FRBNY Staff Analyzes Utility of Sponsored Repo
Commentary by Steven Lofchie
In a recent report on Repo Intermediation and Central Clearing, Federal Reserve Bank of New York ("FRBNY") staff analyzed the "salient forces behind a dealer-intermediary's decision to move a bilateral repo transaction with a customer into central clearing."
The FRBNY concluded that (i) dealers turn to sponsored repo (which allows dealers to net trades on their balance sheets and reduce capital costs) during times of balance sheet strain, such as large Treasury issuances or end-of-month reporting periods; and (ii) "sponsored repo spreads tend to be affected by a range of factors, with the three largest drivers being money market fund assets, a proxy for hedge fund demand for repo funding, and end-of-month dates."
According to the analysis, recent Treasury market disruptions in market functioning, most notably the "dash-for-cash" during the Covid-19 pandemic, highlighted the role of intermediaries and raised questions about the drivers of spreads charged by firms. FRBNY staff noted that, while extensive research has focused on more prominent Treasury markets, little attention has been given to sponsored repo. Staff emphasized that the SEC's recently instituted rule amendments on central clearing "are expected to greatly expand the size of sponsored repo, increasing its importance." (See related coverage.)
Commentary
According to the Report, the major benefit of sponsored (centrally cleared) repo is that it provides broker-dealers and banks an accounting benefit. However, since this accounting benefit does not change the fundamental economics or risk of a transaction, it is not obvious why central clearing should prevent market disruptions caused by real world events, such as the Covid-19 pandemic.
It is troublesome that the FRBNY does not seem to understand how cleared repo works. For example, the Report states that "a main benefit of sponsored [cleared] repo [for customers] is the shift in counterparty risk [from exposure to the dealer] to FICC." In fact, there is no such shift. The FICC knows the identity of the customer, but all payments flow through the dealer, and the customer is not protected from dealer default.
In order for the Treasury and the Federal Reserve to better understand the potential impacts of central clearing of repo, these US government regulators require a better understanding of the legal framework.
Related Articles
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The SEC adopted a rule that any SEC-registered central clearing agency that provides central clearing of U.S. Treasury securities ("USTs") shall require its members to centrally clear (i) most repurchase and reverse repurchase transactions in USTs to which it is a counterparty and (ii) certain cash market purchases and sales of USTs.
