04 October 2013

Fed/Dudley: Introductory remarks at workshop on "Fire Sales" as a driver of systemic risk in tri-party repo & other secured funding markets

Dudley gave a brief overview of some of the problems that had surfaced in this market during the financial crisis of 2008, recognised the improvements that had occurred since then, and highlighted significant vulnerabilities that persist.

The tri-party repo market constitutes a vital component of the US financial system. It plays an important role in providing financing for broker-dealers that make markets in Treasury and agency securities, and is an important mechanism that supports dealer intermediation of credit. The market also provides a secure investment vehicle for those that manage large amounts of liquidity and need an investment vehicle to park these monies. We care about the health and stability of the tri-party repo market both because of our interest in promoting stable and liquid financial markets and because we use it to implement monetary policy.  

As many of you are aware, the Federal Reserve Bank of New York published a white paper in May 2010 that highlighted three critical sources of instability associated with practices in the tri-party repo market: (1) the market’s excessive reliance on intraday credit from the clearing banks; (2) weaknesses in the liquidity and credit risk management practices of cash lenders and clearing banks that left them vulnerable to stress environments; and (3) the lack of a mechanism or process for liquidating collateral during periods of stress in a manner that did not destabilise other segments of the financial system. 

It is vital that we take steps to address this risk now, during a period when markets are functioning without stress, in order to improve the resiliency of this market before the next crisis occurs. This is especially important in light of the heightened threshold established by the Dodd-Frank Act for future central bank interventions in the event of a market disruption. Even if this constraint did not exist, the experience of the recent financial crisis has served to strengthen our resolve to ensure that the market is structured in a way where risk is accurately priced and resilient to stress on a day-to-day basis, without the need for official sector intervention as a first resort.  

As many of you know, the Federal Reserve has been calling for action on this issue over the past two years, and all three Financial Stability Oversight Council annual reports have highlighted this as a significant issue worthy of our attention. However, the diversity of participants in the tri-party repo market has made it difficult to move forward quickly with a market solution that addresses the risk I have outlined. Industry leadership is absolutely critical to overcoming these challenges. If industry is unable to play its role in achieving a holistic solution, regulators may find themselves forced to employ the specific policy tools at their disposal in their respective purviews to address the fire sale risk. While such an approach may indeed enhance the overall stability of this market, it could also lead to unintended consequences that include reducing the efficacy of the critical role played by this market in supporting the broader financial system. 

Full speech

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