The simplest way to understand a tri-party repo (TREPS) is to think of it as a simple repurchase agreement between two parties, where a third-party – historically a very large and reputable bank (only JPM Chase or BNY Mellon, during the time these transactions were widely common) – processes administrative work and even guarantees the cash provided by Company A to Company B and the collateral Company B secures the cash from Company A with. These third parties, commonly referred to as clearing banks, also performed valuation services to ensure the collateral put up by Company B was within the approximate fair market value of the cash lent by Company A.
Tri-Party Repos in the Derivative Era
These transactions actually became popular at the “boom” of the derivative trading era – even though they had a comparatively low-yield percentage for both companies – mainly because of mechanics of how these transactions occurred. They were typically cleared and settled overnight, so the investment banker would have the cash available in the morning when the trading day began. The “unwinding” process of this repo would also happen after the trading day was complete; the dealer (Company B) would finance the broker (Company A) with cash and the third-party clearing bank would take care of the rest for a small fee.
To be clear, the responsibilities of the clearing banks weren’t minuscule, they were tasked with: taking custody of the securities involved in the repo, valuing the securities and making sure that the specified margin is applied, settling the transaction on their books, and offer services to help dealers optimize the use of their collateral. However as mentioned, to give dealers access to their securities during the day, the clearing banks settle all repos very early each day, returning cash to cash investors and collateral to dealers. This would lead to a delay in real-time settlement, therefore in reality the clearing banks wind up extending hundreds of billions of intraday credit to the dealers until new repos are settled in the evening.
Role in 2008 Financial Crisis
It’s argued by many to have played an underscored role in the 2008 US Financial Crisis, primarily because between 2007-2009 these repurchase agreements became a common daily routine for almost all of the largest brokers and dealers in the world. This was for several logical reasons. Firstly, it made sense for securities brokers to engage in because they have access to cash immediately, the second the daily trading day begins.
It equally makes sense for dealers. They are receiving a profit from lending cash and they have the comfort of knowing their cash is backed by collateral that was signed off on by either JPMC or BNYM. Finally, it makes sense for the clearing bank to use their economies of scale and human resources to make a couple percentage points. At the time this was thought to be routine administrative clearing bank procedure. However, it turned out to be a much bigger nightmare than ever imagined.
The nightmare catch is best described by the following scenario. Contemplate what happens if you have a very large and highly levered broker, like Bear Sterns as the famous example. You then encounter a situation where financial markets they have heavy exposure in drop sharply. The collateral a broker like Bear Sterns would put up would be in the form of a portfolio of securities. They wouldn’t contribute any physical assets, or guaranteed/risk-less investments (like T-Notes).
Where Systemic Financial Fragility and Potential Crisis Begins
Now you have a situation where the dealer (Company B) may not feel as comfortable providing liquid cash financing to Bear Sterns anymore. Then you essentially have the clearing bank – JPM Chase or BNY Mellon – incurring the loss because the process was done so hastily. They almost certainly never took the time to deeply look into whether the collateral put up by Bear Sterns was equal in liquid valuation to the cash provided by their various dealers (who by the way would usually be institutions like secondary education private schools, or institutions in a medical (or other) field with a surplus of cash), so the settlement process only occurred on paper for them.
When things went south, even though the clearing banks do not match dealers with cash investors. Nor do they play the role of broker in that market. They had to settle disproportionately valued securities with the most liquid form of financial currency: cash. Looking at Bear Sterns, they would’ve used dozens of cash lenders to diversify. Even more so the clearing banks would be incentivized to not look too closely at their spotted collateral. Picture what happens if you have Lehman Brothers, Goldman Sachs, and Morgan Stanley incurring the same scenarios. The same day, as well. Of course Goldman Sachs and Morgan Stanley are two of the most prestigious investment banks in the world. Likely not enough of their total portfolio was invested in the tri-party repo market to cause them to fail.
However when that market did ultimately fail, things went that route for Lehman and Bear Sterns. Concisely, while on the surface a tri-party repo is a simple repurchase agreement where a third party provides administrative surfaces at a small fee for the two companies engaged in the repo, understanding the mechanics of it are invaluable to appreciating how some financial markets collapsed so rapidly in late 2008.