FICC Tackles Surge in Repo Collateral Substitutions In U.S. Government Securities Market
In response to continued growth in the repurchase agreement (repo) market and dramatic increases in the number of collateral substitutions involving U.S. Government securities, the Fixed Income Clearing Corporation (FICC), a DTCC subsidiary, is implementing a series of systems enhancements to improve the efficiency of the collateral substitution process and, ultimately, remove inter-dealer brokers from the process.
The need for these enhancements became clear on June 30 last year, when FICC experienced a significant spike in requests for collateral substitutions on outstanding repos for U.S. Government securities. (Repos allow financial firms to use securities as collateral in secured cash borrowing transactions-please see box on page 14 for more on repos.)
More than 500 repo substitution requests in excess of $130 billion in collateral poured into FICC that day from inter-dealer brokers – a 70% surge over the previous quarter-end requests. Substituting repo collateral involves manual processes in close coordination with participants. Not surprisingly, the surge of requests created challenges in processing this record number of substitutions. It resulted in an extension of FICC’s collateral substitution deadline, and ultimately caused an extension of the Fedwire close.
FICC immediately began preparations for the end of the next quarter, anticipating even larger volumes in substitution requests. First, it reached out to participants and convened a Repo Substitutions Working Group. The group consisted of representatives from clearing banks, dealers, and inter-dealer brokers. Together with the working group, FICC identified several initiatives aimed at potentially reducing the total number of substitution requests and improving the overall efficiency of the collateral substitution process.
“Helping ensure the continued growth and liquidity of the repo market is mission-critical, and one that FICC is ideally suited to,” said Jeff Ingber, DTCC managing director and general manager of the Fixed Income Group. “Right after the June spike, we started digging into what was going on with all the substitution requests and working on a solution.
“Part of the fix involved making certain internal processing enhancements, which proved invaluable to us in managing the September quarter-end. In fact, due to the changes we instituted, FICC was able to process 40% more substitution requests that day than the previous peak in June,” he said.
High-volume days are nothing new. But what is new is how high the spikes are and how regularly they are occurring. Clearly, part of the reason for the surge in collateral substitution requests can be traced to the popularity of repos themselves. Repos represent a significant portion of the transactions submitted to FICC. Each day, FICC processes more than $1.5 trillion in repo trades in U.S. Treasury bills, bonds, and other securities.
Solutions
FICC’s initial response was to evaluate its current procedures, looking for ways to streamline processes. “In addition to our own internal systems enhancements, which make it easier and faster for us to process requests, we wanted to go deeper to determine what we could do to improve the substitution process on the participant end as well,” said Rachel Tyler, director, FICC Planning Division. “We identified the street’s increased use of forward-starting general collateral repos as a financing tool and a possible cause of the growth in substitutions.” (Forward-starting repos are contracts where settlement of the start-leg occurs one or more business days after trade date.)
FICC then focused on helping customers “pair off” forward-starting repo trades. The idea is that if customers have the ability to recognize offsetting, forward-starting repo and reverse trades executed with the same counterparty, they could elect to pair off these trades prior to their start date. Pairing off would eliminate the need for participants to allocate collateral, thereby potentially reducing further collateral substitution requests throughout the life of the trade.
In late March 2005, FICC introduced a new tool to help customers meet that need. The tool is in the form of two reports that are published daily in the FICC Report Center, an extranet portal for FICC customers. The first report displays a listing of a participant’s outstanding forward-starting general collateral trades sorted by contra party, and subsequently by generic CUSIP. The second report provides the same information in a file that customers can download into an Excel spreadsheet.
“Everyone should take a look at these reports and execute potential pair-offs where possible with their brokers,” said Joe Hoermann, senior vice president at Tullett Liberty Brokerage, Inc. “This will do away with the need to allocate collateral and make substitution requests for these repos on start date and reduce the overall amount of securities that need to be moved street-wide.”
In addition to the reports, FICC is finalizing another solution to allow customers to allocate collateral on forward-starting repos prior to their start date. Customers who “pre-allocate” collateral would be eligible for FICC’s netting service, whereby offsetting deliver and receive obligations resulting from forward-starting trades are aggregated to establish a single net settlement position.
In instances where flat net settlement positions are established, customers would not have to deliver securities to FICC. That, in turn, would lead to fewer collateral allocations on substitution date, therefore, allowing participants to focus exclusively on the substitution process. Rollout of the pre-allocation service is expected in June.
By early 2006, FICC is also working to support the ability of repo brokers and dealers to make repo collateral substitution requests to FICC without having to simultaneously submit replacement collateral details. Upon receipt of a request indicating only the original collateral, FICC will automatically identify the associated reverse repo and create delivery instructions to immediately return collateral to the repo dealer. This proposal aims to spread out broker processing across the business day and ease substitution request volume at the trading deadline.
“With spikes in the number of requests for repo collateral substitutions quickly becoming the norm rather than the exception,” Ingber said, “the FICC will continue to work with our customers and the industry to look for new ways of meeting this challenge. Our ultimate goal is to develop a service that allows repo dealers to submit collateral substitution directly, effectively taking the inter-dealer brokers out of the collateral substitution process.” @
[Editor’s Note: Customers interested in learning more about FICC’s collateral substitution processing enhancements should contact FICC Client Support at 212-855-7651/7652.]