Significant work to be done to reduce the risks of fire sales in repo: Fed’s Dudley
(Reuters) – Participants in the $5 trillion repurchase agreement market need to work harder to develop solutions that reduce the risks the market poses to financial stability, or regulators may need to intervene, New York Federal Reserve Bank President William Dudley said on Friday.
The NY Fed hosted a conference on Friday to discuss ways to reduce the risks from fire sales in repo, which can happen when a dealer comes under stress and dumps assets in a bid to shore up its liquidity. When this occurs, falling asset values can hurt other firm that also hold them, creating a chain of selling.
“Significant work remains to be done” to reduce the risks of fire sales in repo, Dudley said.
In repurchase agreements lenders, such as money funds, make short-term loans to banks or other borrowers and receive collateral such as Treasuries or other bonds to back the loans. Banks then often make similar loans to leveraged investors such as hedge funds that money funds won’t lend to, in what they term a “matched book.”
Those hedge funds often use the loan to enter a highly leveraged trade, which can exacerbate a fire sale if one of these funds comes under stress. Worries over a fire sale of collateral against repos at Long Term Capital Management (LTCM) when it almost defaulted in 1998 led to a group of banks having to purchase the fund and then slowly unwind the firm.
Dudley said industry participants have “yet to fully embrace” their need to develop solutions, and warned that if they are unable to reduce the risks, regulators may have to use other tools to address the problem, a move that he noted could also have unintended consequences for the industry.