NEW YORK, Jan 30 (Reuters) - The central clearing party for U.S. repurchase agreements said on Tuesday it has begun clearing trades by fund companies that are sponsored by banks to provide collateral for the short term loans, opening up a new source of income for buy-side firms and reducing systemic risk.
The move is significant because up to this point, the buy-side, which includes mutual fund companies and money market funds, have been able to provide only the cash side of a centrally cleared trade in the $2.2 trillion a day repurchase agreement, or "repo," market.
The repo market is a key source of short-term bank funding, which is also used by investors and companies as a way to invest spare cash. A repo involves one party selling assets, such as U.S. Treasuries, in return for cash with a promise to repurchase the assets, usually the following day.
Buy-side firms that are sponsored by dealers, typically banks, can now provide the collateral side of a cleared repo trade, giving them the chance to potentially gain more yield, under the Depository Trust & Clearing Corporation's (DTCC's) Fixed Income Clearing Corporation (FICC) unit's new initiative.
The FICC said on Tuesday it had cleared a trade by Capula Investment Management LLP, which was sponsored by State Street Bank and Trust Co, to provide collateral to repo agreement.
Centrally clearing repos provides more transparency to regulators and it also leads to fewer constraints on the sponsor firms' balance sheets, as the risk of a default on the other side of the transaction is taken on by the central clearing party.
"Having all of this activity in clearing and having it all subject to one orderly liquidation by the CCP (central clearing party) in the event of a default helps mitigate risk for the market as a whole," Laura Klimpel, executive director of DTCC clearing agency services, said in an interview.
In bilateral trades, if one party defaults before the trade is settled, the firm is left to liquidate its position on its own and could result in a fire sale.
But because the CCP is able to see all of its clients' positions, it can liquidate the defaulter in an orderly fashion, even in a distressed market, said Klimpel, who leads the DTCC's repo program. (Reporting by John McCrank; Editing by Matthew Lewis)