Treasury to review causes of securities shortage

Mon Mar 5, 2012 5:24pm EST

* Treasury's last non-test position call was in 2008

* Scramble for 7-year notes caused billions in repo fails

By Emily Flitter

NEW YORK, March 5 (Reuters) - U.S. Treasury officials are ready to start reviewing data on a multi-trillion dollar market for cash loans after a sudden shortage of securities led to nearly $73 billion in failed trades on a single day in late February.

The Treasury Department wants to know what caused a scramble that day for seven-year Treasury notes for use in the repurchase market, where securities are exchanged for short-term financing.

Officials requested that all big market participants reveal by last Friday positions of $2 billion or more held in seven-year Treasuries on Feb. 21.

It is the third time since 2005 the Treasury Department has made a call to market participants to examine large positions in response to unusual conditions in the repo market, a Treasury spokesman said.

The Treasury has said there is no reason to believe any market participants engaged in illegal or improper behavior. But if there were market participants hoarding seven-year notes, they could face fines and other forms of sanctions from regulators.

Primary dealers, the firms authorized to deal directly with the Federal Reserve and Treasury, see the investigation as part of the Treasury's recent push to more closely police the opaque repo market.

"Going back to the crisis in 2007 and 2008 when a lot of securities were just not clearing, that's when they really started to try to get into dealer positions and ask who owns what and why things aren't clearing," said Raymond Remy, a Treasury trader at Daiwa Securities in New York. "After the crisis they seemed to be much more focused on positions."

Panic in the repo market played a significant role in the escalation of the 2008 financial crisis, when repo participants lost confidence in each other and abruptly stopped trading to hold on to cash.

In the latest incident, repo traders wanted the Treasury securities, rather than cash.

A scramble began for seven-year notes in particular, pushing cash premiums on seven-year Treasuries to equal the penalty rate for failing to deliver securities in a repo trade, which is around 3 percent.

By the end of the day, some market participants were forced to renege on billions of dollars in repo trade agreements involving seven-year notes.

A member of one firm that is a major repo market particpant, who did not wish to identified, told Reuters the firm's failures in seven-year notes for the day totaled $1 billion "in" and $1 billion "out."

That means the firm was expecting to get $1 billion in seven-year notes via repo transactions and to pass on as much to other repo market participants, but it could not do so.

A spokesman for the Treasury Department did not respond to a question about when the Treasury's review of the positions was expected to be complete.

Treasury's request did not include foreign official institutions, which are exempt from the Treasury's large position reporting rule.

For dealers in the repo market, failures can damage a firm's reputation and perhaps send important clients elsewhere. For the Treasury Department, repo failures can make maintaining liquidity in the Treasury market harder.

The Federal Reserve Bank of New York and the Depository Trust & Clearing Corporation each publish data on the amount of failures to deliver Treasury securities in the repo market, but neither breaks down the failures by specific maturities.

According to the DTCC data, there were $72.9 billion in Treasury repo fails on Feb. 21, compared with $4.8 billion on the previous trading day and $8 billion on the following trading day. Not all of the $72.9 billion in fails occurred in the seven-year maturity, but the rates on seven-year notes as collateral soared to levels far beyond the collateral rates for other Treasury maturities.

Since 1997, the Treasury has made nine separate calls for large position reports in order to test market participants' record-keeping practices. Treasury has also, but more infrequently, called for position reports in response to market events. Before last week's call, the two most recent calls were issued in November 2008 and October 2005.

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