For some time, market participants have been working to develop a contingency plan for handling a loss of confidence in either of the two clearing banks that facilitate the settlement of triparty repos. Recent experience demonstrates the need for additional measures to enhance the resilience of these markets, particularly as large borrowers have experienced acute stress. The Federal Reserve's Primary Dealer Credit Facility, launched in the wake of the Bear Stearns collapse and expanded in the aftermath of the Lehman Brothers bankruptcy, has stabilized this critical market, and market confidence has been maintained. However, this program was adopted under our emergency powers to address unusual and exigent circumstances. Therefore, more-permanent reforms are needed. For example, it may be worthwhile considering the costs and benefits of a central clearing system for this market, given the magnitude of exposures generated and the vital importance of the market to both dealers and investors.

We need to do some things to strengthen the infrastructure we have, the over-the-counter derivative market, the tri-party repossession market, and that which is secured financing between institutions.

The Federal Reserve and other authorities also are focusing on enhancing the resilience of the tri-party repo markets, in which the primary dealers and other large banks and broker-dealers obtain very large amounts of secured financing from money funds and other short-term, risk-averse investors. For some time we have been working with market participants to develop a contingency plan should there ever occur a loss of confidence in either of the two clearing banks that facilitate the settlement of tri-party repos. Recent experience, including Bear Stearns' liquidity problems, demonstrates the need for additional measures to enhance the resilience of these markets, including the development of contingency plans for dealing with the sudden loss of confidence in a large tri-party borrower. Given the critical role that these markets play in our financial system, we need to proceed in a prudent manner in making changes, especially as long as the broader financial markets are experiencing stress. Nonetheless, over time, a stronger financial system may require changes in the way borrowers and lenders use these markets, as well as in the settlement infrastructure operated by the clearing banks.

Strengthening market infrastructure will reduce the expectation that an institution is too interconnected to fail. We need to strengthen our practices and financial infrastructure in the OTC derivatives market and in the tri-party repo system. Important work is underway in each of these areas, and needs to be completed quickly.

We need complementary efforts to mitigate risks to the financial system in the event that services, including Tri-Party Repo, provided by one of the two major clearing banks for government securities were suddenly disrupted or terminated. A related challenge is the vulnerability of the repo markets, including Tri-Party Repo, as a continuous funding source. As we have witnessed, liquidity in the repo markets can evaporate suddenly if counterparties become unwilling to provide even short-term secured financing because of uncertainty. Efforts are needed to ensure that both borrowers and lenders strengthen their credit, operational and liquidity risk management practices.

Of course, the mere creation of a market stability regulator can increase moral hazard and decrease market discipline. The expectation that a regulator will intervene to protect the system must be limited to the greatest extent possible. In other words, we must limit the perception that some institutions are either too big or too interconnected to fail. If we are to do that credibly, we must address the reality that some are. To do that, we must strengthen market infrastructure and operating practices in the OTC derivatives market and the tri-party repo system and clarify the resolution, or wind down, procedures for non-depository institutions. Creating a more stable environment will mitigate the likelihood that a failing institution can spur a systemic event.

We are also initiating important steps to strengthen the financial infrastructure.  We are in the process of encouraging a substantial increase in the resources held against the risk of default by a major market participant across the set of private sector and cooperative arrangements for funding, trading, clearing and settlement of financial transactions that form the "centralized infrastructure" of the financial system. We have begun to review how to reduce the vulnerability of secured lending markets, including triparty repo by reducing, in part, the scale of potentially illiquid assets financed at very short maturities.

So how are these facilities supposed to work? What’s the theory? The notion is that the auction facilities should be the main means by which the Fed provides liquidity support to depository institutions and primary dealers. The PCF and PDCF are standby facilities designed to provide reassurance to market participants that sound depository institutions and primary dealers have access to backstop sources of liquidity. But the actual amount of funds advanced through these facilities is likely to be limited in most circumstances.

The Primary Dealer Credit Facility essentially puts the Federal Reserve in the position of tri-party repo investor of last resort. This helps to reassure the two triparty repo clearing banks and the triparty repo investors that the primary dealers will be able to obtain funding. This bolsters confidence in the triparty repo system and reduces the risk of the type of funding run that led to Bear Stearns’ illiquidity crisis.

The auction facilities have several advantages relative to the backstop facilities. First, they are dynamic—the results shift from auction to auction. The information obtained through the auction process facilities price discovery and helps policymakers assess market conditions and sentiment. Second, the auctions appear to have less stigma than the backstop facilities. Stigma is the word used to describe the unwillingness to use a liquidity facility because of fears that such use could send an adverse signal about the health and viability of the borrower.

For the auction facilities, stigma is very low for several reasons. First, many participants participate in the auctions. This provides cover against the potential for an adverse signal from participation. Second, the auctions are conducted for settlement on a forward basis. For example, in the TAF auction, the bidding takes place on Monday and settlement on Thursday. This time lag makes it clear that participants are not bidding because they need immediate funds and are having serious liquidity problems.

So how have the facilities performed in practice? As designed, most of the dollars have been disbursed via the auction facilities, the FX swaps, and the single-tranche OMOs, rather than via the backstop facilities.