Fire sales in securities financing markets October 31, 2013 at 9:22 am

Jeremy Stein, Governor of the NY FED, gave an interesting speech at their recent workshop on Fire Sales as a Driver of Systemic Risk in Triparty Repo and other Secured Funding Markets (HT FT Alphaville). He gave two examples of the kind of situation that worries the FED.

Example 1: Broker-dealer as principal

In this first example, a large broker-dealer firm borrows in the triparty repo market–from, say, a money market fund–in order to finance its own holdings of a particular security. Perhaps the broker-dealer is acting as a market-maker in the corporate bond market, and uses repo borrowing to finance its ongoing inventory of investment-grade and high-yield bonds. In this case, the asset on the dealer’s balance sheet is the corporate bond, and the liability is the repo borrowing from the money fund.

Example 2: Broker-dealer as SFT intermediary

In this second example, the ultimate demand to own the corporate bond comes not from the dealer firm, but from one of its prime brokerage customers–say, a hedge fund. Moreover, the hedge fund cannot borrow directly from the money market fund sector in the triparty repo market, because the money funds are not sufficiently knowledgeable about the hedge fund to be comfortable taking it on as a counterparty. So instead, the hedge fund borrows on a collateralized basis from the dealer firm in the bilateral repo market, and the dealer then turns around and, as before, uses the same collateral to borrow from a money fund in the triparty market. In this case, the asset on the dealer’s balance sheet is the repo loan it makes to the hedge fund.

The problem is that in both cases if the counterparty fails to perform, the broker/dealer will have to sell the bond, and that ‘fire sale’ could force down prices.

Clearly, there is the potential for fire-sale risk in both of these examples. One source of risk would be an initial shock either to the expected value of the underlying collateral or to its volatility that leads to an increase in required repo-market haircuts (e.g., the default probability of the corporate bond goes up). Another source of risk would be concerns about the creditworthiness of the broker-dealer firm that causes lenders in the triparty market to step away from it.

In either case, if the associated externalities are deemed to create significant social costs, the goal of regulatory policy should be to get private actors to internalize these costs.

Stein then mentions three regulatory tools for addressing this, but I’d add a fourth: a market market of last resort function. Someone – perhaps the central bank or a CCP (who can via their rules strongly incentivise members to bid in an auction) or another market stabilisation body – needs to be able (1) to bid on these collateral portfolios and (2) be credibly capitalised and funded so that it can hold them until the concern of a fire sale no longer pertains.

One might for instance imagine – hypothetically – a fund being set up which was capitalized by fees paid by SFT market participants and which had suitable committed credit lines (ideally with retail rather than wholesale banks) that it could drawn down substantial extra funds. In ordinary times this fund would do nothing, but in crisis it would undertake to bid on and hold defaulter’s collateral pools. The right fees to charge – the internalization of the externality – would be the ones needed to (a) get a AAA rating for the fund and (b) pay the commitment charges on the credit lines in a suitable size (at least $50B, I would guess). The point is that even if you don’t do this, thinking about what it would cost to do it is a way of estimating the cost of the externality.

One Response to “Fire sales in securities financing markets”

  1. All of these regulatory regimes are predicated on qualifier ‘if the associated externalities are deemed to create significant social costs’. What about a regime in which banks/hedge funds/etc. who use irresponsible amounts of leverage are impoverished, while prudent asset managers are enriched at their expense.

    The trade off is additional reforms and regulation paired with implicit guarantees and bailouts. The net effect of the trade off is the unintended consequence that any risky behavior not specifically proscribed ends up being encouraged.

    The best analogy is to forest fires — the way to prevent the gigantic ones is to let the small ones burn.