US Treasury Repo Risks

Good morning, and welcome to Global Custody Pro. 

Today we're taking a high-level look at the systemic risks in the $4+ trillion daily US Treasury repo market, based on a consultation paper released by the Treasury Market Practices Group (TMPG). This is an important issue for stakeholders in fixed income and repo markets globally, especially global custodians and financial market infrastructure operators.

Key Takeaways

This TMPG white paper highlights key weaknesses in risk management within the U.S. Treasury repo market, especially in non-centrally cleared bilateral repo (NCCBR).

The main issues identified include:

• Inconsistent and unclear management of counterparty credit risks

• Potential systemic risks from hidden leverage caused by insufficient use of haircuts

• Unsustainable reliance on dealers to fund margins

The ongoing OFR data collection initiative aims to improve transparency and market stability. It emphasizes the need for consistent use of haircuts and other effective risk management practices.

Proactively addressing these issues by applying consistent haircuts and standardized risk management strategies will strengthen market stability, reduce systemic risks, and enhance the resilience of the financial system.

Who are the TMPG and what does the consultation say?

The Treasury Market Practices Group (TMPG), sponsored by the Federal Reserve Bank of New York (FRBNY), is a group of market professionals who help recommend best practices across the market.

The consultation paper is entitled “Non-Centrally Cleared Bilateral Repo (NCCBR) and Indirect Clearing in the U.S. Treasury Market: Focus on Margining Practices”

The paper recommends that all Treasury repo activity should have a haircut in place to ensure the right risk management practices are in place across all segments of the Treasury repo market.

The U.S. Treasury repo market is one of the world's most important financial markets, with over $2.3 trillion in centrally cleared repos outstanding. The paper estimates non-centrally cleared repos at roughly $1.4 to $2.7 trillion daily.

This wide range occurs because much of the non-centrally cleared activity is bilateral, involving dealer-to-client transactions. The authors estimated this amount by analyzing primary dealers' tri-party repo data. Non-centrally cleared repos represent the highest risk area compared to centrally cleared transactions.

The size of this market creates financial stability risks that regulators and central banks want to monitor closely. They prefer standardized risk management practices among all participants to avoid complications during a crisis.

This concern is driving discussions globally about moving bonds and repos toward central clearing. For example, Australia’s Council of Financial Regulators recently published findings from their review on central clearing for bonds and repos.

They concluded there wasn’t a case for regulatory intervention yet, but expect the industry to work together to align on market practices and risk management.

How The US Repo Market Is Structured

The paper helpfully describes the main categories of the US repo market. At a very high-level, a repo is where a Treasury security is given as collateral for a loan in exchange for cash.

For example, a broker-dealer delivers $100m in US Treasury collateral and receives $98 million in cash from a money-market fund. The $2 million represents the “haircut”.

The FICC GCF Repo and DVP Service are provided by the Government Securities Division (GSD) of Fixed Income Clearing Corporation (FICC).

The BNY tri-party service is settled on BNY’s tri-party platform. The non-centrally cleared bilateral repo represents the trades negotiated between two counterparties, and is where the bulk of the opacity and different standards is sitting from the perspective of both market participants and data collected by the FRBNY.

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Risk Management Practices In Repo

Each box in the diagram above manages risk in different ways. Centrally cleared repo means the FICC margins participants and all of this rich data is easily available for regulators and the clearinghouse.

Risks to the financial system are arguably lower as membership in the CCP comes with a number of obligations and requirements that reduce overall system risk.

Regular margin calls mean that not only is the initial risk managed with a haircut, but any subsequent market risk is managed through variation margin. The report highlighted that in this scenario, a dealer may be fully contributing all of the underlying margin to the CCP without margining back to their underlying client, which is not going to be sustainable in the long run.

Tri-party repo has a similar approach but haircuts are used to manage counterparty risk. Some participants may have much stricter risk management and margining processes behind their participation in tri-party repo.

Non-centrally cleared bilateral repo has risk management differences from central clearing or tri-party. There is less data available here for regulators, but feedback from market participants and the data available indicates no haircuts are applied to the majority of these trades.

The TMPG report also found that portfolio margining and netting agreements are only used by a proportion of dealers when they trade with clients - which represents a risk that regulators want to better understand and mitigate over time.

Why Are The Differences An Issue?

The paper identifies three main issues:

1. Inconsistent and unclear risk management: Clearing, settlement, and margin practices vary widely and lack transparency. Because haircut levels are negotiated individually, overall market risks might be higher than they appear.

2. Hidden leverage risks: While netting usually reduces risk, the default of one key client could expose a dealer to significant losses. This hidden leverage poses a serious systemic risk, especially during crises.

3. Dealer-funded margins: Dealers typically post margins upfront with a clearing house (CCP) and then collect margins from their clients. However, this process isn’t consistently applied, leading to increased risks. As the repo market grows, dealers might face liquidity problems, particularly if margin requirements suddenly spike during a crisis, potentially causing wider market disruptions.

The current market structure has evolved due to practical business reasons and regulatory changes since the Global Financial Crisis. The current situation highlights how despite significant change, there still remain open risks to be mitigated by financial markets infrastructures and market participants.

Any changes will be complex - all participants will need to uplift processes and platforms to ensure that these guidelines are implemented into operating models. There are also a number of operational risks from these non-centrally cleared bilateral repo trades that must be taken into consideration.

One challenge we see on the horizon is the Bank of International Settlements workstream on initial margin and variation margin, and how all these clearing, settlement and margining processes should be made more standardised and transparent over time.

What’s next?

Our regular industry news roundup will be sent every Friday. We’d love to hear any feedback you have - you can just reply to this email. This newsletter was edited by Brennan McDonald.