DEBT IMPASSE EXPOSES ACHILLES' HEEL OF FINANCE / THE FINANCIAL TIMES MARKETS INSIGHT

MARKETS INSIGHT

October 10, 2013 11:44 pm

Debt impasse exposes Achilles’ heel of finance

By Gillian Tett

Risk of an accident in $2tn tri-party repo market is rising

Who is getting spooked by Halloween bonds? That is a question which many traders are wondering. Little wonder. A week ago, I (like most people) blithely assumed that Congress would find a way to resolve the budget and debt ceiling impasse before the crucial October 17 deadline, when the Treasury claims it will start running out of funds.

Now I am less sure. For the situation seems to have fallen into a pattern which defies neat, game-theory solutions: the White House does not want to give the Tea Party any victories, for fear of encouraging more hostage-taking; John Boehner, Republican House Speaker, cannot offer concessions for fear of losing his position; and the Tea Party now regards the fight as a “do-or-die” stand and also fears it.

Of course, since this is Washington - where deadline crises are as ingrained in political culture as “alarm clocks”, as the quip goes - I am still assuming that a last minute deal will get done. The latest calls from Mr Boehner for a six-week “extension” for the debt ceiling to late November, moving the deadline to Thanksgiving, certainly fit this mould.

Shameful omission

But the risk of an accident is rising. For the key thing that investors, voters and politicians need to grasp is that this fight is not simply creating concern about Treasury bills that expire in late October (aka “Halloween”), or even six weeks later, undermining the securities’ sanctity. It is also threatening to expose a dangerous Achilles’ heel of finance – and shameful omission in the recent regulatory reform - that has been haunting markets for years.
The issue at stake is the $2tn tri-party repurchasing market where financial institutions raise cash for short-term needs, by pledging securities (such as those T-bills) as collateral.

Before 2008, this repo world was widely ignored since its operations appeared staid and dull. But when entities such as Bear Stearns and Lehman Brothers tipped into crisis, it became clear American tri-party repo is built on shaky foundations. There is no lender of last resort and no neutral third-party exchange or clearing platform to complete deals swiftly if a party fails, or a security defaults. Instead, clearing is concentrated in the hands of two private-sector players: Bank of New York and JPMorgan. Worse, transactions can be left in a state of limbo during the trading day.

Thus if a jolt hits the system, this can potentially spark panic. And that could spread contagion since the system is such a crucial source of funding for every large financial player.

Now, the good news is that the New York Federal Reserve Bank recognises this vulnerability – and has repeatedly demanded reforms in the past five years. Indeed, just last week Fed officials held a conference where it sternly warned of “fire sale” risks in the repo world – and demanded change. But the bad news is that reform has been shamefully slow and timid, partly because the NYFRB has tried to work in a collaborative manner with the banks, rather than simply using its supervisory powers to force change.

As a result, there is still no watertight framework in place to cope with a scenario where a large party fails, or a panic erupts around certain securities, and sparks fire sales. And while intraday trading balances are being handled better, the risks are not completely resolved. Or as the International Monetary Fund said in its Global Financial Stability Review this week: “Some progress has been made in reducing financial stability risks surrounding repo markets... [however] short term secured funding markets are still exposed to potential runs.”

Repo freeze

If a technical default occurs on those T-bills, in other words, this could freeze parts of the system. Indeed, profound problems could occur even if the Treasury devises clever conjuring tricks to keep paying interest on its bonds after October 17, since these would inevitably be subject to subsequent legal challenge – and foster stigma and uncertainty.

But here is the real rub: though this Achilles’ heel spooks market cognoscenti, most Tea Party supporters have no idea the repo world even exists. Voters know what a crashing stock market looks like; tri-party repo deals are a mystery. And while some senior government officials are trying to find ways to communicate the message - say by likening repo to a giant pawn-shop-cum-plumbing system – this “messaging” challenge is huge.

Hence the risk of an “accident” taking place, if the battle goes to the wire; and hence the growing sense of unease among market insiders. Indeed, the only piece of good news in this sorry tale is that when the dust settles on the debacle – be that with a six-week extension or anything else – this could prod regulators and banks get more serious about repo market reform. It is just a pity that more radical reform did not occur five years ago; if so, this Halloween mess would not look so scary.