EVOLUTION OF REPO CONTRACTING CONVENTIONS IN THE 1980S, THE

Economic Policy Review - Federal Reserve Bank of New York, May 2006 by Garbade, Kenneth D

* The growth of the repo market, new uses for repos, and the appearance of previously unappreciated risks led to dramatic changes in repo contracting conventions in the 1980s.

* The changes included recognition of accrued interest on repo securities, a revision to how federal bankruptcy law applied to repos, and the faster growth of tri-party repo-a new form of repurchase agreement.

* Individual market participants, motivated largely by profit, hastened the growth of tri-party repo.

* Because uncoordinated, individual solutions would have been too costly, market participants took collective action to bring about the recognition of accrued interest on repo securities and petition Congress to amend federal bankruptcy law.

1. INTRODUCTION

Repurchase agreements, or repos, play an important role in U.S. securities markets. securities dealers use repos to finance market-making and risk management activities, and the agreements provide a safe and low-cost way for mutual funds, corporations, and others to lend both money and securities. At the end of 2004, primary dealers with a trading relationship with the Federal Reserve Bank of New York were borrowing a total of $3.2 trillion on repos and lending a total of $2.4 trillion. Repurchase agreements also play an important role in the implementation of monetary policy-the Federal Reserve uses them to dampen transient fluctuations in the supply of reserves available to the banking system. In 2004, the New York Fed's Trading Desk arranged 192 overnight repos, with an average size of $5.9 billion.

A repo is a sale of securities coupled with an agreement to repurchase the securities at a specified price on a later date. It is analogous to a loan, in which the proceeds of the initial sale correspond to the principal amount of the loan and the excess of the repurchase price over the sale price corresponds to the interest paid on the loan. A market participant might, for example, sell securities for $10 million and simultaneously agree to repurchase them ten days later for $10,005,555. As Exhibit 1 shows, this is comparable to borrowing $10 million for ten days at an interest rate of 2 percent per annum. If the borrower fails to repurchase the securities, the creditor can sell them to a third party and use the proceeds to satisfy its claim for repayment. Conversely, if the creditor does not return the securities to the borrower, the borrower can use the funds that it otherwise would have repaid to the creditor to replace the securities.1

Repos have a long history. Federal Reserve Banks used them to extend credit to member banks as early as 1917, when a wartime tax reduced the attractiveness of rediscounting commercial paper.2 During the 1920s, the New York Fed used repurchase agreements to extend credit to nonbank dealers in bankers' acceptances to encourage the development of a liquid secondary market for acceptances. Repos fell into disuse during the Great Depression and World War II, but reappeared following the restoration of Federal Reserve control of monetary policy in 1951.4

Contracting conventions for repurchase agreements hardly changed between the revival of repos in the early 1950s and 1981. However, they began to change dramatically in 1982. The collapse of Drysdale Government Securities, a midsized dealer, in May of that year led to an important change in the treatment of accrued interest on repo securities. The collapse of a second dealer, Lombard-Wall, three months later prompted an equally important change in the application of federal bankruptcy law to repos. Additional dealer failures in 1984 and 1985 accelerated the growth of a new form of repo, tri-party repo.

This paper examines how repo contracting conventions evolved in the 1980s. In the next section, we consider the revival of repo financing in the 1950s and the contracting conventions associated with that revival. Section 3 describes how the rising level and volatility of interest rates and growing Treasury debt fueled a significant expansion in the size of the repo market in the 1970s and early 1980s, as well as an important change in how market participants used repos. Existing contracting conventions proved inadequate for the expanding and changing market. Sections 4,5, and 6 describe how new and previously unappreciated risks led participants to modify those conventions.

Understanding how repo contracting conventions evolved in the 1980s is important for two reasons. First, the evolution illustrates how contracting conventions that are efficient in one market environment may need to be revised when the environment changes. The experience with repurchase agreements suggests that revisions may sometimes come slowly and only in the wake of "precipitative events" that focus attention on inefficient practices.5 Second, the evolution demonstrates that institutional arrangements can change in a variety of ways. The growth of tri-party repo followed from the autonomous adoption of a more efficient contract form by individual market participants acting in their own economic self-interest. In contrast, the change in the treatment of accrued interest was the result of collective action by the major government securities dealers and the change in bankruptcy law was brought about by market participants seeking relief in the form of Congressional legislation, because in both cases uncoordinated, individual action would have been more costly.