A pillar of U.S. regulators' plans to curb risks in the $2 trillion bond-lending market known as repo has been stuck in limbo for more than two years, forcing a key Wall Street utility to speed up alternative plans that would only address a fraction of participants.
Depository Trust & Clearing Corp., which operates a central hub used by banks and brokerage firms to finance their bond trades, is discussing a draft proposal with the Securities and Exchange Commission that would allow pension funds and insurance companies to join as cash providers, a person with knowledge of the matter said.
The DTCC's effort is seen as a stopgap, since the SEC has taken no action on a separate October 2014 proposal to include a much larger pool of cash providers: money-market funds run by behemoth asset managers like Fidelity and Federated Investors (FII) . The DTCC system, known as a clearinghouse, is the only one of its kind in the U.S.; it functions as a central counterparty, essentially guaranteeing the repo loans that are processed through it.
The financial crisis of 2008 exposed the risk that a large firm's default could roil the repo market, triggering a fire sale of liquidated collateral that could send bond prices into a tailspin, in turn saddling more banks and investors with devastating losses. Both the international Financial Stability Board and Federal Reserve Governor Jerome Powell have suggested that greater use of clearing in the market could mitigate systemwide risks by providing a mechanism to gradually wind down a failed firm's bond trades with minimal disturbance.
In clearing, a central hub like the DTCC takes over as the main counterparty for all transactions, assuming the responsibility of collecting additional payments from individual participants when their trades go south. The clearinghouse is set up so that any losses from the default of a single trader are shared among all members, and it also assumes the responsibility for liquidating any collateral that's seized.
"Central clearing has been a regulatory priority to reduce risk, but at the same time regulators have put up unintended obstacles to making this a reality," said Josh Galper, a repo-market expert at Finadium, a consultancy in Concord, Mass.
The repo-clearing initiatives are further clouded by President-Elect Donald Trump's pledge to dismantle some banking regulations enacted following the financial crisis. A rollback could reduce incentives for banks to trim their balance sheets, a key benefit of clearing.
Repo loans, technically known as repurchase agreements or securities-lending contracts, allow Wall Street firms and traders to buy bonds with borrowed money, minimizing the required capital investment and thus magnifying returns. The repo market is considered so crucial to investors that it's often referred to as the "plumbing of Wall Street."
The market became so fraught during the 2008 crisis that the Fed had to set up two emergency-lending programs totaling $340 billion to backstop dealers' repo positions.
The DTCC's October 2014 proposal has been hung up before the SEC's Division of Investment Management, due at least partly to concerns about money-market funds' legal ability to participate in a clearinghouse, the person with knowledge of the matter said. According to DTCC's most-recent annual report, the expanded service was supposed to go live by the end of this year.
The clearinghouse is still pushing for the money-fund expansion but is resigned to waiting until the Division of Investment Management considers it, the person said.
The new draft proposal to incorporate pension funds and insurance companies in the repo-clearing system has been routed to the DTCC's usual regulator, the SEC's Division of Trading and Markets, where the reception has been warmer, according to the person. That narrowed service offering is targeted for launch in early 2017 and would also be open to big institutional cash lenders like sovereign wealth funds and corporate treasurers, the person said.
An SEC spokesman declined to comment.
The DTCC is owned by bond dealers who use the service, including big banks like JPMorgan Chase (JPM) and Citigroup (C) as well as non-bank brokerage firms such as Jefferies & Co. (LUK) and Cantor Fitzgerald. Some of the biggest U.S. firms, which also include Goldman Sachs (GS) and Morgan Stanley (MS) , have scaled back in repo lending to comply with stiffer bank regulations that make the business more costly.
Proponents of expanded clearing say banks would benefit because a central counterparty allows for the netting out of offsetting repo loans, thereby reducing the amount of capital needed to support overall positions; the more participants there are, the more netting that can take place.
Under the DTCC's October 2014 proposal, money-market funds would be relieved of a key requirement that banks face -- namely, to put money into a guarantee fund that must be maintained to cover any clearinghouse losses. The thinking is that full clearinghouse members would be willing to grant the exemption, because of the ample benefits of having a broader pool of cash providers in the network.
"In terms of accessing a more liquid market, it would be good for the industry," said Jim Tabacchi, CEO of New York-based South Street Securities, a repo-focused brokerage firm and a member of the DTCC.
Pension funds and insurance companies would also be exempt from contributing to the guarantee fund, the person with knowledge of the matter said. The funds could still be on the hook for some losses in the event of a major default, but less so than under a direct lending arrangement, according to the person.
The SEC's Division of Investment Management has been swamped with other regulatory initiatives, including major changes last month to the rules governing money-market funds, said Debbie Cunningham, a senior portfolio manager at Federated, which oversees $364 billion. So the DTCC's clearing proposal has taken a back seat.
"They've been stretched thin," Cunningham said.
Expanded clearing would still be in high demand from money-market firms like Federated, she said, but even a limited service allowing for participation by pension funds and insurance companies should increase the breadth and depth of the repo market.
"The more of it, the better," Cunningham said. "We're searching under every rock for non-traditional counterparties, and for those that can use this from a clearing perspective, that's great."