Fed group eyes insurance fund for key market

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Banks, investors and industry groups last week discussed creating a backstop insurance fund among other proposals to lessen the risk a distressed dealer could trigger a crisis in the world's largest funding market.

The discussions took place at a New York Federal Reserve sponsored industry workshop last Wednesday, according to presentations obtained by Reuters.

Participants in the tri-party repurchase market -- a key funding source that briefly seized up during the financial crisis -- have been tasked by the central bank with coming up with reforms to strengthen the market which, at its peak, financed more than USD 2.8 trillion in securities per day.

The market has shrunk from that level since there are now less participants and dealers. It is still the critical finance market for the broader financial system.

Repos, or repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often U.S. Treasuries. In the tri-party repo market, clearing banks JPMorgan Chase & Co and Bank of New York Mellon Corp facilitate trades between counterparties and hold collateral.

After Bear's collapse, the Fed put in place an emergency lending facility for primary dealers. The facility helped stabilize the repo market but was only a temporary fix. It was authorized under a provision of the Federal Reserve Act that allows such lending only when financial conditions are deemed "unusual and exigent." The facility expired on February 1.

A key aim for the reforms currently under discussion is to ensure the central bank only has to intervene very rarely as a lender of last resort.

TWO PROPOSALS

The market participants on Wednesday discussed two main proposals for dealing with a defaulted dealer, according to the presentation documents.

Under the first proposal, a so-called emergency bank would step in as a counterparty on a defaulted dealer's trades to provide temporary liquidity to the dealer's lenders. Losses would ultimately be guaranteed by an insurance fund similar to the Federal Deposit Insurance Corp which provides insurance against failed banks.

All dealers would contribute to this FDIC-like fund, paying premiums assessed according to their portfolios and the duration of their tri-party trades, according to the documents.

One concern with this proposal is that establishing a backstop might create an environment in which investors take more risk, according to the documents.

Under the second proposal, a special purpose vehicle (SPV) would take on the troubled portfolio, acting as a new counterparty. Holders of notes issued by the SPV would then ultimately finance the losses of lenders to the defaulted dealer.

In both cases, one of the first lines of defence would remain the margin charges assessed by lenders that determine how much collateral dealers must put up against trades. The Fed's taskforce is separately looking into improving margin practices, according to the documents.

The tri-party repo reform task force released initial proposals in December that were focused primarily on operational changes. In a statement on Thursday it said it will release further reform proposals in the first half of 2010.

The group hopes to finish its report by the end of March, according to the documents.

A spokesman for the Federal Reserve Bank of New York said in a statement, "We are encouraged by the progress of the task force to date and the commitment of all participants in their work on these and other repo market-related issues."

"We look forward to the final results of this exercise in the coming months," said the the spokesman, Jeffrey Smith.