24. What is tri-party repo?
Tri-party repo is a transaction for which post-trade processing --- collateral selection, payment and settlement, custody and management during the life of the transaction --- is outsourced by the parties to a third-party agent. Tri-party agents are custodian banks. In Europe, the principal tri-party agents are Clearstream Luxembourg, Euroclear, Bank of New York Mellon, JP Morgan and SIS. In the US, there are only two: Bank of New York Mellon and JP Morgan.
Because a tri-party agent is just an agent, use of a tri-party service does not change the relationship between the parties, as the agent does not participate in the risk of transactions. If one of the parties defaults, the impact still falls entirely on the other party. This means that parties to tri-party repo need to continue to sign bilateral written legal agreements such as the GMRA.
Nor does the tri-party agent provide a trading venue where the parties can negotiate and execute transactions. Instead, once a transaction has been agreed --- usually by telephone or electronic messaging --- both parties independently notify the tri-party agent, who matches the instructions and, if successful, processes the transaction. The agent will automatically select, from the securities account of the seller, sufficient collateral that satisfies the credit and liquidity criteria and concentration limits pre-set by the buyer. The selected collateral will be delivered against simultaneous payment of cash from the account of the buyer, subject to initital margins pre-specified by the buyer. Subsequently, the tri-party agent manages the regular revaluation of the collateral, margining, income payments on the collateral, as well as (in the case of most European tri-party agents), substitution of any collateral which ceases to conform to the quality criteria of the buyer, substitution to prevent an income payment triggering a tax event and substitution at the request of the seller.
There are currently important differences between European and US tri-party markets.
- Tri-party agents dominate the settlement of US repo, accounting for something in the order of two-thirds of the US market, compared to about 10% in the European market.
- European tri-party repo is normally used to manage non-government bonds and equity (although the proportion of government bonds has more than doubled since the crisis), whereas US tri-party is focused on Treasury and Agency debt (about two-thirds of that market).
- In European tri-party systems, there has always been true term repo, whereas term repos in US tri-party systems have traditionally unwound each morning, to be re-arranged in the afternoon (the same for open repos). This was intended to give sellers (who are usually broker-dealers) the daily opportunity to substitute collateral and adjust for price fluctuations (instead of margining with the other party), but it requires the tri-party agents to finance the sellers for most of the day, creating a systemic intra-day credit exposure. In Europe, the need to unwind tri-party repos daily has been avoided by the use of direct substitution and margining. Concern about the systemic risk posed by the huge intra-day credit exposures taken by the US tri-party agents (JP Morgan and Bank of New York Mellon) have prompted reforms to the US tri-party market which have brought it closer to the European tri-party model.
- The US tri-party market is dominated by two types of investor, money market mutual funds and securities lending agents reinvesting cash collateral, who account for almost two-thirds of the market. These investors have short-term liabilities and are required or prefer to invest in short-term assets such as repo. However, most tri-party repos are against medium or long-term securities. Provided there is no default, repo collateral does not appear on the balance sheet of the investor. But if there were to be a default on a repo, investors would receive the securities onto their balance sheets. Given that they cannot or do not wish to hold such collateral, they would be obliged or feel impelled to immediately sell the collateral. If the default was by a large borrower, sufficient collateral might be sold to trigger a fire sale. that is, a self-reinforcing cycle of disposal and price collapse. The Europe tri-party repo market does not suffer from such a concentration of the investor base.