What’s Behind the Decline in Tri-party Repo Trading Volumes?
The tri-party repo market is a platform where security-rich borrowers are matched with cash-rich lenders. The borrowers pledge their securities as collateral for the cash they want to borrow. It is called tri-party because the transactions are settled on the books of two banks: The Bank of New York Mellon (BNYM) and JPMorgan Chase (JPMC), which act as third-party custodians for the collateral securities. These banks provide, among other things, settlement services to finalize the transaction.
At its peak, around $2 trillion worth of securities changed hands daily in this market. Often referred to as the bloodline and plumbing of the financial system, the tri-party repo market motivated a number of policy interventions during the recent financial crisis after the potential for disruptions in the market threatened to interrupt funding flows. Here we look at what is happening currently in this important market.
Total collateral value is an estimate of the market value of the underlying securities involved in the deals that are made in a market. Total collateral value in the tri-party repo market rose steeply after 2011, peaked toward the end of 2012, and then fell steeply.
Tri-party repos can be classified according to the type of asset that acts as collateral. We can decompose total collateral value into its respective asset-class categories to see which asset class was most responsible for the decline. When we do this, we see that the decline in the total is mainly due to a decline in agency securities that are used for tri-party collateral, while the value of Treasury securities and other securities seems to have held roughly steady. The submarket for agency securities has experienced a steep decline of almost 40 percent since mid-2012.
The agencies referred to here are government-supported enterprises or GSEs (Fannie Mae, Freddie Mac, Ginnie Mae), which are supported by the US government to help the housing market. Agency securities are the sum of three different types of securities: agency collateralized mortgage obligations (CMOs), agency debentures and strips, and agency mortgage-backed securities (MBS). The decline in agency securities traded is mainly the result of a decline in agency MBS, which represent a big chunk of the agency securities traded in the tri-party market.
Next, we present data on repo rates. These are the interest rates charged on the loans supported by the collateral. We see that concurrent with the drop in the collateral value traded, there is a drop in rates charged for the repo transactions.
One possible explanation for these concurrent declines in repo rates and in total tri-party collateral value traded is Federal Reserve purchases of securities from the open market. As part of its policy response in the aftermath of the financial crisis, the Fed started buying securities for its own account. Asset holders who previously funded their assets in the tri-party repo market can now sell them to the Fed instead, reducing demand in the tri-party market.
In fact, there is some evidence that supports the story of the Fed playing a role in the tri-party market decline. The chart below shows the Federal Reserve’s holdings of agency securities along with the agency securities used as collateral in tri-party repos. These two series show a strong negative correlation. When Fed holdings declined or held steady, there was a rise in the volume of agency securities in the tri-party repo market. A steep increase in Fed holdings beginning in 2011 happened at the same time that this type of repo collateral began its steep decline. To put the numbers in this figure into perspective, we next analyze changes in the total share of the MBS market going to the Fed and to tri-party repo collateral.
One of the new securities being purchased on the open market by the Fed is agency MBS. The Fed owned about 20 percent of the MBS market around the beginning of 2010. The Fed’s share of total market declined slightly to about 15 percent around mid-2012. After that, we see a clear upward trend in the Fed’s holdings of these securities, coinciding with the decline in the tri-party repo volumes. Currently, the Fed owns about 25 percent of the market, having increased its share by 10 percent since mid-2012.
Only about 8 percent to 12 percent of the total MBS market is traded in the tri-party market. This is a small amount of the total market. But given that the MBS market is a huge market, this share translates into a pretty big number.
As we saw with agency securities in general, the upward trend in Fed purchases and holdings of MBS coincides with the decline in the share of MBS traded in the tri-party market. This is surprising, particularly because the Fed increased its market share of these securities by only 10 percent of the total market since mid-2012, and the tri-party MBS constituted only about 12 percent of that market at the time. These observations suggest that Fed purchases were from market participants who were otherwise willing to borrow in the tri-party market. If the Fed purchases dipped into the almost 90 percent of the market not trading in the tri-party repo, we might not see such a strong negative correlation between Fed purchases and the drop in the MBS tri-party repo.
We have presented some evidence that the increase in Fed purchases and holdings of agency securities might have been responsible for some of the decline in the volume of agency securities traded in the tri-party repo market. With the Fed tapering its purchases, it will be interesting to see if the tri-party repo market experiences a rebound as Fed purchases start to fade away.