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![]() 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. |
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