The Federal Reserve Bank of New York published the research paper, "The Risk of Fire Sales in the Tri-Party Repo Market" earlier this week. The Abstract says, "This paper studies the risk of "fire sales" in the tri-party repo market, a large and important market where securities dealers find short-term funding for a substantial portion of their own and their clients' assets. We distinguish between fire sales of assets by a dealer who, facing a run that could lead to default, sells securities to generate liquidity, and fire sales of assets by repo investors after a dealer's default has occurred. While fire sales do cause damage no matter how they arise, the tools available to lessen the harm from the two types of fire sales are different. We find that limited tools are available to mitigate the risk of pre-default fire sales and that no established tools currently exist to mitigate the risk of post-default sales."
The paper explains, "The risk of "fire sales," rapid sales of assets in large amounts that temporarily depress their market prices, is a major source of financial instability. Policymakers' concern for fire sales was one of the driving forces behind the creation of the Term Securities Lending Facility and the Primary Dealer Credit Facility in 2008. Fire sales can amplify problems faced by a financial firm because the reduced sale price of the assets can result in realized losses that lead to a decrease in capital and the possible need for additional asset sales. Excessive sales by a single firm can also propagate stress to other institutions if they face margin calls and are forced to sell assets. The presence of such externalities suggests that market outcomes may not be efficient. As a consequence, mitigating the risk of fire sales is an important objective in the effort to promote financial stability."
The NY Fed's research tells us, "In this paper, we discuss the risk of fire sales in the tri-party repo market, a large and important market where securities dealers find short-term funding for a substantial portion of their own and their clients' assets. Because of the size of this market and the fact that some of its participants are vulnerable to runs, fire sales are particularly likely in this market. They can result if a securities dealer defaults and its secured creditors decide to liquidate the collateral -- or even in the absence of a formal default if funding becomes difficult to obtain, spurring a rapid reduction in positions."
It adds, "Fire sales are one of the three systemic risk concerns highlighted in a May 2010 whitepaper by the Federal Reserve Bank of New York on tri-party repo infrastructure reform (Federal Reserve Bank of New York, 2010). These three risks are 1) the market's excessive reliance on clearing-bank provision of intraday credit to complete settlement, 2) poor liquidity and credit risk management practices on the part of various classes of tri-party repo market participants, and 3) the absence of any mechanism to mitigate the risk of fire sales of collateral in the aftermath of a large-dealer default."
The paper tells us, "Progress is being made in addressing two of these three risks. Industry work currently under way will result in sharply reduced intraday credit usage by the end of 2014. The required behavioral and process changes associated with this reduction are also expected to bring improvements in market participants' risk management practices. However, these efforts will not mitigate the risk of fire sales of tri-party repo collateral in the event of a large dealer's default on its repo obligations. Fire sales remain a concern of regulators; the 2013 report of the Financial Stability Oversight Council points to the vulnerability of the wholesale funding markets to runs that can lead to destabilizing fire sales. Also, a recent speech by New York Fed President William C. Dudley at the 2013 Annual Meeting of the New York Bankers Association focused on the danger of spiraling asset sales during the crisis."
Finally, the NY Fed research says, "In this paper we argue that, in the tri-party repo market, it is important to distinguish between fire sales of assets by a dealer who, facing a run that could lead to default, sells securities to generate liquidity, and fires sales of assets by repo investors after a dealer's default has occurred. While fire sales do damage no matter how they arise, the tools available to lessen the harm from the two types of fire sales are different. The risk of pre-default fire sales by dealers comes from the fact that dealers perform maturity and liquidity transformation (explained in more detail later), and they cannot expect to liquidate longer-maturity assets as quickly as their short-term funding may evaporate. In contrast, the risk of post-default fire sales by counterparties to a defaulted dealer is posed by the exemption from the automatic stay of bankruptcy that repo contracts enjoy, which means creditors may immediately take possession of collateral in a bankruptcy. While this exemption is very important for the secured funding model, the lack of a process, or mechanism, to ensure an orderly disposal of the assets collateralizing repos across all creditors of a defaulting dealer could lead to rapid sales, price dislocations, and a deleveraging spiral."
