Liberty Street Economics

« Hey, Economist! Tell Us about Your First Year as Research Director of the New York Fed | Main | The Cost and Duration of Excess Funding Capacity in Tri-Party Repo »

October 02, 2017

Excess Funding Capacity in Tri-Party Repo



LSE_2017_Excess Funding Capacity in Tri-Party Repo

Security dealers sometimes enter into tri-party repo contracts to fund one class of securities with the expectation they will wind up settling the contract with higher quality securities. This strategy is costly to dealers because they could have borrowed funds at lower rates had they agreed to use the higher-quality securities at the outset. So why do dealers do this? Why obtain or arrange excess funding for the initial asset class? In this post, we discuss possible rationales for an excess funding strategy and measure the extent of excess funding capacity in the tri-party repo market. In a second post, we examine the maturities of repos used to generate excess funding capacity and estimate the costs of this strategy.

Background on Repo
A repo is effectively a collateralized loan, structured as a paired sale and future repurchase of securities at specified terms. The difference between the future and current price of the securities determines an implied interest rate, which is typically used to price the repo. The interest or repo rates are typically lower the higher the quality (in terms of risk and liquidity) of the securities posted as collateral (for example, see the tri-party repo rates posted by the Bank of New York Mellon). This feature makes generating excess funding capacity costly, because dealers negotiate a repo rate based on lower-quality collateral, but end up allocating higher-quality securities.

Another important feature of repos is the haircut, which represents the additional collateral available to the lender to cover losses in the event of a counterparty default. Unlike with rates, the haircut for a given trade will depend on the quality of the eligible securities allocated at settlement; if a dealer posts better-than-necessary collateral to a repo, the required haircut declines accordingly but the negotiated interest rate on the cash does not change.

Why Maintain Excess Funding Capacity?
A dealer might maintain excess funding capacity for two reasons. First, it may be difficult to find investors willing to provide funding against certain asset classes. When such an investor is found, the dealer might negotiate more funding than necessary to ensure funding in the future.

Second, a dealer may want excess capacity as a buffer in times of crisis when investors may reduce the amount of funding they are willing to provide against particular asset classes. Having excess capacity gives a dealer time to find other investors or to de-lever. In fact, some dealers consider excess funding capacity in their internal stress tests.

How Prevalent Is Excess Funding?
Using confidential, daily data covering March 2017, we compute dealers’ excess funding capacity in tri-party repo, where U.S. dealers obtain a large part of their secured funding (for background, see this blog post). Our data cover a variety of transactions types but we focus on those labeled as repos that are not between affiliated parties. This subsample accounts for around 65 percent of the total value of tri-party repo in aggregate and by asset class (see total value statistics here).

Our data reveal both the lowest-quality asset class from which securities can be used to fulfill the obligations of a repo and the asset class of the securities actually allocated at settlement. We define excess funding capacity to be the amount of a repo backed by higher-than-necessary quality collateral, with the table below outlining what is considered higher quality than necessary. As an example, suppose that a dealer enters into a $95 repo where equities are the lowest-quality securities permissible. If the dealers allocates $90 of equities and $5 of U.S. Treasuries to the trade, the dealer has generated excess funding of $5 ($95-$90) with this repo (ignoring the securities allocated to satisfy the haircut requirements.)


Excess Funding Capacity in Tri-Party Repo_Part 1


The table below reports excess funding capacity by asset class. For example, of roughly $17 billion in agency debt repos in our sample (principal amount), nearly $6 billion, or 36 percent, represents excess capacity. The two asset classes with the highest amount of excess capacity are agency mortgage-backed securities (MBS) and equities repos, with $76 billion and $13.1 billion, respectively.


Excess Funding Capacity in Tri-Party Repo_Part 1


The chart below shows the distribution of repos, weighted by principal amount, by the excess funding capacity they generate. Not surprisingly (since excess capacity is costly), 76 percent of repos do not generate excess funding capacity, (including all “Any” and U.S. Treasuries repos, which by definition cannot create excess funding). Twelve percent of repos by value, however, generate excess capacity of 50 percent or more, indicating that dealers are entering into these contracts with deliberate intent to acquire excess funding capacity. Focusing on repos which acquire 50 percent or more excess funding capacity, we find that agency MBS and equities trades dominate and are a significant part of the entire market, accounting for 8.1 percent and 1.4 percent, respectively, of total value traded.


Excess Funding Capacity in Tri-Party Repo


Takeaways
In the tri-party repo market, we find that dealers seek excess funding capacity, especially for agency MBS and equities securities. This fact suggests that dealers value the option of having funding available for such asset classes in the future. In our next post, we examine the repos generating excess funding capacity in more detail and estimate how much this strategy costs dealers.


Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.





Adam Copeland Adam Copeland is an officer in the Federal Reserve Bank of New York’s Research and Statistics Group.

Ira SeligIra Selig is a manager in the Bank’s Supervision Group.


Noah Zinsmeister Noah Zinsmeister is a senior research analyst in the Bank’s Research and Statistics Group.



How to cite this blog post:
Adam Copeland, Ira Selig, and Noah Zinsmeister, “Excess Funding Capacity in Tri-Party Repo, Federal Reserve Bank of New York Liberty Street Economics (blog), [Insert Publish Date], 2017, Permalink: http://libertystreeteconomics.newyorkfed.org/2017/09/excess-funding-capacity-in-tri-party-repo.html.
Posted by Blog Author at 07:00:00 AM in Dealers, Financial Intermediation
Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Working...
Your comment could not be posted. Error type:
Your comment has been saved. Comments are moderated and will not appear until approved by the author. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.

Working...

Post a comment

About the Blog
Liberty Street Economics features insight and analysis from economists working at the intersection of research and policy. The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Donald Morgan.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.


Economic Research Tracker

Liberty Street Economics is now available on the iPhone® and iPad® and can be customized by economic research topic or economist.


Useful Links
Comment Guidelines
We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:
Please be brief: Comments are limited to 1500 characters.
Please be quick: Comments submitted after COB on Friday will not be published until Monday morning.
Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.
Please be on-topic and patient: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post. We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will not be posted.‎
Disclosure Policy
The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.
Archives