Tri-Party Repo and the Clearing Banks

A money-market fund with $2 billion to lend overnight does not want to pick individual bonds, check each one's CUSIP is eligible, and settle two hundred separate securities transfers before breakfast. It wants to lend against "Treasuries and agencies, generally," and let someone else handle the plumbing. That someone is a clearing bank, and the structure is a tri-party repo.

What the clearing bank actually does

In the US, this role is split between BNY Mellon and JPMorgan. The borrower (typically a dealer) holds its securities in an account at the clearing bank. The lender specifies eligibility rules in a collateral schedule — say, "US Treasuries, agency MBS, investment-grade corporates, minimum haircut 2%." Each morning, the clearing bank's system automatically allocates specific securities from the dealer's account that satisfy the schedule, marks them to market, and confirms the allocation to both sides. The cash lender never selects a bond itself; it only ever sees "collateral value $X against cash lent $Y."

Worked example

A prime money-market fund lends $500 million overnight general collateral against a schedule allowing Treasuries and agency debt, haircut 2%. The clearing bank allocates a basket worth $510.2 million in face value of Treasury notes — comfortably above the $510 million required ($500m / (1 − 0.02)) — pulled automatically from the dealer's inventory of eligible securities based on that morning's prices. If overnight the dealer needs to substitute a bond out of the basket (say, to deliver it elsewhere), the clearing bank swaps in another eligible security of equal or greater value without either the fund or the dealer negotiating the substitution by hand.

Why it matters

Tri-party made it possible for a cash-rich money-market fund to lend against a diversified basket to a dealer holding a hugely varied balance sheet, without either side building the operational capacity to process thousands of individual security movements. The tradeoff, made painfully visible in 2008, was intraday credit risk: historically the clearing bank unwound all overnight repos each morning and re-collateralized them each evening, meaning it extended enormous intraday credit to dealers — a fragility that post-crisis reforms largely eliminated by removing the unwind.