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Adam Copeland, Michael Fleming, Frank Keane, and Radhika Mithal
The Treasury Market Practices Group (TMPG) recently released a consultative white paper on clearing and settlement processes for secondary market trades of U.S. Treasury securities. The paper describes in detail the many ways Treasury trades are cleared and settled— information that may not be readily available to all market participants—and identifies potential risk and resiliency issues. The work is designed to facilitate discussion as to whether current practices have room for improvement. In this post, we summarize the current state of clearing and settlement for secondary market Treasury trades and highlight some of the risks described in the white paper.
Editor's note: In the original version of this blog post, a computational error was reflected in the chart “Distribution of Premiums Paid on ‘Excess Capacity’ Repos” and related text. Both have been corrected. (October 23, 2017, 12:37 p.m.)
In a previous post, we showed that dealers sometimes enter into tri-party repo contracts to acquire excess funding capacity, and that this strategy is most prevalent for the agency mortgage-backed securities (MBS) and equity asset classes. In this post, we examine the maturity of the repos used to pursue this strategy and estimate the associated costs. We find that repos that generate excess funding capacity for equities and corporate debt have longer maturities than the average repo involving either of these asset classes. Furthermore, the premiums dealers pay to maintain excess funding capacity can be substantial, particularly for equities.
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.
Regulatory reforms since the financial crisis have sought to make the financial system safer and severe financial crises less likely. But by limiting the ability of regulated institutions to increase their balance sheet size, reforms—such as the Dodd-Frank Act in the United States and the Basel Committee's Basel III bank regulations internationally—might reduce the total intermediation capacity of the financial system during normal times. Decreases in intermediation capacity may then lead to decreased liquidity in markets in which the regulated institutions intermediate significant trading activity. While recent commentary by market participants claims that this is indeed the case—a Wall Street Journal article [subscription required] notes that “three-quarters of institutional bond investors say that liquidity provided by bond dealers has declined in the past year...”—empirical studies have struggled to find evidence supporting this narrative. In this post, we summarize the findings of our recent article in the Journal of Monetary Economics that addresses the apparent disconnect between the market-participant commentary and the empirical evidence by focusing on the relationship between bond-level liquidity and financial institutions’ balance sheet constraints.
Viral V. Acharya, Michael J. Fleming, Warren B. Hrung, and Asani Sarkar
During the 2007-08 financial crisis, the Fed established lending facilities designed to improve market functioning by providing liquidity to nondepository financial institutions—the first lending targeted to this group since the 1930s. What was the financial condition of the dealers that borrowed from these facilities? Were they healthy institutions behaving opportunistically or were they genuinely distressed? In published research, we find that dealers in a weaker financial condition were more likely to participate than healthier ones and tended to borrow more. Our findings reinforce the importance of Bagehot’s principle that the lender-of-last resort should lend only against high-quality collateral and at a penalty rate so as to discourage unneeded or opportunistic borrowing.
Alexandra Altman, Kathryn Bayeux, Marco Cipriani, Adam Copeland, Scott Sherman, Brett Solimine
Editor’s note: When this post was first published, the linked file with historical rates and volumes for the three Treasury repo rates had some minor errors. The data and related charts have been corrected. These changes did not alter the authors’ conclusions. (January 30, 2018, 4:00 p.m.)
Editor’s note: In the data file originally released with this post, some repo volume figures were misaligned with their dates; the problem has been corrected. (December 19, 2016, 11:15 a.m.)
In its recent “Statement Regarding the Publication of Overnight Treasury GC Repo Rates,” the Federal Reserve Bank of New York, in cooperation with the U.S. Treasury Department’s Office of Financial Research, announced the potential publication of three overnight Treasury general collateral (GC) repurchase (repo) benchmark rates. Each of the proposed rates is designed to capture a particular segment of repo market activity. All three rates, as currently envisioned, would initially be based on transaction-level overnight GC repo trades occurring on tri-party repo platforms. The first rate would only include transactions in the tri-party repo market, excluding both General Collateral Finance Repo Service, or GCF Repo®, transactions and Federal Reserve transactions. (GCF Repo is a registered service mark of the Fixed Income Clearing Corporation.) Henceforth in this post, this segment will be referred to as tri-party ex-GCF/Fed. The second rate would build on the first by including GCF Repo trading activity while still excluding Federal Reserve transactions. Finally, the third rate would include tri-party ex-GCF/Fed transactions, GCF Repo transactions, and Federal Reserve transactions. The repo benchmark rates would be calculated as volume-weighted medians, as is currently the case for the production of the effective federal funds rate (EFFR) and the overnight bank funding rate (OBFR), and would be accompanied by summary statistics. The three proposed rate compositions result from staff analysis on the various market segments and characteristic trading behavior, though the New York Fed expects to work with the Board of Governors of the Federal Reserve System to seek public comment on the composition and calculation methodology for these rates before adopting a final publication plan.
Editors’ note: The original version of this post had the terms “borrowers” and lenders” reversed and had some figures wrong. The corrected figures do not suggest, as before, that dealers who switch between borrowing and lending are pursing collateral swapping strategies. We regret the error. (August 16)
In this post, the third in a series on GCF Repo®, we describe dealers’ trading strategies. We show that most dealers exhibit highly regular strategies, using the GCF Repo service either to borrow or to lend, on net, on almost all the days in which they are active. Moreover, dealers’ strategies are highly persistent over time: Dealers that use GCF Repo to borrow (or to lend) in a given quarter are highly likely to continue to do so in the following quarter. Understanding how dealers trade in the GCF Repo market may provide insight about the role of the repo market more generally and about how recent regulations and market reforms can affect dealers’ trading strategies.
Michael Fleming, Frank Keane, and Ernst Schaumburg
The recent Joint Staff Report on October 15, 2014, exploring an episode of unprecedented volatility in the U.S. Treasury market, revealed that primary dealers no longer account for most trading volume on the interdealer brokerage (IDB) platforms. This shift is noteworthy because dealers contribute to long-term liquidity provision via their willingness to hold positions across days. However, a large share of Treasury security trading occurs elsewhere, in the dealer-to-customer (DtC) market. In this post, we show that primary dealers maintain a majority share of secondary market trading volume when DtC trading is taken into account. We also use survey data on large dealers to characterize activity in the DtC market and discuss some of the gaps in the available Treasury trading volume data.
Securities broker-dealers (dealers) trade securities on behalf of their customers and themselves. Recently, analysts have pointed to the decline in U.S. dealers’ corporate bond inventories as evidence that dealers’ market making capacity is impaired. However, historically such inventories also reflect dealers’ risk management and proprietary trading activities. In this post, we take a long-term perspective on the evolution of dealers’ inventories of corporate bonds, Treasuries, and other debt securities and relate those inventories to expected returns in fixed-income markets in an effort to better understand the drivers of dealer positioning.
Tobias Adrian, Michael Fleming, Or Shachar, and Erik Vogt
First in a six-part series
Commentators have argued that market liquidity has deteriorated in recent years as regulatory changes have reduced banks’ ability and willingness to make markets. In the corporate debt market, dealer positions, which are considered essential to good liquidity, have indeed declined, even as issuance and outstanding debt have increased. But is there evidence of reduced market liquidity? In previous posts, we discussed these issues in the context of the U.S. Treasury securities market. In this post, we focus on the U.S. corporate bond market, reviewing both price- and quantity-based liquidity measures, including trading volume, trade size, bid-ask spreads, and price impact.
Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.
The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.
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