New Worry in 'Repo': Just One Bank for $3.5 Trillion Market

By Katy Burne Features Dow Jones Newswires

When ED&F Man Capital Markets in June opened a settlement account for government bonds at Bank of New York Mellon Corp., it was a watershed moment in the world of "repos."

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London-based ED&F became the first bond broker to change clearing banks in this obscure but vital corner of the global financial system in nearly a decade.

The move signaled that a market whose resistance to change has long vexed regulators is now shifting in a way that intensifies many traders' concerns about repo safety.

Bank of New York's onetime sole rival in the business of clearing U.S. Treasurys and repos backed by them, J.P. Morgan Chase & Co., is exiting the business, prompting more than two dozen brokers to move to Bank of New York.

Individual brokers' transitions have by all accounts been smooth. Yet many traders fret over the risks of having a single bank handle all clearing and settlement -- the process of completing trades and distributing funds according to contract -- in a short-term lending market estimated by the Treasury's Office of Financial Research at $3.5 trillion.

Many worry that having all those transactions handled by just one clearing bank potentially exposes the world's safest bond market to threats ranging from mundane power outages to cyberattacks and terrorism.

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"This clearing function is only in one bank now and is so systemically important," said Scott Skyrm, head of repo at Wedbush Securities, a Los Angeles broker dealer.

In repos, or "repurchase agreements," lenders such as money-market funds make short-term loans to bond brokers, often using government bonds as collateral.

The market has been targeted by the Federal Reserve for reform for nearly a decade. Those efforts picked up after shortcomings in repos were exposed in 2008, when lenders' retreat from Bear Stearns Cos. and Lehman Brothers Holdings Inc. played a role in accelerating the financial crisis.

Troubles at those firms and others, driven in part by their exposure to subprime-lending losses and reliance on short-term loans to fund longer-term investments, helped pave the way for an updated repo market.

A decade ago, many financial firms funded themselves "wholesale" by borrowing in the market overnight. Today, repo borrowings tend to be longer-term and backed by stronger collateral, such as Treasury securities rather than privately issued mortgage bonds.

"When bad things happened in 2008, we saw that there were virtually no bids in the market for anything other than the risk-off sovereign market, " said Mark Robinson, a former managing director at Bank of New York and most recently a business development executive at fintech company Broadridge Financial Solutions.

Regulators have been trying on and off for years to resolve concerns about problems in repo spilling over to broader financial markets.

In April, Federal Reserve Bank of New York President William Dudley wrote that repo markets pose risks to market functioning and "are not settled yet," in part because participants can still choose to raise cash in a hurry by selling assets in a so-called "fire sale."

With J.P. Morgan's 2016 decision to retreat from clearing government securities, concerns about market stability began falling squarely on Bank of New York, which already controlled 85% of the market. The company this past May formed a new unit with a separate governance team to oversee the repo business, acknowledging its unique role and responsibility.

Bank of New York this summer began transitioning some clients of J.P. Morgan. Besides ED&F, it has also added as new clearing clients INTL FCStone and Landesbank Baden-Württemberg. In all, about 30 are expected to move.

"We were nervous at first," said Bruce Fields, group treasurer at INTL FCStone. But he said his fears have been allayed since his firm's conversion on July 10, which he said has provided access to a wider array of repo lenders than at J.P. Morgan.

Beyond Bank of New York, efforts to make repo safer continue. In May a unit of Depository Trust & Clearing Corp., a financial plumbing firm controlled by large banks, got permission from the Securities and Exchange Commission to expand a repo safety net already in use for bond brokers, covering institutional investors too. Some view this as potentially mitigating fire sales. Hedge fund firm Citadel LLC joined in June.

Trading volumes have shrunk, owing to new rules that have levied extra capital charges on banks. Other rules have meant more repos are locked in for longer terms, reducing the incentives for firms to borrow short term while lending long term and creating an unsound condition known as an asset-liability mismatch.

Perhaps most important, the hundreds of billions of dollars in intraday loans that J.P. Morgan and Bank of New York once made every morning to bond brokers have been reduced by 97%, according to Fed estimates, virtually eliminating the exposure the two clearing banks had precrisis to a broker default.

Write to Katy Burne at katy.burne@wsj.com

(END) Dow Jones Newswires

August 30, 2017 12:25 ET (16:25 GMT)