From the June 01, 2012 issue of Futures Magazine • Subscribe!

Why the swaps market will follow the repo model

Benefits of the CCP

In the 1990s, the repo market saw a definite need for a CCP. Previously, dealers were “grossing up” their assets. Inter-dealer trades were spread across the entire dealer community in a web of trades. Once a CCP was established, inter-dealer trades moved to one central CCP, allowing offsetting trades to net. Consequently, the repo market enjoyed a significant boost, moving from a gross to net asset business.

To understand the netting process, you must look at the before and after. Suppose Goldman Sachs owned $100 million of a U.S. Treasury bond that they loaned to Salomon Brothers, who in turn loaned it to Paine Webber, who then loaned it to Dean Witter. Each firm had $100 million in assets and $100 million in liabilities on their books. In total, there were $400 million in assets and $400 million in liabilities. 

Now, here is the same transaction today with clearing. Goldman Sachs still owns $100 million of a U.S. Treasury bond and loans it to Citibank, who loans it to UBS, who loans it to Morgan Stanley. Morgan Stanley has $100 million in cash and holds the Treasury collateral against its cash investment. At the end of the day, there are only two trades that exist “on balance sheet:” 1) a trade between Goldman Sachs and the CCP and 2) a trade between the CCP and Morgan Stanley. Goldman Sachs has a repo with the CCP and Morgan Stanley has a reverse-repo with the CCP. The transactions net off the balance sheets of the two other banks and overall industry assets are cut in half.

Evolution of the repo market

Simply put, it was a dealer world. The repo market originally was based on a traditional dealer-customer model. It was dominated by the large dealers who maintained significant barriers to entry. The dealers were the “Primary Dealers” recognized by the Federal Reserve (see “Insiders,” below). They were allowed to buy securities at auction and trade directly with the Fed.

The primary market was established by the Fed, and only recognized Primary Dealers could buy Treasury securities at auction. The secondary market was OTC and traded through the Inter-Dealer Brokers (IDBs). It was protected by the market participants who limited access to the IDB market. Some broker-dealers and large banks were “allowed” to act as dealers and market makers, but they could not trade directly with the Fed. 

In the 1990s, IDBs provided voice execution for U.S. Treasury, agency, repo and other bond trading. The IDBs did no principal transactions, they simply arranged the trade and brought buyers and sellers together. IDBs acted as “give ups,” meaning the counterparty’s name would be “given up” to the other counterparty. As a result, Primary Dealers knew their counterparty. That knowledge allowed them to enforce access to the trading screens.

The brokers naturally wanted to expand their business and allow as many participants as possible to access their markets. However, only Primary Dealers were allowed to trade on the IDB broker screens. Primary Dealers controlled enormous trading volume, which they used to limit market access. For example, if an IDB tried to book a trade with a new institution, one or more Primary Dealers would threaten to “pull” their business. The broker was left with an easy decision. They could do business with a new small dealer who might generate $500 million a day in volume or continue to do business with a major dealer, perhaps generating $20 billion a day in volume. The Primary Dealers always won. 

“Central Clearing,” as the name implies, works best when there’s only one central clearinghouse. In the mid 1990s, two rival clearinghouses, Delta Clearing Corp. and Government Securities Clearing Corp. (GSCC), fought to become the preeminent repo clearinghouse.

Delta was owned by two IDB brokerage firms, Intercapital Group Ltd. and EXCO plc. It was first incorporated as Delta Government Options Corp. in 1988. At the time, they provided counterparty clearing for OTC U.S. Treasury options. In 1996, they changed their name to Delta Clearing Corp. to reflect the broader range of clearing services, including repos. 

GSCC was established in 1986 as a subsidiary of the National Securities Clearing Corp. to provide general clearing and settlement services for U.S. Treasuries. They entered the repo clearing business in the mid-1990s. They were purchased by Depository Trust Clearing Corp. (DTCC) in 2002 and became FICC. 

Delta and GSCC were competing for dominance of the repo clearing business between 1997 and 1999. Back then, when you traded on the broker screens, you had three options: Give-up, GSCC or Delta. Because the same security could be cleared three separate ways, it created a distortion in the market. A dealer might bid for a security on the GSCC line at the same rate as the offered side on the Delta clearing line. Sometimes the give-up market traded through the GSCC or Delta market. 

By 1999, all dealers and liquidity migrated to GSCC. Delta and “give-up” markets were dropped. Today, any bank trading on the broker screens must be a member of FICC. GSCC won the CCP battle and now is the market standard.

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