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* The 2007-09 financial crisis exposed weaknesses in the design of the U.S. tri-party repo market that could rapidly elevate and propagate systemic risk.
* A study of the market identifies the collateral allocation and unwind processes as two key mechanics contributing to the market's fragility and delaying reforms.
* The problems stem from the considerable intervention by dealers to allocate collateral and their reliance on intraday financing to unwind, or settle, expiring repos.
* Streamlining the collateral allocation process and eliminating the time gap associated with the unwinding of repos could reduce market fragility and financial system risk.
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1. Introduction
uring the financial crisis of 2007-09, particularly around the time of the Bear Stearns and Lehman Brothers failures, it became apparent that weaknesses existed in the design of the U.S. tri-party repo market, used by major brokerdealers to finance their inventories of securities. These design weaknesses had the potential to rapidly elevate and propagate systemic risk.
Following the crisis, an industry-led effort sponsored by the Federal Reserve Bank of New York was undertaken to improve the tri-party repo market's infrastructure, with the main goal of lowering systemic risk. This article describes some key mechanics of the market-in particular, the collateral allocation process and the "unwind" process-that have contributed to the market's fragility and delayed the reforms.
A repurchase agreement, or "repo," is effectively a collateralized loan. A well-functioning tri-party repo market depends on the ability to efficiently allocate a dealer's securities-the collateral in the transaction-to the various repos that finance those securities. In the United States, collateral allocation currently involves considerable intervention by dealers, which slows the entire process. Collateral allocation is also complicated by the need for coordination between the Fixed Income Clearing Corporation (FICC), which clears some interdealer repos, and the clearing bank, which facilitates the settlement of tri-party repos. The length of time necessary to allocate collateral in the tri-party repo market has been a significant obstacle to market reform.
Another impediment to reform is the unwind process, the settlement of expiring repos that occurs before new repos can be settled. The unwind creates a need for intraday funding to tide dealers over in the period between when they return cash to investors and when...