Wall Street Puts Repo Traders on Edge

These days, it’s virtually impossible to become a bona fide monopoly on Wall Street. But that’s exactly what is happening in one vital part of the US financial system, which has more than a few traders on edge.

Come mid-2018, just one entity—the Bank of New York Mellon Corp.—will be responsible for ensuring almost two trillion dollars of securities financed by so-called repurchase agreements are cleared and settled each and every day. With its lone longtime rival, JPMorgan Chase & Co., exiting the business, BNY Mellon began the process of moving over clients this summer, Bloomberg reported.

The problem isn’t so much that BNY Mellon might abuse its position in what’s become a highly regulated, utility-like part of the repo market. After all, JPMorgan threw in the towel after post-crisis rules made the business costly and onerous. Instead, traders are worried that relying on a single bank for all clearing and settlement—which involves checking every transaction is valid, transferring money from one account to another and safeguarding collateral backing each contract—could mean big trouble if something goes wrong.

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 US 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.

Point of Failure

“A single point of failure in the US 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 which 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 US markets more vulnerable to everything from natural disasters and computer glitches to terrorism and cyber attacks.

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.

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 AG. “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.