the relevant issues and evaluates various policy responses.
Systemic Risk and the Tri-Party Repo Clearing Banks
The recent crisis in financial markets has focused attention on systemic risk, that is, on how the failure of one financial institution can wreak havoc on the financial system as a whole. But one significant source of systemic risk has not received much general attention because it lies in the relatively obscure tri-party repo system, through which broker-dealers fund a sizeable portion of their assets. In short, the poor design of the tri-party repo system has the potential to wreck the financial health of a large clearing bank or to contribute to the demise of yet another broker-dealer. While regulators and industry specialists are aware of this danger, their proposed solutions to date are not ideal, ranging from the Fed’s overseeing voluntary industry improvements to an explicit government role in the system and the establishment of a too-big-to-fail back-up entity.
This paper first explains how the design of the tri-party repo system, while solving various operational problems in the secured funding markets, actually creates significant systemic risk. More precisely, by giving broker-dealers use of their security collateral during the day the system effectively transfers the intra-day risk of a broker-dealer default from many secured lenders to the two clearing banks. The paper then argues that imposing capital requirements and risk charges on this intra-day risk will force the industry to correct the existing systemic risk on its own. Furthermore, as an added benefit, these requirements and charges will, by leveling the playing field in the provision of services to the secured funding market, spur competition and innovation. Finally, this paper argues that the alternate policy proposals mentioned above will not be as effective in stabilizing and strengthening the secured funding market.
Read more about Derivative and Repo Markets on the CFS Detailed Proposals and Related Research page.
Risk Management and Derivatives Symposium
The Center for Financial Stability (CFS) recently hosted a derivatives and risk management symposium and dinner including presentations by: CFS Advisory Board Member and Nobel Laureate Myron Scholes, Bruce Tuckman (Director of Financial Markets Research), and Steven Lofchie (Non-Resident Senior Fellow). (September 23, 2010). Read More and Presentations.
A Note to the Federal Reserve Bank of New York (FRBNY)
Comment on Tri-Party Repo Infrastructure Reform
Bruce Tuckman, Director of Financial Markets Research, has submitted a note to the Federal Reserve Bank of New York (FRBNY) in response to their requests for comments on the Tri-Party Repo Infrastructure Task Force Report and the accompanying FRBNY white paper. His note can be found on the Fed's website or on the CFS website.
Bruce first commends the work of the task force with respect to the "practical elimination" of the daily unwind. See his earlier paper calling for such changes, "Systemic Risk and the Tri-Party Repo Clearing Banks."
Bruce then argues that regulators should encourage or require the complete separation of tri-party repo operations from other banking activities, i.e., from the clearing banks. Put another way, tri-party repo clearing should be organized like all other major clearing houses, that is, as a stand-alone, regulated entity. This change would reduce systemic risk, eliminate conflicts of interest in the clearing of tri-party repo, and improve incentives of repo investors with respect to counterparty risk management.