The Securities and Exchange Commission's Division of Investment Management has issued guidance for money market funds on counterparty risk management practices with respect to tri-party repos. IM Guidance Update 2013-03 (July 2013). A repo, or repurchase agreement, is an agreement to purchase securities for cash, combined with an agreement to resell those securities at a specified price and time. In substance, a repo functions as a fully collateralized short-term lending arrangement. A tri-party repo is a repo in which a clearing bank (JPMorgan Chase or Bank of New York Mellon) acts as third-party agent to provide collateral management services and to facilitate the exchange of cash against collateral between the two repo counterparties. The SEC staff addressed its guidance largely to money market funds because these funds tend to have more significant portfolio holdings of tri-party repos than do other types of mutual funds.
The Financial Stability Oversight Council's 2013 Annual Report warned that the tri-party repo market remains vulnerable to runs by lenders in the event that concerns emerge regarding the financial condition of borrowers such as securities broker-dealers, who depend heavily on this channel for short-term funding. The staff guidance notes this warning and states that, as a matter of prudent risk management, money market funds and their investment advisers are encouraged to consider the legal and operational steps they may need to take if a repo counterparty fails and the repos it issued default. The guidance refers to a checklist that the Investment Company Institute has prepared for funds holding repos in the event of a repo counterparty insolvency, and it suggests that a fund's adviser should prepare in advance for a default, including the following steps:
*Review the master repurchase agreements and related documentation to consider any specified repo default procedures. If these procedures call for notifications or other documents, the fund may consider having templates prepared in advance.
*Consider operational aspects of managing a repo default. For example, funds may want to evaluate whether the systems at the fund or its custodian are capable of appropriately holding, valuing, trading and accounting for the collateral underlying the fund's repos.
*Consider, to the extent possible, whether there are potential legal considerations under the Investment Company Act of 1940 or otherwise that the fund could consider in advance or will need to evaluate at the time of any repo default. For example, money market funds may want to consider whether they can hold certain types of repo collateral and remain in compliance with Rule 2a-7, and they may also want to identify any required notifications to the SEC and to determine the effect of bankruptcy laws. The fund may also want to evaluate what notifications and information the adviser should provide to the fund's board of directors regarding the default and what disclosures, if any, the fund should provide to its shareholders.
The staff guidance is available online at
The ICI checklist for the event of dealer insolvency is at
For FSOC's 2013 Annual Report, see
John M. Baker
Stradley Ronon Stevens & Young, LLP http://www.stradley.com
1250 Connecticut Avenue, NW, Suite 500
Washington, DC 20036
FundLaw Listowner http://groups.yahoo.com/group/FundLaw/