NEW YORK, May 7 (Reuters) - Next to nothing stands in the way of a destabilizing fire sale in a vast part of U.S. financial markets if a dealer were to default, top Federal Reserve researchers warned in a paper that aims to rejuvenate debate over supervising the industry.
The paper on the triparty repo market, published Tuesday, finds regulators have “limited” tools to stop dealers from rapidly selling off these assets when they face default, and, once a dealer defaults, they have “no established” tools to stop investors from dumping the assets.
The paper is co-authored by the head of research at the New York Fed, James McAndrews, and could help kick-start stalled discussions on how to safeguard the nearly $2-trillion triparty repurchase agreement market, known as triparty repo.
Reforms have only inched forward since the 2007-2009 financial crisis when the repo market came under severe stress as investors liquidated holdings, prompting the U.S. central bank to launch emergency lending facilities.
Yet triparty’s problems were first laid bare back in 1998 when Long Term Capital Management (LTCM) collapsed and needed a bailout after a fire sale at the fund sapped liquidity and rocked U.S. markets.
The case of LTCM “underscores the need for a well-established arrangement to be set up in advance,” argue the New York Fed researchers, who include McAndrews, Brian Begalle, Antoine Martin and Susan McLaughlin.
“Because of the size of this market and the fact that some of its participants are vulnerable to runs, fire sales are particularly likely,” they say.
The repos are a prime source of short-term bank funding and are backed by Treasuries or riskier collateral, including mortgage-backed debt.
Large, rapid sales of the assets could depress their prices and lead to even more losses and dwindling capital for firms facing defaults, possibly forcing others to dump assets too.
Last summer the New York Fed unveiled reforms that would force banks to reduce their reliance on the short-term loans. And in February, New York Fed President William Dudley advocated expanding the U.S. central bank’s backstop to triparty dealers doing “socially useful” business or forcing them to rely more on longer-term funding.
Last month the country’s top financial stability group, the Financial Stability Oversight Council, singled out triparty repos in an annual report warning that short-term funding markets for banks remain susceptible to runs.
The landmark 2010 Dodd-Frank U.S. financial reform law includes some tools to wind down a so-called systemically important broker dealer, “but these might not be invoked, creating possibly damaging uncertainties,” the paper argues.
Stopping a post-default fire sale requires a pre-established mechanism for the “orderly liquidation of triparty collateral, including by funding such instruments for a period of time and clarifying the incidence of any losses,” it says, adding dealers will likely need to be actively engaged in the process.