Financial Innovation: The Origins of the Tri-Party Repo Market, Antoine Martin and Susan McLaughlin First in a two-part series. “The conventional wisdom about financial innovation is that it is typically undertaken as a way to increase profits. However, financial innovation can also occur as a response to the need to reduce risk. Tri-party repo is an example of such innovation. While tri-party repo ultimately evolved in ways that created and amplified systemic risk (as we describe in the second post in this series), its origin was as a solution to inefficiencies and risks associated with the repo settlement arrangements prevailing at the time. In the Beginning . . . The tri-party repo arrangement was created in the late 1970s by Salomon Brothers, a securities dealer, in cooperation with its Treasury securities clearing bank, Manufacturers Hanover. The problem they were trying to solve was to eliminate the “double” financing costs that Salomon incurred whenever Treasury securities that had been pledged to a repo lender were returned to the dealer too late in the day to be re-delivered as collateral to a new repo lender. To illustrate, suppose that Salomon borrowed $100 million against Treasury securities from Investor A in an overnight repo yesterday, but Investor A does not want to renew the repo today. To continue to finance these securities, Salomon would look for a new counterparty, Investor B, that would agree to lend it $100 million against the same collateral. To effect the change in counterparty, the securities would have to be delivered to Salomon via the Fedwire^® Securities Service by Investor A against repayment of the repo, and then sent to Investor B in a separate movement of securities. If Investor A sends the securities back too late in the afternoon, it may not be possible to deliver them to Investor B before the securities wire closes for the day. In such a case, Salomon would incur a “double” charge: it would still have to pay interest to Investor B, but it would also need to finance the securities it held overnight through a “box loan” with its clearing bank, on which it was also charged an interest rate. In the tri-party repo arrangement, Salomon—the dealer—and all its potential repo lenders had accounts on the books of the clearing bank, Manufacturers Hanover. Settlement would occur by Manufacturers Hanover transferring cash and securities between the accounts of Salomon and Salomon’s lenders on Manufacturers Hanover’s books. Under this arrangement, the dealer no longer depended on Fedwire to receive the securities from one lender and to send them to the other lender’s account. Indeed, settlement could occur at any time, even after the close of Fedwire Securities…”