Valuing the Risk: FICC Proposes Rule Change to Protect Against Repo Volatility
On Tuesday, June 29, 2022, the Fixed Income Clearing Corporation (“FICC”) filed a rule change proposal (the “Proposal”) with the U.S. Securities and Exchange Commission (“SEC”) to amend the required margin requirements for FICC Members participating in the clearing operations of the FICC’s Government Securities Division (“GSD”), specifically by revising the formula used to calculate the amount of margin needed (the “VaR Charge”) in light of the potential volatility of the interest charged on repurchase agreement financings. That Proposal was published by the SEC on Tuesday, July 12, 2022, “to solicit comments” on the Proposal. Repurchase agreements, known as Repos, are short-term financings critical to the orderly operation of American and global capital markets.
I have written frequently about Repos and their importance to the smooth functioning of those markets; see, for example, my Dec. 9, 2019 Blog “SOFR and the Shutdown of Overnight Repos: What Happens If There Is Nothing to Measure?”; and my Aug. 10, 2021 Blog “Improving the Plumbing: The Fed Responds to the Group of 30 and Creates Two Standing Repo Facilities.” Repo interest rate volatility was the focus both of the response of the Board of Governors of the Federal Reserve System (“FRB”) to the interest spike on overnight repos in September 2019 (after suddenly climbing towards 10% in less than a week, the FRB had to inject $80 billion to increase market liquidity and cause the rate to return to normal levels), and in March 2020 (in the face of Covid and the economic shutdown, the market for repos froze until the FRB created special liquidity facilities). It was this second occurrence that led to the July 28, 2021 report from the Group of 30, which in turn led to the FRB’s action to create two standing repo facilities, one a $500 fund for domestic entities, the other for foreign and international monetary authorities with a $60 billion limit for participants.
I have also written frequently about clearing agencies and the key role they play as intermediaries in trading securities in the capital markets. My April 29, 2021 Blog “Tightening the Reins: SEC Approves Proposed Rule Change to Clearing Agency Investment Policy” includes a history of the development of clearing agencies in the U.S. as a result of the “back-office” paperwork turmoil arising from the growth in the volume of trading in the 1960’s. This eventually led the holding company formed in 1999, Depository Trust and Transfer Corporation (“DTTC”), to create FICC in 2003 as a DTTC subsidiary dealing with fixed income, as opposed to equity, securities. In that Blog, I introduce the reader to the existence of the GSD, which focuses primarily on the trading of Treasuries and other Government securities, and “whose regulatory positions are not necessarily congruent with those of the FICC.” The FICC (other than the GSD) must also accommodate the extensive trading in corporate debt securities.
Concerns about the financial stability of the FICC, given the potential for wide swings in market prices and interest rates in these securities (as laid out in extraordinary detail in “Manias, Panics, and Crashes” by Robert Z. Aliber and Charles P. Kindelberger, 7th edition 2015), and especially with regard to the repo market, any number of third parties have urged the FICC to adopt greater “buffers” against a possible Member default or other inability to perform FICC’s clearing function. This concern has already been addressed by FICC’s sibling that clears trades in equity securities, the National Securities Clearing Corporation (“NSCC”), as laid out in my May 27, 2021 Blog “’Margin, I Have to Have More Margin’: the National Securities Clearing Corporation Proposes to Increase the Minimum Required Fund Deposit.” NSCC took this step because NSCC determined that the aggregate of the then Minimum Required Fund Deposits was “insufficient to manage NSCC’s risk in the event of an abrupt or sudden increase in a Member’s activities.”
See also in connection with FICC and repos, my June 8, 2021 Blog “Fixing FICC: Agency Proposes Rule Changes to Encourage More Repo Clearing” and my Aug. 10, 2021 Blog “Improving the Plumbing: The Fed Responds to the Group of 30 and Creates Two Standing Repo Facilities.” The FRB’s actions, summarized above, were a “response” to a July 28, 2021 Group of 30 Report entitled “U.S. Treasury Market: Steps Toward Increased Resilience,” which discussed the “fragility” of the multi-trillion dollar market for Treasury securities, and especially as they are used as the securities subject to repurchase agreements. In a similar vein, my Dec. 9, 2021 Blog “Call the Plumber: Bank for International Settlement and IOSCO Call for Reforms” addressed the issue of “portability,” i.e., “the relative ability to move a client’s clearing operation to another clearing agency in the event of a default or other inability of a clearing agency to function.” The Bank for International Settlement (“BIS”) was organized in Basel, Switzerland, on May 17, 1930, after World War I, and the inception of the Great Depression, in an effort to provide an international body that might ameliorate, if not deter financial collapses. IOSCO which is the acronym for the International Organization of Securities Commissions, was founded in 1983 in Madrid, where it is headquartered, to bring together the world’s securities regulators from over 130 jurisdictions, representing over 95% of those regulators, and acts as a setter of global standards. IOSCO has been endorsed by the G-20 Nations, the International Monetary Fund, and the World Bank.
As we have learned from unpleasant experiences, financial institutions can, indeed, collapse (see “Manias, Panics and Crashes” by Aliber and Kindelberger). Those concerned about the working of the financial system have spent a great deal of attention on creating “buffers” against loss. So in the aftermath of the Great Recession of 2007-2009, the U.S. Congress passed the Wall Street Reform and Consumer Protection Act (known as the “Dodd-Frank Act”), signed into law on July 21, 2010, which calls for periodic “stress tests” of major banks and other key financial institutions. Those tests evaluate the institutions’ consolidated losses, revenues, and balance sheets under different macroeconomic scenarios to assess whether the institutions have sufficient capital to survive and even prosper if one of those scenarios should occur.
Similarly, the Basel Committee on Bank Supervision of the BIS, in the years after 2007, developed a series of three different recommendations to tamp down the risk of a financial crash. These Basel Accords, as they are known, also sought to enhance the capital reserves of banking and other financial institutions in order to survive moments of stress. See for example my March 23, 2021 Blog “Swiss Miss: The Fed, Basel III, and SLR,” which noted the Committee’s “insistence on stability sought by the requirements of Basel III,” which I suggested might in fact turn out to be a “Maginot Line.”
What then does FICC propose now? The Proposal explains that “repo interest” is “the difference between the repurchase settlement amount and the start amount paid on the repo inception date,” in other words the interest is the greater amount paid at the end of the transaction when the repo security is “sold back” to the initial seller, compared to the amount paid to the seller of the security by the buyer at inception. As noted in the Proposal, “the FICC guarantees that the borrowers receive their repo collateral back at the close of the repo transaction while lenders receive the start amount paid on the repo inception date plus repo interest.” The Proposal further notes that the “…market value of interest payments for the remaining life of the repo trades are subject to the risk of movements of the market repo interest rates,” as occurred most tellingly in September 2019, as discussed above.
FICC imposes a repo interest volatility charge to “mitigate such risks,” which the Proposal notes is currently computed on the assumed basis period of three days. Using that assumed basis, the VaR is currently calculated for each Member taking into account a “haircut schedule” for each “risk bucket “ of all of a Member’s repo transactions (after netting short and long repo interest positions) in that bucket. In order to introduce “more flexibility…so FICC can respond to rapidly changing market conditions more quickly.” Under the Proposal, the VaR would, in the future, be calculated using a “haircut schedule” based on whether each individual repo transaction in a “risk bucket” is long or short.
The FICC uses regular “back-testing” on a running 12-month basis to check whether the repo interest risk “reserve” provides at least 99% coverage of that risk. In 2020 and 2021, the 99% level of coverage was not maintained; indeed, the coverage was as low as 98.7% for some of that period. The FICC conducted a study (the “Impact Study”) for the period January 2018 to February 2022 and found that the proposed changes to the VaR, had they then been in place, would have affected 90 out of 145 (approximately 62%) of the portfolios of the GSD Members each day. The Impact Study further found that the daily margin increase would have been about $0.7 million and that the proposed change would result in an aggregate average daily VaR increase of approximately $86 million.
The Proposal acknowledges that the proposed changes may have an adverse impact on Members, as some Members would have to post higher margin amounts. This development might make the affected Members less attractive to potential counter-parties. However, the Proposal goes on to state that the proposed changes in margin requirements “would lead to better risk management practice because it would enable FICC to refine its calculation of the repo interest volatility charge in response to fast-changing market conditions.” FICC further notes that “these proposed changes have been specifically designed to assure the safeguarding of securities and funds which are in the custody and control of FICC.”
The SEC will act on the Proposal within 45 days of its publication in the Federal Register unless that period is extended up to 90 days. The Commission may approve or disapprove of the Proposal, or institute proceedings “to determine whether “the Proposal should be disapproved. If approved, the rule change set out in the Proposal will apparently increase the “buffer” available to FICC, if FICC has to deal with a dysfunctional occurrence involving a Member of the GSD. It will be interesting to review the comments of Members to the Proposal – it may be that there are unsuspected weaknesses in its design.