Repo experts propose plans to counteract rise in ‘fails’
Thursday, November 13th, 2008
Repo experts propose plans to counteract rise in ‘fails’
By Michael Mackenzie in New York
Published: November 12 2008 20:00 | Last updated: November 12 2008 20:00
A group of financial firms on Wednesday announced a series of proposals designed to bolster the government repurchase or repo market, which has been roiled by severe trading disruptions since the bankruptcy of Lehman Brothers nearly two months ago.
The Treasury Market Practices Group (TMPG), which comprises senior members of securities dealers, banks and investment firms and is sponsored by the Federal Reserve Bank of New York, endorsed a number of measures to alleviate so-called repo fails.
In the repo market, a Treasury fail occurs when a borrowed security in exchange for a short-term cash loan is not returned on time. Fails have recently fallen from a record $2,700bn to a still highly elevated level of $1,700bn.
Settlement problems erupted in the wake of Lehman’s collapse and that has been compounded by the sharp drop in official interest rates set by the Fed. So far this month, the effective Fed funds rate has averaged 0.27 percentage points, well below the current target rate of 1 per cent.
In such an environment, repo fails become a persistent feature of trading as the penalty rate for not delivering a security that has been borrowed is very low.
In its proposal, the TMPG said: “While some settlement fails are inevitable, these widespread and persistent fails prevent efficient market clearing and impose credit risk on market participants, and are therefore damaging to overall market liquidity.” In response the group recommends that the market adopt a financial penalty for fails, calculated by a formula of 3 per cent minus the fed funds target rate. Such a penalty would be 2 per cent at this time.
The TMPG said: “This out-of-pocket cost to the party failing to deliver securities will provide a compelling incentive to resolve fails promptly.” When the Fed funds target rate rises to 3 per cent, there would be no explicit financial penalty for failing, the TMPG said.
Longer term, the TMPG supports the idea that the US Treasury temporarily supply new specific securities at a penalty rate when settlement fails persist.
Repo dealers said a fail penalty could discourage trading in the morning, as traders would wait until the end of the day when they have a better idea of what securities will be returned. Some traders may also target failing securities in the hope they earn a penalty from a fail.
The TMPG said the proposal “raises operational, legal and other implementation issues that may vary across various Treasury market participants”. The group also said that it will undertake “further analysis of these issues and expects to make recommendations for implementing the new convention by January 5, 2009”.
Repo traders were more receptive to the idea of providing margin when a security fails, as counterparty risk rises when fails linger in the system.
The TMPG also wants the market to pursue mutually agreed, bilateral cash settlement of failing Treasury transactions beyond five days and enhance current multilateral netting arrangements that, the TMPG says, “would reduce the number and severity of fails”.
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Copyright The Financial Times Limited 2008
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