The market for U.S. Treasury securities is generally regarded as the model of liquidity and efficiency. Changes to its operation are considered carefully and undertaken gingerly, so as not to disturb the market or the way it is perceived. And yet, the Treasury market is about to implement a practice that may fundamentally alter the repo and securities lending markets, with reverberations across the universe of Treasury settlements.

Adjusting to Changes in Environment
In the past 12 months, and arguably since 2003 or earlier, the Federal Reserve Bank of New York, which oversees the Treasury market, has sought to overcome inconsistencies that occur at very low interest rates. When fed funds rates move below 3%, the Fed has noted that ‘desirable’ practices associated with repo markets and securities lending deteriorate as interest yields approach zero.

Simply put, securities lenders lose their desire to lend when returns approach zero. On the other hand, short sellers have been known to let a transaction fail ‘strategically’ when the cost of failing is about the same as the cost of borrowing—or less.

These conditions produced temporary but extreme spikes in fail rates in 2001, 2003 and 2004. Therefore, when the current financial crisis arrived last summer and fail rates spiked to unforeseen levels, the Fed was already examining potential solutions.

The Fed’s Treasury Market Practices Group (TMPG) defines itself as “a group of market professionals committed to supporting the integrity and efficiency of the U.S. government Treasury market.” 1 It includes senior business managers and legal and compliance professionals from securities dealers, banks and buy-side firms (including J.P. Morgan), and is sponsored by the Federal Reserve Bank of New York.

Initially announced by the TMPG in November 2008, the market is attempting to self-regulate the quirks in the repo and securities lending markets by implementing a fail penalty when fed funds borrowing rates go below 3%.

The concern, however, is that this simple medicine for the repo market may turn into a bitter pill for ‘ordinary’ investors.

‘Buy and hold’ investors in Treasuries are not active in the repo market. They may passively allow an agent to lend some of their portfolio, but do not actively seek lending opportunities. These investors rarely experience settlement failures, and if they do, the problem is usually human error. This rather large market segment would need to invest in the data, systems and people necessary to participate in the claims process—likely for little marginal return.

The cost of participating may be significant, and the process is only applicable when interest rates fall below 3%. While we may experience very low interest rates in the near term, a fed funds rate below 3% is historically a very rare occurrence, suggesting that the process is likely to ‘go away’ just as investors become really comfortable with it.

Participate or Ignore
The TMPG and the Federal Reserve are taking care to reinforce that this is a suggested best practice, not a rule the Fed could or would seek to enforce with supervision.

Therefore, large players active in repo and securities lending markets will be encouraged to create a claims process, and anyone leveraging the FICC for clearing Treasuries will find the practice engineered into the FICC process, with claim adjustments processed automatically.

On the other hand, the potential exists for ordinary investors to choose to ignore the practice and refuse to make or pay claims to counterparties. If and when the buy side makes that choice, the sell-side broker—which may face ‘street-side’ practices it cannot ignore—will have to decide whether to continue trading with the buy side. Assuming the relationship is a good one, and the client manages an efficient back office, fails should be rare, and most brokers will not want to lose a good relationship over an occasional fail.

What You Need to Know to Participate
Treasury market participants that embrace the new practice will begin to track fails and calculate claims in May, for presentation in June. The suggestion is for claims to be issued by the tenth business day of the following month, and claimed or refuted by the last business day of that same month. The TMPG have published the recommended timeline shown below.

Claims will be calculated based on the difference between 3% and the applicable fed funds borrowing rate for the number of days a transaction fails. The mathematical formula is:
C = 1/360 * .01 * max (3 - R, 0) * P

Where:
• C = claim amount in dollars
• R = TMPG reference rate at the close of business on the business day preceding the fail, in % per annum
• P = total trade proceeds due from buyer in dollars

J.P Morgan is participating in TMPG and SIFMA discussions, as well as direct discussions with the Federal Reserve Bank throughout the winter and spring as we seek to understand and influence these developments.
If you haven’t already given the development some thought, it’s time to talk to your trading partners, and of course your J.P. Morgan relationship manager is always ready to discuss market developments and how our services can help you.

1. Treasury Market Practices Group (TPMG), http://www.newyorkfed.org/tmpg/

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