10 events that changed the repo market

From the Federal Reserve to Dodd-Frank, the repo market has evolved

1. The Federal Reserve and the creation of Repo market 1917

The modern use of Repo financing began shortly after the U.S. entered World War I in 1917. The Federal Reserve was created three years earlier in 1914, and part of it’s mandate was to “provide an elastic currency,” which included providing liquidity to the banking system. During its first few years, injecting cash into the system exclusively involved the “rediscounting” of commercial paper; the Fed loaned money to banks using commercial paper as collateral. With the growing issuance of Liberty Bonds by the U.S. government, banks began presenting government securities to the Fed for rediscounting. Soon after, the Repo market for government securities was born.

2. Drysdale: Reforming the Repo market 1982

Before 1982, “accrued interest” was ignored by Repo market participants for trade pricing, and the bankruptcy court system was not sure whether a Repo was a collateralized loan or a sale and a buy-back. 

David Heuwetter, the head trader at Drysdale Government Securities, put together a scheme to take advantage of differences in the market convention between outright Treasury transactions and Repo pricing. He short-sold U.S. Treasurys outright, where he received the price plus the accrued interest, then borrowed the securities to cover his short in the Repo market, paying only the market price. The scheme allowed him the full use of the accrued interest on the bonds at no cost.

By May 15, 1982 Heuwetter was wiped out and didn’t have enough money to make coupon payments. But the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate it in the event of a default. There was no law on books differentiating a Repo from a collateralized loan, and a case was never tested in court. The market was unsure whether they could liquidate the Drysdale Repo trades.

After Drysdale’s collapse, the Primary Dealer’s Association formally adopted accrued interest pricing and by October 1982, the New York Fed ordered accrued interest to be included on all Repo trades, moving to “full accrual pricing.” But the story still didn’t end.

The government securities and Repo markets were frozen. In September 1982, the Federal Bankruptcy Court of New York ruled that a Repo was a separate buy and sell transaction, meaning it was not a collateralized loan. The court recognized that allowing prompt liquidation was necessary to continue the orderly functioning of the market. Two years later, in 1984, Congress passed an extension of the Federal Bankruptcy laws so that Repo on Treasurys, Federal Agencys, CDs and BAs were exempt from automatic stays in a bankruptcy by law. 

3. Broker-Dealer bankruptcies and the creation of Tri-Party 1985

Surprisingly, it took the bankruptcies of an assortment of small government bond dealers in the 1980s to create the Tri-Party market. As “customers” were entering the Repo market in the early 1980s, they routinely gave their cash to securities dealers to hold in a safekeeping account. Sometimes called “Hold-In-Custody” (HIC) Repo and unaffectionately known as “trust me” Repo. The cash investors had a lot of faith in their securities dealers, trusting them to hold the cash, hold the securities, and price the securities accurately. As it turned out, many of those small bond dealers end up defaulting and abusing the collateral deposits. Lombard-Wall, Lion Capital Group, E.S.M Government Securities, RTD Securities and Bevill Bresler and Schulman Group were some of them. Between 1977 and 1985, failures by government bond dealers resulted in almost $1 billion in losses.

Not surprising, customers were unwilling to invest their cash in “Hold-In-Custody” Repo after 1984. The Street had a major problem, HIC Repo was an easy source of funding for dealers and good investment for cash customers. The Street needed a safer way of transacting safekeeping Repo and they realized an agent was needed to stand in between the cash provider and the securities provider. A few dealers approached a clearing bank to set up “safekeeping” arrangements where the bank would act as a joint custodian in the transaction. Some time in 1985 or 1986, the Tri-Party Repo market was born.

4. Central clearing of Repos 

In the 1990’s, the Repo market began to see the need for a Central Counterparty (CCP). Before the CCP, dealers were “grossing up” their assets with inter-dealer trades spread across the entire market in a web of trades. Once the CCP was established, it allowed offsetting trades to net moving from a gross to net asset business. 

In the mid 1990s, two rival clearing houses, Delta Clearing Corp. and Government Securities Clearing Corp. fought for control of the Repo market between 1997 and 1999. Back then, when you traded on the broker screens, you had three options: “Give-up,” “GSCC,” or “Delta.” By 1999, all dealers and liquidity migrated to GSCC. Delta Clearing 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 is now the market standard.

5. Brokertec And Electronic Trading

With the dawn of the internet age in the late 1990s, electronic trading platforms began to develop. The first one to hit the Repo market was Brokertec, backed by broker ICAP. Up until then, voice brokering was the heart and soul of the Repo market. The Repo market was more personal, with information passing through the brokers and well as red wine and steaks passing through the traders.

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