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Federal Reserve white paper on the use of clearing banks to fund loans via repurchase agreements.
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TaskForceonTriPartyRepoInfrastructurePaymentsRiskCommitteeReportMay17,2010
The Task Force on TriParty Repo Infrastructure was formed in September 2009 under the auspices of thePaymentsRiskCommittee,aprivatesectorbodysponsoredbytheFederalReserveBankofNewYork. TheTaskForcemembership includesrepresentativesfrommultipletypesofmarketparticipantsthatparticipate inthetriparty repo market, as well as relevant industry associations. Federal Reserve and SEC staff participated inmeetingsoftheTaskForceasobserversandtechnicaladvisors.
TriPartyRepoInfrastructure TaskForceReport
TableofContentsSection1: IntroductionandSummary...................................................................................................... 3 Section2: SummaryListofTaskForceRecommendations.......................................................................11 Section3: Background............................................................................................................................14 Section4: OperationalArrangements .....................................................................................................15 Section5: DealerLiquidityRiskManagement .........................................................................................19 Section6: MarginingPractices................................................................................................................21 Section7: ContingencyPlanning .............................................................................................................25 Section8: Transparency .........................................................................................................................28 Section9: Assessment ............................................................................................................................30 Section10: NextSteps..............................................................................................................................33 Section11: Annexes .................................................................................................................................34
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Section1: IntroductionandSummaryInthefallof2009,toaddressthesystemicriskthathadbecomeevidentduringthefinancialcrisis,theFederalReserveaskedmarketparticipantstoreviewandmakerecommendationsregardingopportunitiesforimprovementtothetripartyrepoinfrastructure.TheTaskForceonTriPartyRepoInfrastructurewasformedandthisReportcontainsitsfindingsandrecommendations.TheReportandtheworkunderlyingithavebeendevelopedthroughthejointeffortofalargenumberofmarketparticipants,representingmultipletypesoffinancialinstitutionsthatparticipateinthetripartyrepomarket.TheworkoftheTaskForcewasthesubjectofaworkshopinFebruary2010attendedbyrepresentativesfrommorethan100differentorganizations.FederalReserveandSECstaffattendedTaskForcemeetingsandprovidedclarificationofrelevantpolicyconcernsandpositions.However,itisimportanttomakeclearthattheconclusionsoftheTaskForceareitsown.Noendorsementofitsconclusionshasbeensoughtorreceivedfromanyregulatoryauthority.TheTaskForceisawareofandsupportstheFederalReservessimultaneousissuanceofaWhitePaperthatprovidesitsperspectiveontheissuescoveredintheTaskForceReportandrequestspubliccomment.Itisimportanttoemphasizethatthetripartyrepomarketandthemarketsfortheunderlyingcollateralaredynamic.TaskForcemembersarecommittedtoongoingindustryassessmentoftheissuesaddressedinthisReport.DescriptionofTriPartyRepoMarketThetripartyrepomarketislargeandimportant,butnotverywellunderstood.ItrepresentsasignificantpartoftheoverallU.S.repomarket,inwhichmarketparticipantsobtainfinancingagainstcollateralandtheircounterpartiesinvestcashsecuredbythatcollateral.LargeU.S.securitiesfirmsandbanksecuritiesaffiliatesfinancealargeportionoftheirfixedincomesecuritiesinventories,aswellassomeequitysecurities,viathetripartyrepomarket.Thismarketalsoprovidesavarietyoftypesofinvestorswiththeabilitytomanagecashbalancesbyinvestinginasecuredproduct.ThetripartylabelreferstorepotransactionsthatsettleentirelyonthebooksofoneoftwoClearingBanksintheU.S.market:BankofNewYorkMellon(BNYM)andJPMorganChase(JPMC).TheClearingBankisthusathirdpartyinvolvedintherepotransactionbetweenaDealer(party,notnecessarilyaBrokerDealer,borrowingcashagainstsecuritiescollateral)andaCashInvestor(partylendingcashagainstsecuritiescollateral).1Theattractivenessofthetripartyrepomarketisdrivenbythetreatmentofrepurchasetransactionsinbankruptcy,theuseofsecuritiesascollateral(includingdailymarginingandhaircuts),andthecustodianservicesoftheClearingBankswhichprovideprotectionsthatdonotexistforbilateralrepoinvestorsorunsecuredcreditors.Asaresult,theU.S.repomarketcontributessignificantlytotheliquidityandefficiencyoftheU.S.TreasuryandAgency(includingAgencyMBS)securitiesmarkets,whichcollectivelymakeupapproximately75%ofthetotalcollateralintheU.S.repomarket.TheimportanceoftheU.S.repomarketisunderscoredbythefactthatitisthemarketinwhichtheFederalReserveoperationallyimplementsU.S.monetarypolicy.Thetripartyrepostructuredevelopedinthemid1980sinresponsetothedesirebyCashInvestorstohavecollateralheldbyathirdpartyagent.ThetripartymarketcontinuedtogrowastheClearingBanksinvestedininfrastructureadvancementsthatallowedDealersandCashInvestorstooptimizetheiruseoftheplatform.Atpeaklevelsin2008,over$2.8trillioninsecuritieswerebeingfinancedthroughtheU.S.tripartyrepomarket.TheU.S.repomarketingeneralandthetripartyrepomarketinparticularhaveprovidedimportantbenefits(e.g.flexibilityandreducedfundingcostsduetocreditprotectionsandoperationalefficiencies)tothefinancialsystem
1Forclarityandconsistency,thisReportusesthecapitalizedtermsClearingBank,Dealer,andCashInvestorthroughouttheReporttorefertothesethreepartiestoatripartyrepotransaction. 3of43
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andhavehelpedtoreducethecostofborrowingfortheU.S.Treasury,therebyloweringdebtservicecostsbornebytaxpayers.2Atseveralpointsduringthefinancialcrisisof20072009,thetripartyrepomarkettookonparticularimportanceinrelationtothefailuresandnearfailuresofCountrywideSecurities,BearStearns,andLehmanBrothers.Thepotentialforthetripartyrepomarkettoceasefunctioning,withimpactstosecuritiesfirms,moneymarketmutualfunds,majorbanksinvolvedinpaymentandsettlementsglobally,andeventotheliquidityoftheU.S.TreasuryandAgencysecurities,hasbeencitedbypolicymakersasakeyconcernbehindaggressiveinterventionstocontainthefinancialcrisis.SummaryofRecommendationsBasedonitsanalysis,theTaskForceidentifiedthefollowingareaswhereimprovementsareneeded:
OperationalArrangementsLargelytoobtainoperationalefficiencies,currentarrangementsincluding
thedailyunwindofalltransactionsregardlessoftermrequiremassiveamountsofintradaycredittobeprovidedbythetwoClearingBanks.Thelackofclearunderstandingconcerningtheultimateallocationofcreditandliquidityrisksamongrepomarketparticipantsweakenedincentivestomanageandconstrainthoserisks.
DealerLiquidityRiskManagementSomeDealersdidnotproperlyanticipatethepotentialforsecuredfinancingtobeunavailable,evenforhighqualitycollateral.SomeDealersbecameexcessivelyreliantonshorttermrepofinancing,especiallyinregardtocollateraltypesthatwereorbecameilliquidandsubjecttovaluationuncertainty,contributingtogreaterleverageinthesystem.
MarginingPracticesMarketparticipantsinmanycasesdidnotanticipatetheextenttowhichmarketconditionscouldworsenanddidnotsetmarginsaccordingly,leadingtoprocyclicalincreasesinthosemarginswhenconditionsdidworsenduringthecrisis.MostCashInvestorsdidnotanticipatethepotentialforlossesascollateralpricesdeclined.
ContingencyPlanningInmanycases,CashInvestorswereunpreparedtocopewiththeconsequencesofaDealerdefault,inparticularthepotentialneedtomanageandliquidatecollateralsecuringadefaultedrepoposition.Insomecases,CashInvestorsfinancedassetsthattheywouldnotnormallyholdoutright.
TransparencyTherewasinsufficienttransparencywithrespecttomanyaspectsofthetripartymarket,includingitsaggregatesizeandcomposition,theextentofconcentrations,andtypicallevelsofmargin.ThiscontributedtothebuildupofexposuresandthelackofpriorconcertedactiontoaddresstheissuesidentifiedinthisReport.
ThedetailedrecommendationscontainedinthemainbodyoftheReportaddressalloftheseareas.OperationalArrangementsFirstandforemost,theTaskForcehasfocusedonthespecificactionsneededtofundamentallystrengthentheoperationalarrangementsattheheartofthetripartyrepomarket.TheseactionsarenecessarytoreducethemarketsrelianceonintradaycreditprovidedbytheClearingBanksandclarifythecreditandliquidityrisksbornebymarketparticipants.Substantialefforthasbeenundertakentoidentifytheprecisestepsnecessaryandthekeydependenciesinvolved.TangiblestepshavebeentakenandintradayexposuresarelowerthanattheoutsetoftheTaskForceswork.Thepercentageoftripartyrepotradesunwoundonadailybasisdecreasedanaverageof
2BenefitsofthetripartyrepomarketarediscussedintheFRBNYWhitePaperontheTriPartyRepoInfrastructureReformTaskForce. 4of43
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10%fromSeptember2009toMarch2010.3TheTaskForcebelievesthattheobjectiveshouldbethepracticaleliminationofintradaycreditprovidedbytheClearingBanks,definedbytheTaskForceasapointbeyondwhichtheresidualamountsofintradaycreditextensionsarebothsmallandcanbegovernedbytransparentbilateralarrangements,knowninadvancetoparticipants.Thekeyoperationaladvancementneededtoachievethisobjectiveisautosubstitution,whichwillallowfortheautomatedsubstitutionofsecuritiescollateralsupportingatripartyrepotransaction,whilethattransactionremainsinplace.BothClearingBankshavecommittedtoimplementthisfunctionalitybyFebruary2011.TheTaskForcebelievesachievementofthepracticaleliminationobjectivecanandshouldbeachievedwithinsixmonthsfollowingtheimplementationofautosubstitution,implyingatargetdateofmidyear2011.AlongsidethisefforttoradicallyreducetheamountofintradaycreditprovidedbyClearingBanks,theTaskForcebelievesitiscriticaltoreinforcethatCashInvestorsareatriskiftheirrepocounterpartydefaults.Clarityinthisrespecthelpstoensurestrongincentivestomitigaterisksandtoundertakeappropriatecontingencyplanning.DealerLiquidityRiskManagementTripartyrepoactivitymustbeanessentialfocusforliquidityriskmanagement.Dealersshouldnotassumethatsecuredfinancingisinherentlystable.SinceCashInvestorsareatriskiftheDealerdefaults,DealersshouldrealizethatsomeCashInvestorsmayreduceand/oreliminatefundingasthecreditqualityoftheDealerdeteriorates,despitetheexistenceofcollateral.Assuch,Dealersshouldaccountforthelossofsecuredfundingwithintheirliquidityriskmanagementplansandliquiditystresstests.Dealerliquiditybuffersshouldbesizedaccordingly.Hadsuchanapproachbeeninplaceconsistentlyacrosstheindustryduringthecrisis,itismuchmorelikelythatilliquidcollateralwouldhavebeenmatchedbyacorrespondingliquiditybuffer,limitingthepotentialsystemicimpactofthelossofthatfinancing.Inaddition,Dealersshouldlengthenandstaggerthematurityprofileoftheirfinancing,seektocombineshorttermandlongtermfinancingwiththesamecounterpartyandshouldcontinueexploringalternativemechanismsthatmaybeabletoachievemoredurablefinancingofcertaintypesofsecurities.TheTaskForcesupportstheincreasedemphasisonliquidityriskmanagementbysupervisorsandregulators.Theserecommendationsonliquidityriskmanagementechothoseofmanyotherreportsandpapersanalyzingaspectsofthefinancialcrisis.TheTaskForcebelievesthattherecommendationsinthisareahaveparticularrelevancefortripartyrepotransactions.MarginingPracticesMarginingpracticesmustbebroadlystrengthenedinthewakeofthecrisis.TheReportoutlinesanumberofmarginingbestpracticesbutstopsshortofrecommendingonespecificapproach.Marketparticipantsshouldundertakestatisticalanalysisandstresstestingofcollateralpricemovementsthatallowsthemtoassessthepotentialforlossesatdifferentlevelsofmarginsandtomakedecisionsbasedontheirappetiteandcapacitytoabsorblosses.CashInvestorsshouldseekinformationthatallowsthemtoassessthepotentialconcentrationofrepocounterpartieswithrespecttoaparticulartypeofsecurity;wheresuchinformationisnotforthcoming,theyshoulduseaggregatemarketinformationand/ormakeconservativeinferences.Marginprocyclicalityreferstotheprocessbywhichmarginlevelsarereducedingoodtimesandincreasedinbadtimes.Procyclicalitycannotbefullyeliminated,sincequantitativemeasuresusedtoguidemarginlevelsfluctuateovertime.Nevertheless,improvementscanbemade.Theapproachtomarginingshouldbeunderstoodacrossmarketparticipants.Marginagreementsshouldavoidprecipitousandunanticipatedincreasesinmargins.Marginsshouldbesetinaccordancewithregulatoryliquidityriskmanagementandmarginriskmanagementstandards.Theregularpublicationofmarginlevelsinthetripartyrepomarketandqualitativesurveysofcredit3FiguresarebasedonaggregatesprovidedbytheClearingBanks. 5of43
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terms,asproposedinarecentBISreportonmarginrequirementsandhaircuts,canaidmarketparticipantsinsettingappropriatemarginlevels.ContingencyPlanningCashInvestorsshoulddevelopliquidationplansforthemanagementandliquidationofrepocollateralintheeventofaDealerdefault.Theseplansshouldcoverbothpracticalaspectssuchascustodialarrangements,aswellasstresstestsofpotentiallossesduetocollateralpricemovementsandstresstestsofpossibleliquidityneeds.ExplorationofadditionalliquiditytoolsandmechanismsbyCashInvestorsshouldalsobeconsidered.CashInvestorsshouldregularlyreviewtheirliquidationplanswiththeirseniormanagementandboardsasappropriatedependingonthenatureoftheorganization.CashInvestorsshouldbeabletodemonstratethatpotentialstressscenariosontheirsinglelargestrepocounterpartywillnotleadtodestabilizinglosses,evenwhenassociatedcollateralvaluationsaresubjectedtoreasonablyseverestresstests.Additionally,DTCCand/orotherinterestedprovidersshouldexplorethedevelopmentofacollateralliquidationmanagerservicethatwouldbemadeavailabletoabroadrangeofmarketparticipantsonavoluntarybasis,aswellastoolsthatwilllegallysupportoffsettingofsecuredexposuresrelatedtothedefaultingparty.ImpedimentstotherapidinitiationofliquidationplansbyCashInvestorswouldincreaseuncertaintyandsystemicrisk.Therefore,theTaskForcebelievesthatSIPC(SecuritiesInvestorProtectionCorporation)shouldagreenottoimposeastayonrepocounterpartiesexercisingtheircontractualremedies.ThisisconsistentwiththeapproachthatSIPChastakeninpriorDealerdefaults.TransparencyThetripartyrepomarketrequiresgreatertransparency.TheTaskForcehasworkedcloselywiththeFederalReservetodevelopatemplateforregularpublicationofkeyinformationprovidedbytheClearingBanks.ApilotversionofthistemplatewithactualdataasofApril2010isincludedonthefollowingpageandisdiscussedintheReport.Thisshowstheaggregatesizeofthetripartymarket,brokendownbyassetcategory,withassociatedmeasuresofDealerconcentration.ThesecondtablereportsonmarginhaircutlevelsreportedbytheClearingBanksforeachassetcategory.MeasuresofDealerconcentrationarealsoincludedonananonymousbasis.Transparencyofcollateralvaluationisanessentialcomponentofsecuredfunding.Collateralthatispronetoilliquidityandsignificantuncertaintiesinvaluationaddstosystemicriskwhenfundedintheovernightrepomarket.Marketparticipantsshouldevaluatetheprudenceoffundingthistypeofcollateralintheshorttermrepomarkets.TheTaskForcewillestablishaworkinggroupofvaluationspecialistsacrosstripartyrepomarketparticipantstoevaluatecollateralpricingmethodologiesandmakerecommendationsforimprovements,includingthefeasibilityofsamedaypricing.
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Table1TripartyRepoStatisticsasofApril9,2010
SeeAnnex3forExplanatoryNotes
CompositionandConcentrationofTriPartyRepoCollateral
ABS(Investmentandnoninvestmentgrade) 41.7 2.4% 45%AgencyCMOs 112.7 6.6% 46%AgencyDebentures(includingstrips) 179.5 10.5% 33%AgencyMBS 584.9 34.2% 45%CMOsPrivateLabelInvestmentgrade 25.2 1.5% 48%CMOsPrivateLabelNoninvestmentgrade 18.9 1.1% 47%CorporatesInvestmentgrade 79.6 4.7% 39%CorporatesNoninvestmentgrade 34.7 2.0% 54%Equities 73.3 4.3% 59%MoneyMarkets 27.4 1.6% 74%USTreasuriesexcludingstrips 474.4 27.7% 39%USTreasuryStrips 38.7 2.3% 46%Other 19.5 1.1%Total 1,710.5 100% 38%
Asset Group Collateral Value ($ billions) Share of TotalConcentration by
Top 3 Dealers
DistributionofInvestorHaircutsinTriPartyRepo
10th Percentile Median
90th Percentile
ABS(IGandnonIG) 41.7 0% 5% 8%AgencyCMOs 112.7 2% 3% 5%AgencyDebentures(includingstrips) 179.5 2% 2% 5%AgencyMBS 584.9 2% 2% 4%CMOsPrivateLabelInvestmentgrade 25.2 2% 5% 7%CMOsPrivateLabelNoninvestmentgrade 18.9 0% 8% 8%CorporatesInvestmentgrade 79.6 2% 5% 8%CorporatesNoninvestmentgrade 34.7 5% 8% 15%Equities 73.3 5% 8% 20%MoneyMarkets 27.4 2% 3% 5%USTreasuriesexcludingstrips 474.4 2% 2% 2%USTreasuryStrips 38.7 2% 2% 2%Other 19.5Total 1,710.5
HaircutsAsset Group Collateral Value ($ billions)
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AssessmentofRecommendationImpactTherecommendationssummarizedaboveanddetailedintheReportareambitious,farreaching,andwillsubstantiallymitigatethesystemicriskpotentialassociatedwiththetripartyrepomarket.
ThroughthepracticaleliminationofintradaycreditextendedbytheClearingBanks,anypotentialthreattothesolvencyofeitherClearingBankduetothisexposure,howeverremote,islikewiseremoved.Thisaloneisasubstantialmitigationofsystemicrisk.
Byclarifyingtheresponsibilityforcreditandliquidityrisksamongtripartyrepoparticipants,incentives
forrobustriskmanagementarestrengthened.o Goodincentivesworkbestwhensituatedwithinahighlytransparentenvironmentwithwell
articulatedexpectationsandfrequentopportunitiesforeffectivebenchmarkingbyauthoritieswiththepowertocompelchangesinbehavior.
o TheTaskForcerecommendationsintheareasofcontingencyplanning,marginpracticesandvaluation,andtransparencyaremeanttoprovidetheseadditionalsupportmechanismsforstrongriskmanagementpractices.
TheTaskForcesrecommendationstobringgreatertransparencytothetripartyrepomarketviaregularreportingofvolumes,marginlevels,andrelativeconcentrationsbyassetcategoryandacrossDealerswillsubstantiallyenhancetheabilityforsupervisorsandmarketparticipantstoassesstrendsandcallattentiontoemergingissuesbeforetheybecomesystemicinnature.
TheimplementationbyDealersofstrongerliquidityriskmanagementpractices,asrecommendedbynumerousotherreportsandsupervisoryreviews,hasanumberofimportantbenefitsinregardtotripartyrepotransactions,andmustproceedhandinhandwiththeotherrecommendationstoreducethesystemicriskpotential.
o Forexample,feedbackbetweenforcedsalesandassetpricedeclinesandthelossorchangeinthetermsofshortdatedrepofinancingcanbemitigatedeitherbyanextensioninthematurityofthatfinancingorbysizingliquiditybufferstoabsorbthelossofrepofinancingonlessliquidcollateral.
o Intheextremecasewheremarketsareunderseverestress,thereisapotentialforasuddenpullbackinrepoavailabilitytobecomeaselffulfillingsolvencyeventastheimpactedDealerisforcedtoselllargeamountsofilliquidassetsunderextremetimepressure.ThispotentialisagainmitigatedifthepullbackinrepofinancingcanbemetviasaleofhighqualityassetsfromtheDealersliquiditybuffer.
o ThisstrongerapproachtoliquidityriskmanagementimpliesthatincaseswhereaDealersdefaultisprecededbyaperiodofdeterioration,thereshouldbegreaterscopetoreducethesizeoftherepobookinadvanceofdefaultandthereforetheamountofcollateralthatCashInvestorswouldneedtoliquidateatthepointofdefault.
TheTaskForcebelievesthatthecombinationofmeasuresitisrecommendingwillreducethescopeforDealerstousethetripartyrepomarketasamechanismtofinanceexcessivelevelsofilliquidcollateral.
Inspiteofthesesubstantialimprovements,theTaskForcebelievesitisimportanttobeclearaboutwhatitsrecommendationswillnotdo.
Theserecommendationswillnotmaketripartyrepofinancingstableinthefaceofeventsthatgiverisetoconcernswithcounterpartycreditstanding.
o DiscussionswithintheTaskForceemphasizedrepeatedlythatsomeCashInvestorsfocusprincipallyonDealercreditquality.AnytimeaDealersfinancialconditionisvisiblyweakened,tripartyrepofinancingmaybesubjecttowithdrawal.
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o Attheheightofthefinancialcrisis,contagionconcernsaffectedcounterpartyriskassessmentsbymanymarketparticipants.
o However,theTaskForcebelievesthatsomeCashInvestorswillbecomemorecomfortableinrelyingontripartycollateralasacreditriskmitigantduetoriskbasedmarginingandimprovedtransparency.Thiswillimprovethestabilityofthisfinancing.
ImplementationoftheTaskForcesrecommendationswillnoteliminatethepossibilityofthesaleoflargeamountsofrepocollateralduetoaDealerdefault.However,theTaskForcerecommendationsmaychangethemannerinwhichastressscenarioinvolvingDealerswouldevolve.
o Improvementsintransparencyandinriskmanagementpracticesbyallparticipants,aswellasongoingenhancementstotheregulatoryframework,shouldimprovetheresiliencyofaDealertoawithdrawalofrepofinancingfollowingaweakeninginitsfinancialcondition.
o Therewillalsobemuchgreaterclarityregardingthestatusofexposuresonanintradaybasisandimportantlywhowillbeartheexposuresintheeventofadefault.
TheTaskForceconsideredandrejectedrecommendingthemandatoryusebyallCashInvestorsofa
singleliquidationagentinsuchcircumstancestoeffectacoordinatedliquidation.o CashInvestorsrepresentedontheTaskForcewereconcernedthatsuchanapproachwould
resultinsuboptimaloutcomesrelativetoallowingCashInvestorsflexibilityinchoosinghowtomanagethissituation.Theybelievedthatamandatoryapproachwouldresultinlessvaluefortheirconstituents.
o TaskForcediscussionsfocusedontheimportanceofaccesstofundingasthecriticalprerequisitetoavoidfiresaleimpacts.4Centralizingtheliquidationproblemdoesnotaddresstheunderlyingproblemofwheresuchfundingwouldcomefrom.TheTaskForcedidnotbelieveitwasappropriatetoassumethataFederalReserveorotherofficialliquidityfacilitywouldbemadeavailabletoacentralizedliquidationagentandthepremiseofthefiresaleconcernispreciselythatprivatemarketfundingisnotavailable.
o TheTaskForcebelievesthatabetterbalancewillbeachievedbyrecommendingthatCashInvestorsplaninadvanceforaDealerdefaultandmanagetheirexposurestoindividualDealersinlightofthepotentialimpactofsuchadefaultontheiroverallportfolioliquidity.
AdditionalConceptsandTopicsTheTaskForcediscussedseveralconceptsthathavebeenputforwardaspossibleideasthatcouldbeconsideredinthefuture.
Theseincludethefollowingconcepts.
o ALiquidityStabilizationUtility(LSU)thatwouldfunctionasabankwiththeexplicitpurposeofprovidingliquidityagainstcollateraltoCashInvestorsafteraDealerdefault.
o CashInvestorsobtainingcommittedlinesofcredit.o Acentralcounterpartyfacilitythatwouldsubstituteitscreditstandingforthatofindividual
Dealersinthetripartymarket.o AnEmergencyBankthatatroubledDealercouldtransferitsrepoportfolioto,possibly
supplementedbyanadditionalguaranteefund.
TaskForcediscussionshighlightedanumberofchallengeswitheachoftheseconceptsandaccordinglytheTaskForceisnotendorsinganyoftheseconcepts.
4SeeBrunnermeierandPedersen,MarketLiquidityandFundingLiquidity,ReviewofFinancialStudies2009,Vol.22,No.6,pp.22012238,foraneconomicanalysisofthislinkage. 9of43
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Asnotedearlier,theTaskForceisawareandhighlysupportiveoftheFederalReservesplantosimultaneouslyissueaWhitePaperthatrequestsfurthercommentontheseandanyotherissuesraisedbytheTaskForcesReportandrecommendations.
ConclusionThefollowingSectionsoftheReportspelloutthespecificrecommendationsindividuallyandthenaddresstheissuesandrecommendationsineachareaoftheTaskForceswork.TheTaskForceisconvincedthattheserecommendationscanandshouldbeimplementedandthattheywillcollectivelymakeamaterialdifferenceintheextentofsystemicriskpotentialassociatedwiththetripartyrepomarketinfrastructure.TheTaskForcegreatlyappreciatesthetimeandeffortsofallwhocontributedtoitsdiscussions.
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Section2: SummaryListofTaskForceRecommendationsOperationalArrangementsTheTaskForceRecommendationssetoutthemilestonesfortheindustryactionplandevelopedandagreedbytheTaskForcetoeliminatetothegreatestextentpossibleClearingBankextensionsofintradaycreditbyenhancingoperationalarrangementsinthetripartyrepomarket.Recommendationsareaddressedtoalltripartyrepomarketparticipantsunlessspecified.
1. ImplementoperationalenhancementstoachievethepracticaleliminationofintradaycreditbytheClearingBanks,wherepracticaleliminationisdefinedasapointbeyondwhichtheresidualamountsofintradaycreditextensionsarebothsmallandcanbegovernedbytransparentbilateralarrangements,knowninadvancetoparticipants5.
30Jun2011
1A.ClearingBankstoprovideprojectplansinrelationtotheirimplementationofrobustautomatedcollateralsubstitution(autosubstitution)capability.
15July2010
1B.EliminateremainingsourcesofambiguityorinaccuracyintripartyrepobookingproceduresandtradecommunicationstotheClearingBanks,includinginformationrelatedtothetermofthetransaction.
31Aug2010
1C.Agreetostandardizedintradaysettlementtime(s)formaturingrepotrades(e.g.,MorningSettlement,EndofDaySettlement),thatwillbeimplementedfollowingprerequisiteenhancements(e.g.,autosubstitution).
31Aug2010
1D.Agreesolution(s)forthreeway,realtime,pointoftradeconfirmationsfortripartyrepotransactions,inclusiveofdiscussionswiththirdpartyvendors.
15Oct2010
1E.ClearingBankstocompletedevelopmentofsoftwaretosupportautosubstitutioncapabilityandconfirmtimelinesforfullimplementation.
15Feb2011
1F.DealersandCashInvestorstoconfirmthatinternalprocessesrelatedtoallaspectsoftripartyrepoarepreparedfortheoperationalenhancementsrecommendedinthisReport.
15Feb2011
1G.Implementmarketwide,threeway,realtime,pointoftradeconfirmationsolution(s)whichmemorializeslegallybindingrepotransactionsenteredintobetweenCashInvestorsandDealers.
15Apr2011
2. DealersandCashInvestorstoundertakeregularduediligencereviewsofClearingBanksthatcover,ataminimum,operationalandcontractualconformity,adherencetocollateralallocationrules,andcollateralpricingmethodologies.
Ongoing
5Marketparticipantsshouldtargetthereductioninintradaycredittobelessthan10%ofaDealersnotionaltripartybook(representingtheestimatedportionofaDealer'sbookthatreachesfinalmaturityandisnotrolledonagivenday).
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DealerLiquidityRiskManagementTheTaskForceRecommendationssupportotherassessmentsofthefinancialcrisisinemphasizingtheimportanceofstrongerliquidityriskmanagement.
3. Dealersneedtoincorporatelessonsfromthefinancialcrisisexperiencerelatedtotripartyrepoinmakingappropriateimprovementstoliquidityriskmanagementandplanning.
Ongoing
4. Dealersshouldnotassumethatshorttermtripartyrepofinancingwithalloftheircounterpartiesthroughoutallmarketconditionsisinherentlystable.
Ongoing
5. DealersandClearingBankstoassessandclarifytermsforthepotentialavailabilityofsecuredintradaycreditfacilities(bothdiscretionaryandcommitted)tomitigatetheliquidityrisksassociatedwithmaturingrepotrades.
15Nov2010
MarginingPracticesTheTaskForceRecommendationssupportabroadstrengtheningofmarginingpractices,basedontheprinciplesthatmarginsshouldberiskbased,shouldnotbeprocyclical,andshouldbebasedonobjective/transparentcriteria.
6. CashInvestors,Dealers,andClearingBankstodetermineappropriatecollateralmarginsinlinewiththeprinciplessetoutinSection6ofthisReport,takingnoteofmonthlyTriPartyRepoStatisticstobepublishedontheFederalReserveBankofNewYorkwebsite.
Ongoing
7. ClearingBankstocontinuetoshareinformationonintradaymarginmethodologiesandprocesseswithrespectiveDealers.
Ongoing
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ContingencyPlanningTheTaskForceRecommendationssupportimprovingthepreparednessofCashInvestorsandthetripartyrepomarkettocopewithaDealerdefault.
8. CashInvestorstoundertakeregularstresstestsoftripartyrepocounterpartyexposuresthatconsideradefaultofthelargestrepocounterpartytogetherwithpotentialchangesinthemarketvalueoftheunderlyingcollateral.
Ongoing
9. CashInvestorstoputinplaceandregularlyreviewcontingencyplansforaDealerdefaultthatcover,ataminimum,aprocessforeffectivelymanagingcollateral,includingaplantomanageliquidityandriskexposureduringtheliquidationprocess.
15Jan2011
10. RelevantindustryassociationsinconjunctionwiththeirconstituentsareencouragedtopublishcomprehensiveBestPracticeguidanceforCashInvestors. 30Sep2010
11. DTCCanditsaffiliatestoworkwithothermarketparticipantstomaximizethepotentialforoffsettingofpositionsintheeventofaDealerdefault;DTCCand/orotherinterestedpartiescanprovideaviablecollateralliquidationmanagementserviceforthoseCashInvestorswishingtodelegatetheseactivities.
30Nov2010
12. Allmarketparticipantstocontinueexploringadditionalconceptsthathavethepotentialtoaddtothestabilityandresilienceoftripartyrepofinancingand/orreducethepotentialforcollateralfiresalesintheeventofaDealerdefault.
Ongoing
TransparencyTheTaskForceRecommendationsareintendedtoincreasetransparencywithrespecttothesize,composition,andconcentrationofthetripartyrepomarket,therangeofmarginsapplied,andthevaluationmethodologiesappliedtotheunderlyingrepocollateral.
13. Initiatemonthlypublication,viatheFederalReserve,ofaggregatestatisticsontripartyrepocollateralandCashInvestormarginlevels,withdisclosurebyassetclass,basedoninformationprovidedbytheClearingBanks.(SeeTable1forapilotversion.)
30Jul2010
14. TheTaskForcewillestablishaworkinggroupofvaluationspecialistsacrosstripartyrepomarketparticipantstoevaluatecollateralpricingmethodsandmakerecommendationsforimprovements,includingthefeasibilityofsamedaypricing.
15Oct2010
15. CashInvestorstoregularlyvalidatetripartycollateralforpricing,appropriateness,andclassification.DealerstoregularlycomparecollateralmarksontheirownbooksandrecordswithvendorpricesprovidedbytheClearingBanks.
Ongoing
16. DealerstoinformCashInvestorsandClearingBanksincaseswheretheDealersmarksaremateriallybelowthevendorpricesprovidedbytheClearingBank.
Ongoing
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Section3: BackgroundTheaccompanyingWhitePaperissuedbytheFederalReserveprovidesadditionaldetailonthehistoryandmechanicsofthetripartyrepomarket.Accordingly,theTaskForceisnotreplicatingthatmaterialhere.Inthissectionwesimplyreviewsomeofthemainpointsnecessaryasastartingpointforfurtheranalysis.TripartyrepogrewfromitsoriginasafundinginstrumentforU.S.TreasuriestoincludenearlyallsecuritiesheldbyDealers.ThegrowthofthetripartyrepomarketmirroredthegrowthofDealerbalancesheets.Themarketevolvedfromastrictlyovernightmarkettoincludesignificanttermtrading.Atpeaklevelsin2008,overUS$2.8trillioninsecuritieswerebeingfinancedthroughtripartyrepotransactions,manywithveryshortmaturities,andinvolvingthedailytransferofnearlythefullamountofassociatedcashandsecuritiesontheaccountsofoneortheotherofthetwotripartyClearingBanks:BankofNewYorkMellon(BNY)andJPMorganChase(JPM).IndividualDealers(reposellers/borrowers)routinelyfinancedmorethanUS$100bninsecuritiesviathetripartymechanism.ThelargestsinglefirmexposurepeakedatmorethanUS$400bn.Tripartyrepoarrangementswereatthecenteroftheliquiditypressuresfacedbysecuritiesfirmsattheheightofthefinancialcrisis,especiallyasthepricingtransparencyandliquidityofsomeformsoftripartycollateraldeterioratedatthesametimethatcounterpartycreditconcernswereescalating.CashInvestorsinthetripartymarketincludemoneymarketmutualfunds(2a7funds),securitieslendingagents(typicallymajorcustodianbanks),andotherinstitutionalinvestorsorfundmanagers(includingcommercialbanksandcorporatetreasurers)whoseektoinvestcashshortterm.Therepotradescanbeovernighttrades,termtradeswithsomefixedfuturematuritydate,oropentradeswhichremaininplaceuntiloneortheotherpartieselectsnottorenewthetrade.Atitsheart,thetripartyrepomarketmatchesalargedemandonthepartofCashInvestorsforsafe,flexible,shortterminvestmentswiththedesireforbanksandsecuritiesdealerstofinancetheirsecuritiesinventoriesonamoreefficientandreliablebasisthantheycanborrowonanunsecuredbasis.Thetreatmentofrepurchasetransactionsinbankruptcy,theuseofsecuritiesascollateral(includingdailymarginingandhaircuts),andthecustodianservicesoftheClearingBanksprovideprotectionstorepoCashInvestorsthatdonotexistforunsecuredcreditors.ThismechanismforfinancingDealersecuritiesinventoriesgrewduringthelastdecadetobecomeasubstantialportionoftotalDealerbalancesheetliabilities.Forreference,thedailyvolumeoftripartytransactionsisamultipleoftheentirefinancialcommercialpapermarket.Dealerscollectivelybelievedthatthismethodoffinancingwouldbemorestablethanunsecuredfinancingintheeventofmarketorfirmspecificstresseventsgiventheprotectionsdescribedabove,inparticularthefactthattherepoCashInvestoriscollateralized.Currently,thebulkoftheentiresecuredexposurepassesfromtheCashInvestorstotheClearingBanksintradaytoprovideoperationalefficiency.Thebulkoftripartyrepotransactionscurrentlyareunwoundvs.cashontheClearingBanksbookseachday(normallyaround8am),withnewallocationseffectedonthebooksoftheClearingBanksbeginningintheafternoon.Asaresult,theamountofsecuredcreditandmarketriskexposurebornebythetwoClearingBanksinthenormalcourseofbusinesstodayisextremeandthereisuniformsupportfromalltripartyrepomarketparticipantsontheimportanceofreducingthisintradayexposureasthetoppriorityfromasystemicriskperspective.
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Section4: OperationalArrangementsTheTaskForceworkstreamcoveringoperationalarrangementsfocusedfirstonidentifyingtheprocessesthatmustbeenhancedtoenablelargereductionsinintradaycreditextensionsbytheClearingBankswithouthinderingthetradingandfinancingfunctionalityassociatedwiththecurrentplatform.6Threecoreprocesseswereidentified.
TradeBookingProcess:SomemarketparticipantsdonotsubmitcompletetradeinformationtotheClearingBanksonatimelybasisaftertradeexecution.BookingandsubmissionflawsaretworeasonsClearingBanksreturncollateraltoDealersandcashtoCashInvestorseveryday,evenwhentherepohasamaturitydatebeyondoneday.
TradeConfirmation:Thereisnoindustrywideformalizedtwoway(DealersandCashInvestors)orthree
way(addingClearingBank)tradeconfirmationpracticeatthetimeoftradeexecution.CashInvestorsandDealersgenerallyconfirmtheirtradesbilaterally.ThetimelyreportingoftradeinformationtoClearingBanksgivesthemmoreinformationforbetterriskmanagement.
IntradayCollateralManagement:InmosttripartyrepotradestheClearingBankreturnscollateraltothe
DealerandcashtotheCashInvestoreveryday,evenfortermrepotransactions.Thispracticeiscalledtheunwind.ThepurposeoftheunwindisoperationalinthatitgivesDealersaccesstothecollateralfordailysettlementactivity.TheresultisthatmostofthesecuredexposureistransferredfromtheCashInvestorstotheClearingBanksuntilcollateralisreturnedtotheCashInvestorlaterinthebusinessday,resultinginexcessive,albeitsecured,intradayexposuresforthetwoClearingBanks.
TheTaskForceconcludedthatenhancementsintheseareas,inparticularthedevelopmentofrobustautomatedintradaycollateralsubstitution(autosubstitution)capability,togetherwithimplementationofnewstandardizedsettlementtimesformaturingrepotrades,shouldenableverysubstantialreductionsinintradayexposureswithoutlossoffunctionality.Accordingly,theTaskForcehasdevelopedandagreedonanambitiousindustryactionplantoachievethisobjective.Thisactionplanculminatesinthepracticaleliminationofintradayexposurebythemiddleofnextyear.Recommendation1.Implementoperationalenhancementstoachievethepracticaleliminationofintraday
creditbytheClearingBanks,wherepracticaleliminationisdefinedasapointbeyondwhichtheresidualamountsofintradaycreditextensionsarebothsmallandcanbegovernedbytransparentbilateralarrangements,knowninadvancetoparticipants7.(30Jun2011)
TheuseofthepracticaleliminationstandardasdefinedinthisRecommendationreflectsthedesiretomeasureprogresstangiblyandquantitatively,whilealsorecognizingthatzerointradaysecuredfinancingisnotarealistictargetinthistimeframe.
6ClearingBankshaveemployedtwotacticalsolutionstoreduceintradayexposuressinceDecember2009:
Byeliminatingtheunwindofselectedtermrepos,participatingDealerskeepspecifictermloansfullycollateralizedandperformaminimallevelofsubstitutionincoordinationwiththeClearingBanks,
Bydelayingthemorningunwindprocess,Dealersreducedeliveryobligationsandcanthenreallocatetradestoeliminateintradayexposure.
Participationhasbeenbroadbasedandhasachievedanapproximate$150billionreductioninthedailyunwindatthetwoClearingBanks.Marketparticipantsarecommittedtoimplementingtacticalsolutionsuntilthestrategicsolutionisimplemented.Termtradesrepresent10%40%oftheentiremarket.Goingforward,marketparticipantscanreduceintradayexposurebyreplacingovernightmaturingtradeswithtermmaturingtradesandbysegregatingovernightmaturingtradesfromopenmaturities.7Marketparticipantsshouldtargetthereductioninintradaycredittobelessthan10%ofaDealersnotionaltripartybook(representingtheestimatedportionofaDealer'sbookthatreachesfinalmaturityandisnotrolledonagivenday).
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TheactionplanconsistsofadditionalintermediatemilestonesthattheTaskForcebelievesarenecessarytoachievesuccesswithrespecttotheoverallobjective.Theseareasfollows.TradeBookingProcessAnimportantprerequisiteformoreambitiouschangesistofirstensureashighalevelofaccuracyaspossibleintherecordingandcommunicationofallrelevanttradedetails.Recommendation1B.Eliminateremainingsourcesofambiguityorinaccuracyintripartyrepobooking
proceduresandtradecommunicationstotheClearingBanks,includinginformationrelatedtothetermofthetransaction.(31Aug2010)
TradeConfirmationAthreewayconfirmationprocesswillimprovethequalityandtimelinessoftradeinformationreceivedbytheClearingBanks.Errorswillbecaughtandresolvedearlierintheday.Sincemosttradesareexecutedearlyinthemorning,ClearingBankswillhavetheessentialfundinginformationnecessarytomakeaninformeddecisionaboutextensionofintradaycredittoindividualDealers.TheTaskForcesupportstheuseofopenarchitectureandstandardmessagingprotocolsinregardtopossibletradeconfirmationsolution(s).Recommendation1D.Recommendation1G.
Agreesolution(s)forthreeway,realtime,pointoftradeconfirmationsfortripartyrepotransactions,inclusiveofdiscussionswiththirdpartyvendors.(15Oct2010)Implementmarketwide,threeway,realtime,pointoftradeconfirmationsolution(s)whichmemorializeslegallybindingrepotransactionsenteredintobetweenCashInvestorsandDealers.(15April2011)
Itisessentialthatallrepoparticipantsagreethattripartyrepotradesarelegallybindingagreementswhicharememorializedatthepointofconfirmation.SeeAnnex1fortheMinimumParametersRequiredforTradeMatchingdevelopedbytheTaskForce.IntradayCollateralManagementTherearetwoprimaryelementstotheoperationalimprovementsneededinintradaycollateralmanagement.First,theClearingBankswillneedtodevelopandproviderobustautosubstitutioncapabilitythatallowsDealerstoaccessandsettletradesinvolvingcollateralbeingfinancedwithtripartyrepowithoutunwindingtheunderlyingtripartyrepotransaction.Thesecondchangeinintradaycollateralmanagementneededistoestablishagreed24hoursettlementcyclesthatkeepinvestorscollateralizedandborrowersfundedthroughoutthatperiod,sincethiswillbydefinitionreducetheneedforroutineintradaycreditextensionsbytheClearingBanks.Insum,themodelthatthiswillsupporthasthefollowingaspectsforeachmajorparticipant.Dealers
Preservesliquiditybyallowingreadyaccesstoencumberedcollateral ReducescreditdependencyontheClearingBanksascreditexposureiskeptwithCashInvestors Minimalimpacttocurrenttradingpracticesasprocessbecomesfullyautomatedandhighlyefficient
CashInvestors
GreatlyreducesunsecureddepositorrisktotheClearingBanks Ensuresappropriatemarginedcollateralizationwitheligiblesecuritiesandcashthroughouttheday
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ClearingBanks GreatlyreducestheoutsizedintradaycreditextensiontoDealersresultingfromthedailyunwind AllowsforgreaterclarityincreditlinesandcreditrelationshipswithDealers
KeymilestonesinrelationtotheClearingBankimplementationofautosubstitutionareasfollows.Recommendation1A.Recommendation1E.
ClearingBankstoprovideprojectplansinrelationtotheirimplementationofrobustautomatedcollateralsubstitution(autosubstitution)capability.(15Jul2010)ClearingBankstocompletedevelopmentofsoftwaretosupportautosubstitutioncapabilityandconfirmtimelinesforfullimplementation.(15Feb2011)
ThesecondchangeinintradaycollateralmanagementthatisneededistoestablishagreedsettlementtimesthatkeepCashInvestorscollateralizedandborrowersfundedthroughouttheperiod,sincethiswillbydefinitionreducetheneedforroutineintradaycreditextensionsbytheClearingBanks.Recommendation1C.
Agreetostandardizedintradaysettlementtime(s)formaturingrepotrades(e.g.,MorningSettlement,EndofDaySettlement),thatwillbeimplementedfollowingprerequisiteenhancements(e.g.,autosubstitution).(31Aug2010)
Althoughthenewstandardizedsettlementtimeswillnotbeimplementedrightaway,itisimportanttoreachagreementonthemwithinthenextfewmonthsinordertoplanotherelementsaroundthem.Inthiscontext,itisalsocriticaltorecognizetheagreementbytheLegalSubcommitteeregardingconfirmation(viathethreeway,pointoftradeconfirmation)ofthelegallybindingrepotransactionsenteredintobetweenDealersandCashInvestorsatthepointoftrade,asthiswillcreateamoresolidfoundationwithinwhichtheindustrywilloperate.Marketparticipantsshouldensurethatlegaldocumentationisappropriatelysupportiveofthisobligation.Thefollowingpointssummarizethecurrentthinkinginregardtopotentialstandardizedsettlementtimes,takingintoaccounttheworkdonebytheTaskForceslegalworkstream,assummarizedinAnnex2oftheReport.TheseconceptswillbediscussedfurtherandvettedacrosstheindustrypriortofinaldecisionsbytheTaskForce. Marketparticipantsshouldweighthemeritsofdevelopingastandardsettlementformaturingtransactions
duringtheafternoon,unlessthetwocounterpartiesotherwiseagreetoamorningsettlement.o Thebenefitsofatwicedailysettlementperiodforfinalmaturityoftransactionsaresignificant;itwould
provideadditionalopportunitiestoreduceintradaycreditextensionsbytheClearingBanks,itwouldallowadditionaltimeforCashInvestorstoprovidefinalallocationaccountinformationtotheDealersandClearingBanks,anditwouldkeepCashInvestorsfullysecuredthroughthe24hourcycle.
o Thesebenefitsneedtobebalancedwiththechallengesofintroducingasecondsettlementperiod,includingoperationalcomplexityduringacompressedendofdaytimeframe,aswellastheinabilityofCashInvestorstotakepossessionand/orliquidatecollaterallateintheday.
AsagreedbytheLegalSubcommittee,alltradesenteredintobetweenaCashInvestorandaDealer,including
blocktrades,representlegallybindingcommitmentstoprovidefinancingfromCashInvestortoDealerwhichismemorializedviathethreewayconfirmation.Otherwise,thissolutionwillnoteffectivelymitigateintradayexposure.(SeeAnnex2).
ItisincumbentuponCashInvestorstodeliversubaccounttradeinformationasearlyaspossibleduringthe
daytotransfertheriskofDealerdefaulttotheappropriatespecificentity(s)providingfinancingtotheDealer.
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CashInvestorsandDealersshouldseektoexecuteandconfirmrepospriorto10a.m.Notethatlaterdaytradesshouldstillbeabletobesettled;howeverifbothpartiesagreetoatransactioninthemorningitshouldbecommunicatedthroughtheconfirmationprocessimmediatelysotheClearingBankhasanappropriateassessmentofdailyfinancingactivity.
ReadinessforChangeTheoperationalchangesdiscussedherewillrequirealargeamountofcoordinationandcooperationtoachieve,especiallyintherapidtimeframeenvisioned.ClearingBankshaveamajorroletoplayinlayingouttheirplansandworkingcloselywiththeircustomers.CashInvestorsandDealersalsoneedtoworkconstructivelyandaggressivelytobesuretheyarereadyforthesechanges.Recommendation1F.
DealersandCashInvestorstoconfirmthatinternalprocessesrelatedtoallaspectsoftripartyrepoarepreparedfortheoperationalenhancementsrecommendedinthisReport.(15Feb2011)
TheTaskForcehasidentifiedthefollowingareasformarketparticipantstoconsiderastheyprepareforthesechangesinoperationalarrangements.
Extensiveoperationalandtechnologychangesarerequiredofallpartiestosupportasignificantincreaseinthelockupofcollateralfromthecurrentmodel.
Substitutions,accounting(includingthecalculationandpaymentofinterest),collateralvaluationmethodologies,andrelatedprocessesneedtobeadaptedtothenewmodel.
CashInvestorsandDealersrequirerealtimeinformationofthecompositionofcollateralsecuringatermtradeatanypointduringtheday.
DefiningcollateralsubstitutionprocessforinterbankGCFRepocollateralpledgedtotermtrades. EfficientlytargetingintradaysecuritiesandcashsubstitutionstominimizeCashInvestors'unsecured
depositorexposuretotheClearingBanks Atransparentprocessformanagingfailswillneedtobedevelopedpendingagreementonnew
standardizedsettlementtimes.ImpactWhencollectivelyimplemented,thenewoperationalarrangementswilldrasticallyreducetheneedforintradaycreditfromtheClearingBanks.EstimatesfromClearingBanksareanimmediate1040%reductioninintradaycredittoDealersfromtacticalsolutionsalreadyunderway,withreductionstargetedat90%ormorewhenthestrategicsolutionsareinplace.OngoingDueDiligenceInadditiontotheactionplandevelopedtosupportimprovementsinoperationalarrangements,theTaskForcesupportsbothDealersandCashInvestorsreviewingtheoperationalpracticesoftheClearingBanksonaregularbasis.Thisshouldincludemonitoringcollateralallocationstoensurethatcollateralhasbeenproperlyallocatedandcheckingthepriceoftheallocatedcollateral.Recommendation2.
DealersandCashInvestorstoundertakeregularduediligencereviewsofClearingBanksthatcover,ataminimum,operationalandcontractualconformity,adherencetocollateralallocationrules,andcollateralpricingmethodologies.(Ongoing)
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Section5: DealerLiquidityRiskManagementDealerliquiditycontingencyplansandliquidityriskmanagementpracticesprecrisishadevolvedpredominantlyduringstableenvironmentsandinmanycaseswerepredicatedonshorttermsecuredfundingbeingmorestableduringtimesofstressthanunsecuredfunding.TheseapproachestoliquidityriskmanagementdidnotsufficientlyappreciatethesensitivityofmanyCashInvestorstocounterpartyconcernseveninthepresenceofhighqualitycollateral,thepotentialforabroadpullbackintripartyrepofinancing,andthelossofpricetransparencyandliquidityforcertaincollateraltypes.Dealershavetakentheselessonstoheartandhavebeenapplyingthemtotheirliquidityriskmanagementpractices.Thesupervisoryandregulatorycommunityhasalsomadeliquidityriskapriorityissueandhavebeendrivingfurtherimprovementsthroughproposedregulatorychangesandheightenedsupervisoryreview.AmongtheareasofemphasisthathavebeenhighlightedinTaskForcediscussionsarethefollowing.
Improvingliquidityriskmeasurementandreportingcapabilities,withrespecttobothgranularityandfrequencyandthecaptureofinstrumentswithcontingentliquidityimplications.
Undertakingmoresystematicanddetailedliquidityriskstresstestsandusingtheresultstohelpsizemorerobustliquiditybuffers.
Makinggreateruseoftermfundingwhereavailable.Staggeringmaturitiesandcombiningshorttermandlongtermfundingwiththesamecounterpartytomodifyincentivestowithdrawshorttermfunding.
Morerobustgovernanceandincreasedseniormanagementfocus.LiquidityriskmanagementwasnotintendedtobeaprimaryfocusoftheTaskForce,butisacrucialaspectfortheanalysisofhowfuturestressscenarioscouldevolveandthereforefortheassessmentofsystemicriskinrelationtotripartyrepoactivity.IntermsofRecommendations,theTaskForcesupportsthebroademphasisonstrengtheningliquidityriskmanagementpracticesandwishestohighlighttheneedforDealerstoensurethattheliquidityriskmanagementaspectsoftripartyrepoactivitiesreceivepriorityattention.Recommendation3.
Dealersneedtoincorporatelessonsfromthefinancialcrisisexperiencerelatedtotripartyrepoinmakingappropriateimprovementstoliquidityriskmanagementandplanning.(Ongoing)
Inthecontextofthetripartyrepomarket,thelessonlearnedthatstandsoutthemostistheoverrelianceonshorttermsecuredfundinganditspresumedstability.DiscussionsintheTaskForceemphasizedrepeatedlythatmanyCashInvestorsfocusprimarilyifnotalmostexclusivelyoncounterpartyconcernsandthattheywillwithdrawsecuredfundingonthesameorverysimilartimeframesastheywouldwithdrawunsecuredfunding.Recommendation4.
Dealersshouldnotassumethatshorttermtripartyrepofinancingwithalloftheircounterpartiesthroughoutallmarketconditionsisinherentlystable.(Ongoing)
IntradayCreditAparticularaspectofliquidityriskinthetripartymarketgoingforwardwillbethetreatmentofmaturingrepos.IfaDealerisunabletorolloverrepofinancingorotherwisefinancethematuringassets,theClearingBankmaychoosenottoallowtherepotomature,meaningtheCashInvestorwillretaintherisk.Dealerswillnaturallybeeagertopreventeventsfromreachingthispoint,especiallyifitisnotreflectiveofabroaderdeteriorationintheDealerscondition.
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DealersthereforehaveastronginterestinclarifyingthetermsunderwhichClearingBankswouldbewillingtoprovideintradaysecuredfinancing,eitheronadiscretionarybasisorpossiblyonacommittedbasis.ClearingBankshaveaninterestinunderstandingtheassumptionsDealersaremakingwithrespecttopotentialrequestsforClearingBankcreditinastressevent.Bilateraldiscussionstoexplorethesetopicsandaddresstherangeoftermsinvolved(e.g.,amount,drawdownconditions,maturity,fees,expiration,collateraleligibility,marginlevels)willbebeneficialinprovidingclaritytobothDealersandClearingBanksaheadoffuturestressevents.Recommendation5.
DealersandClearingBankstoassessandclarifytermsforthepotentialavailabilityofsecuredintradaycreditfacilities(bothdiscretionaryandcommitted)tomitigatetheliquidityrisksassociatedwithmaturingrepotrades.(15Nov2010)
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Section6: MarginingPracticesRecentmarketeventshavehighlightedseveralissuesrelatedtomarginingpractices.Theseissuesinclude:
MarginLevels:Marginlevelsincertainassetclasseswereinsufficienttocoverthecloseout/liquidationriskofthesecuritiesheldascollateral.
Valuations:Marketparticipantsdidnotsufficientlyanticipatethepotentialforsometypesofrepo
collateraltolosepricetransparencyandliquidityforextendedperiodsoftime. MarginingProcessbetweenDealerandClearingBank:TheClearingBankunwindandmarginingprocess
wasnotwellunderstoodbyallDealersandCashInvestorsDuetotheissueshighlightedabove,someCashInvestorswerebecomingmoreexposedtocounterpartycreditriskatthesametimethatcounterpartycreditconcernswereescalating.Asaresult,behaviorstartedtotrendclosertothebehaviorofunsecuredcreditinvestors,resultinginCashInvestorsexitingtherepomarketordrasticallychangingtheircollateralrequirements.Giventheheavyrelianceontherepomarketforfinancing,thispullbackinfundingandthemeaningfulincreasesinmarginrequirementsinadeterioratingmarketcontributedtosystemicriskconcerns.Toaddresstheseissues,theTaskForceinitiatedaworkstreamonmarginingpractices,whichhasdevelopedasetofprinciplesforfirmstouseinsettingmargins.TheTaskForcebelievesthatifCashInvestorsandClearingBanksfullyincorporatetheseprinciplesintotheirmarginprocesses,theresultwillbemorerobust,lessprocyclical,andmoretransparentandpredictablemargins.Inturn,thiswillcontributetothestabilityoftherepomarketinfuturetimesofmarketstress.ItisimportanttonotethattheTaskForceisnotendorsingstandardizationofmarginingmethodologiesorofmarginlevelsacrossthemarket.TheTaskForcebelievesthemarginingprocessisariskmanagementtool,andeachinstitutionshouldbeaffordedtheflexibilitytomanagetheirriskinaccordancewiththeirownriskmanagementpolicies,principles,andprocesses.PrinciplestoConsiderForMarginRequirementsRiskBasedAsvolatilityincreasedthroughout2008,marketparticipantsrecognizedthattheliquidationvalueofthecollateralreceivedmightnotbesufficienttorecover100%oftherepofinancingintheeventofaDealerdefault.TheTaskForcebelievesthatthisuncertaintycanleadtoinstabilityasCashInvestorsaremorelikelytoexittherepomarketorexcludebroadassettypesinordertoavoidunsecuredexposureinadeterioratingmarket.InhindsightwebelievethatthisuncertaintywaslargelydrivenbyanunderestimationofhowquicklyahealthymarketcantransitionintoastressedmarketinwhichaDealerscreditqualityandassetliquiditybecomesaconcern.ThereisbroadagreementwithintheTaskForcethatClearingBanksandCashInvestorsshouldsetmarginrequirementsconsideringthepotentialpricedeclineofthesecuritiesheldascollateralduringaperiodofmarketstressandvolatilitywhileassumingastrongcorrelationwithaDealersfailuretoperform.Thisriskbasedanalysisshouldalsoconsider:
Portfolioconcentrationrisks:Aportfolioofdiverseassetsmayperformbetterthanahighlyconcentratedportfolio.Inotherwords,anincreaseinportfolioconcentrationswillcorrespondtoanincreaseinsecurityspecific,idiosyncraticgaprisk.
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Liquidationhorizon:Aconservativeliquidationtimehorizonshouldbeassumedtosupportanorderlyliquidationofcollateralandtoaccountforpotentialdelaysinliquidatingaportfolio.Thesedelayscanbedrivenbypotentialstayperiods(e.g.SIPCStay)orbyassetconcentrations(e.g.asecurityholdingmayexceedthedailytradedvolume,andthereforemultipledaysmayberequiredforthemarkettoabsorbtheposition),orpossiblyotherfactors.
Implied&historicalassetvolatility:Whencalculatingcounterpartyriskexposure,marketparticipantsshouldcomplementahistoricalvolatilityanalysiswiththeimpliedvolatilityinthemarkets.Thisisimportantsincehistoryisnotalwaysagoodproxyforthefuture.
Stresstesting:Incasesofstablemarketswhereimpliedvolatilityislowandhistoricalvolatilityassumptionshavedecayed,anoverlayofmarketstresstestingtodeterminemarginlevelsiscriticaltoensurethatalowvolatilityenvironmentdoesnotleadtoprocyclicalbehavior.
ItisimportanttonotethatalthoughtheTaskForceencouragesallmarketparticipantstofullyanalyzeallrisksinherentinthetripartyrepomarket,itisnotintendedtobeariskfreemarket.Marketparticipantsshouldhaveflexibilitytoscaletheirmargininglevelsupordowninexchangeforincrementalyieldbasedupontheirindividualriskappetite.Thekeyisformarketparticipantstosizetheirappetiteforunsecuredcreditriskandthensetassumptionsandmarginsaccordingly8.GranularityInordertoproperlyquantifytheliquidationrisk,themarginanalysisshouldbeconductedatleastatalevelgranularenoughtodistinguishtheriskbetweenthevariousassetclasses,creditratings,durations,etc.Asanexample,itmaynotbesufficienttolookatthehistoricalpricevolatilityofCorporateBonds.TheCorporateBondassetclassisverybroadandincludessubassetclassesthatmayhavedifferentriskandliquidityprofiles.ByenablingmarginlevelstobesetatamoregranularlevelClearingBanks/CashInvestorswillbeinabetterpositiontounderstand/assesstheriskofcollateralthattheyhold,aswellasensurethatthemarginproperlycoverstheirliquidationrisk.PeriodicReviewItisimportanttoreviewthemethodologiesandassumptionsthatareusedinthecalculationonaperiodicbasisinordertorecalibratethehaircuts.Althoughtheinitialhaircutshavealreadyassumedastressedscenario,therecalibrationwillberequiredifchangesinmarketconditionsprovethatvariousassumptionsweretooaggressiveortooconservative.Reliable3rdPartyValuationsCollateralizingtripartyrepotradeswithassetsthathavereliable3rdpartyvaluationsisanintegralpartofanyriskbasedmarginingprocess.ThisisdiscussedfurtherinSection8below.PracticalityAsacounterbalancetotheprinciplesabove,anymarginingproposalshouldconsiderthepracticalityofthecalculation/implementation.Simplyput,arobustriskbasedalgorithmthatanalyzesstresslevelsandvolatilityatthecusiplevelmaybeidealfromariskmanagementapproach,butthepracticalrequirementsofbuildingthisinfrastructureandrollingoutthisapproachtoallmarketparticipantsisbeyondwhatmarketwideinfrastructurecancurrentlymanage.FormostCashInvestors,theTaskForcebelievesthatsettingmarginlevelsbyassetclassprovidesanappropriatebalance,allowingcreditratingsandmaturitiestobetakenintoaccount,withsufficientgranularitytoensuresufficientriskdifferentiationbutalsoensuringthatthenumberofcollateraltypesassociatedwithmarginlevelsismanageable.Inaddition,therepomarketwillneedtobalanceanynewriskbasedapproacheswiththepotentialcostofimplementationaswellastheoperationaldifficultiesassociatedwithdayto8AsdiscussedinSection5,someCashInvestorsassignmoreweighttotheDealercreditquality,independentlyofthecollateralpledged,soriskbasedmarginingmaynotpreventCashInvestorsfromexitingtripartyreposwithadeterioratingDealer. 22of43
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daymanagement.However,theprinciplesoutlinedhereshouldbefollowedbyallmarketparticipants,regardlessoftheriskmanagementtoolsandthespecificapproachtheyusetoimplementthem.ThismaymeanthatsomesecuritiesarenotappropriateforcertainCashInvestors.Thiswillbedriven,atleastinpart,bytheCashInvestorsabilitytoanalyzetheriskofthespecificassetclassgiventheirinternalrisksystems.AvoidProCyclicalBehaviorAsriskwasperceivedtobelowerandspreadstightenedthroughoutthelastcreditcycleacommontrendwastoseereductionsintheamountofcollateralthatwasprovidedintherepomarket.Atthetime,themarketacceptedthispracticebasedupontheprevailingstablemarket.Asthemarketsdeterioratedin2008and2009marketparticipantschangedmarginrulesetsbyexcludingcertainassettypesandincreasingmarginlevelsinordertooffsettheperceivedhighercollateralliquidationriskduetotheincreaseinpricevolatility.Attheextreme,someparticipantspulledoutoftherepomarketbecausetheybecameuncomfortablewiththeunsecuredcreditriskresultingfrominsufficientmargin.Thisprocyclicalbehaviorincentedrisktakinginperiodsofstabilityanditconstrainedliquidityattheworstpossibletime.Insomecases,thisalsoresultedinparticularconcernassomeDealersreliedonClearingBankstofinancecollateralnolongeracceptedbyCashInvestorswhilealternativefinancingwassought.Ingeneral,theTaskForcebelievesthemarginingprocessshouldavoidprocyclicalbehaviorwherebyClearingBanksandCashInvestorschangetheirrulesetsinasuddenandcapriciouswayintimesofstress,leavingDealerswithlittlefinancingoptionsforilliquidcollateral.Asamoreriskfocusedandstressbasedhaircutapproachisincorporatedwebelievethisprocyclicalbehaviorwillbereducedbecauseofthehighermarginlevelsthatwillbeappliedexanteandregularlyadjustedthroughoutthemarketcycle.Thisshouldreducedramaticorunexpectedcallsforadditionalcollateral.Furthermore,thisthroughthecyclemarginwillprovidesufficientprotectionsuchthatincreasesinvolatilityorreductionsinliquidityandpricetransparencywillnothavethesamesignificantimpactonrepofundingormarginarrangements.Objective&TransparentMethodologyMisunderstandingsrelatedtothetripartymarginingprocessbetweenDealersandClearingBankswasanotherdriverofinstabilityintherecentmarketcrisis.WhilebothClearingBanksandCashInvestorshaddiscretiontoincreasetheirmargin,therewasnoframeworktodiscloseorexplainthemarginmethodologyorunderlyingdriversandassumptions.Incontrast,theTaskForcebelievesthatanobjective,welldefined,andtransparentmethodologythatreducesunexpectedincreasesordecreasesinmarginrequirementsshouldcontributetotheeliminationofthisuncertainty.Furthermore,webelieveamoretransparentapproachwillreducetheneedforunanticipatedandpoorlyunderstoodmargincalls.Akeyfeatureofthisapproachwillbedisclosurethatexplainsthedriversandrationaleofthecalculation,aswellasitsunderlyingassumptionsandmechanics(e.g.,howarecreditrisk,interestraterisk,liquidity,concentrationrisks,etc.accountedfor?).Additionally,anychangestothemethodologyshouldbecommunicatedtoallparties,andshouldbephasedintothemarginingprocesswithreasonablenoticetime.Althoughtheabilitytoincreasehaircutsisakeycomponenttoriskmanagement,thephasinginofchangestothemarginingprocessshouldnotmateriallyimpactthevariouspartiescreditexposureanalysisastheagreeduponthroughthecyclehaircutshavealreadyassumedastressbasedcushion.Additionally,thisphasedinapproachwillgiveDealerssufficienttimetoprepareforincreasedhaircutsortootherwisemanagetheirinventoryifpostingtheincrementalmarginisuneconomic.Asaresult,webelievethisprocesswillreducethepossibilitythatchangesinrepomarginingwillhaveadestabilizingimpactonthemarket.DeterminingAppropriateMarginsBecauseofthecomplexitiesofthemarginingprocess,theTaskForceisnotmakingdetailedtechnicalRecommendationsonmarginapproaches.Instead,theTaskForcehasarticulatedtheprinciplesjustdescribedand
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recommendsthatmarketparticipantsadopttheseprincipleswithintheirownriskmanagementapproaches.Inaddition,theTaskForcerecommendsthatmarketparticipantsreviewtheregularpublicationoftripartyrepomarginlevelsthatwillbecomeavailableastheresultoftheTaskForcesRecommendationsinSection8oftheReport.Theseshouldserveasabenchmarkforassessingmarginlevelsbutarenotasubstituteforundertakingonesownanalysis.InformationontherelativeconcentrationofDealersindifferentassetcategoriesmaybeinformativewithrespecttothepotentialforlargerliquidityeffectsonpricingintheeventofaliquidationandthereforemightbeparticularlyusefulinthemargincontext.Recommendation6.
CashInvestors,Dealers,andClearingBankstodetermineappropriatecollateralmarginsinlinewiththeprinciplessetoutinSection6ofthisReport,takingnoteofmonthlyTriPartyRepoStatisticstobepublishedontheFederalReserveBankofNewYorkwebsite.(Ongoing)
AlthoughthisRecommendationisaddressedtobothClearingBanksandCashInvestors,itisimportanttonotethattheimplementationconsiderationsaredifferent.Therefore,itshouldnotbeexpectedthatthespecificmarginingmethodologies/processeswouldbethesamebetweenClearingBanksandCashInvestors.MarginingProcessbetweenDealerandClearingBankTheClearingBankunwindandmarginingprocesswasnotwellunderstoodbyallDealers.Ashighlightedabove,theTaskForcedoesnotproposeaprecisemarginingmethodologytobeusedbyallClearingBanks.InsteadwerecommendthatClearingBanks/Dealersworktogethertoimprovetransparencyandreducesubjectivityinthedailymarginingprocess.Recommendation7.
ClearingBankstocontinuetoshareinformationonintradaymarginmethodologiesandprocesseswithrespectiveDealers.(Ongoing)
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Section7: ContingencyPlanningThefocusofthispartoftheTaskForceseffortshasbeenonimprovingpreparednesstocopeeffectivelywiththedefaultofaDealerfirm.GiventheRecommendationsonoperationalarrangementsandtheenvisionedreductionsinClearingBankprovisionofintradaycredit,itfollowsthatCashInvestorsshouldhaveevenstrongerincentivestoengageineffectivecontingencyplanningforsuchevents.Acriticalstartingpointforsuchcontingencyplanningistheassessmentofpotentialimpactsfromsuchadefaultevent.ThistypeofstressanalysisshouldconsiderthedefaultoftheCashInvestorssinglelargestrepocounterparty(asmeasuredbyexposure),astandardthathaslongbeenappliedtoparticipantsinsystemicallyimportantpaymentandsettlementarrangements.Inaddition,itshouldconsidertheimpactofthatDealersdefaultonthepriceofthecollateralthatwouldneedtobeliquidated,thelengthoftimetheCashInvestorbelieveswouldbeavailableforsuchliquidation,andanyotherfactorsthatmightimpacttheproceedsfromcollateralliquidation.TheresultsofthestressanalysisshouldfactorintotheriskassessmentandriskappetiteofCashInvestorsaswellastheircollateralconcentrationlimitsandmarginsettingprocesses.Theseresultsshouldbediscussedwithseniormanagementandboardsasappropriatedependingonthenatureoftheorganization.Recommendation8.
CashInvestorstoundertakeregularstresstestsoftripartyrepocounterpartyexposuresthatconsideradefaultofthelargestrepocounterpartytogetherwithpotentialchangesinthemarketvalueoftheunderlyingcollateral.(Ongoing)
AfteraDealerdefault,CashInvestorshavetherighttoseizeandliquidatethecollateralandshouldhaveappropriateprocessesandprocedurestohandlecollateralmanagementandliquidation.IntheeventthatthecollateralliquidationproceedsareinsufficienttooffsettheentireamountoftheCashInvestorsclaim,theCashInvestorretainsanunsecuredclaimagainsttheDealerfortheamountnotsatisfied.ThoughtfulmanagementofthecollateralcanminimizetheimpacttoanindividualCashInvestorandtothemarketasawhole.CashInvestorsshouldbepreparedforaborrowerdefaultbyhavingpolicies,procedures,andsystemsinplacetobeabletofacilitatethedeliveryofcollateral.ThisplancouldincludeinstructingtheClearingBankthatholdsthecollateralonbehalfoftheCashInvestorpriortothedefaulttotransferthecollateraltoasegregatedcollateralaccountattheClearingBank.TheCashInvestor,eitherdirectlyorwiththeassistanceofanagent,mustbeabletopricethecollateralinordertoassignapricetotheirdefaultedrepopositionheldbytheCashInvestor(e.g.,marketvalueofdefaultedrepopositionisdependentuponthemarketvalueofthecollateralitexpectstoreceiveuponliquidation).CashInvestorsshouldhaveacohesivestrategyandresourcestosupporttheorderlyliquidationofadefaultedDealerstripartyrepocollateral.Dependinguponmarketconditions,immediateliquidationmaynotbethebestoptionforsomeCashInvestors.ThedefaultedrepopositioncouldbeanilliquidholdingandtheCashInvestormayneedliquiditybeforetherepocollateralisliquidated.EachCashInvestorshouldhaveanoverallliquidityplanwhichtakesintoaccountthepossibilityofaDealerdefault.SomeCashInvestorsmaychoosetomanagethesaleofcollateraldirectlywhileothersmayelecttouseadelegatedliquidationagent.Cashinvestorsshouldestablish,monitor,andtesttheseprocedurestoensurethatagentsareabletoacceptthedeliveryofcollateralatanytime.Recommendation9.
CashInvestorstoputinplaceandregularlyreviewcontingencyplansforaDealerdefaultthatcover,ataminimum,aprocessforeffectivelymanagingcollateral,includingaplantomanageliquidityandriskexposureduringtheliquidationprocess.(15Jan2011)
BuildingontheworkofTaskForce,towhichithascontributedsubstantially,theInvestmentCompanyInstituteisdevelopingamorecomprehensivesetofBestPracticeguidancefortheCashInvestorcommunity,withaparticularfocusonmoneymarketmutualfunds.TheTaskForcestronglysupportsthisinitiative. 25of43
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Recommendation10.
RelevantindustryassociationsinconjunctionwiththeirconstituentsareencouragedtopublishcomprehensiveBestPracticeguidanceforCashInvestors.(30Sep2010)
MitigatingliquidityimpactofDealerdefaultThereareseveralpossiblewaystoreducetheliquidityimpactofafailingDealeronCashInvestors,inadditiontotheobviousapproachofreducingthesizeofrepoexposuresinthefirstplace.PrearrangingsecuredliquidityfacilitiesCashInvestorsmaychoosetoenterintoacommittedliquidityfacilitythatwouldallowthemtoobtaintemporaryliquiditysecuredbyhighqualityunencumberedsecuritiesthattheyown.ManyCashInvestorsownsufficienthighquality,shortdatedsecuritiesthatcouldcollateralizethefundingundersuchafacility.Thefacilitywouldreducetheneedtoengageinafiresaleofcollateralthatcoulddepresssecuritiesprices.Cashinvestorswouldneedtogaugehowlargeacreditfacilitymightbeneededtocovertheirliquidityneeds.Thismustbereassessedregularly.ThepotentialuseofsuchfacilitiesbyregulatedCashInvestorsshouldbediscussedwiththoseregulators.Netting/offsetofDealerpositionsthroughDTCC(TheDepositoryTrust&ClearingCorporation)OffsetingpositionsthatCashInvestorsholdrelativetoadefaultedDealerandthosethattheDealerheldwithitsotherclientsreducesthenumberofpositionsthatneedtobeliquidated.Themorepotentialoffsetsthatcanbeidentified,thelesspotentialliquidationneedstooccurIntheeventofaDealerdefault,ClearingBanksandDTCCshouldreviewallFICC(FixedIncomeClearingCorporation),NSCC(NationalSecuritiesClearingCorporation),andDTC(TheDepositoryTrustCompany)sellpositionsinordertoidentifytripartyrepocollateralthatcanbeusedtosatisfythedefaultedDealersshortpositionsthroughanetting/setoffprocess,whichcouldresultinlesscollateraltobeliquidatedintheopenmarket.Proceduresneedtobeinplacetocontrolthisflow.DTCChasexistinginfrastructureinplacewithClearingBanksthatcouldpotentiallybeleveragedtoaccommodatethisprocess.DTCCdidapreliminarysampleanalysisofthreelargetripartyrepoportfoliosbasedondatareceivedfromeachoftheClearingBanks.TheanalysisfocusedonU.S.TreasuryandU.S.Agencydebtcollateral.Nettingopportunitiesrangedfrom9%to18%.Recommendation11.
DTCCanditsaffiliatestoworkwithothermarketparticipantstomaximizethepotentialforoffsettingofpositionsintheeventofaDealerdefault;DTCCand/orotherinterestedpartiescanprovideaviablecollateralliquidationmanagementserviceforthoseCashInvestorswishingtodelegatetheseactivities.(30Nov2010)
AdditionalConceptsLiquidityStabilizationUtilityThisisamorefarreachingconceptasmentionedinSection1oftheReport.Theideawouldbetoestablishanongoingbankentity,theLiquidityStabilizationUtility(LSU),whichwouldexistfortheprimarypurposeofprovidingliquiditytoCashInvestors.TheLSUcouldprovideCashInvestorsacollateralizedloantransactionsecuredbyhighqualityshorttermassetsownedbytheCashInvestors.CashInvestorscouldthendisposeoftherepocollateralreceivedfromthedefaultedDealerinanorderlymanner.Asabank,theLSUcouldinprincipleraisecashtofundtheloanstotheCashInvestorsbypledgingthehighqualityassetstotheFederalReservediscountwindow.TheobjectivewouldbetoeliminateasfaraspossibletheriskoflosstotheLSUortheFederalReservebyhavingtherelevantCashInvestorscontractuallyobligatedtobearthe 26of43
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firstlossofanyshortfallsduetothepricesobtainedintheultimateliquidation.CapitalwouldbebuiltupintheLSUovertimethroughfees,allowingittoplayagreaterroleinprovidingliquidityasitgrows.AsnotedinSection1,theLSUraisesanumberofissues,includingitsultimaterelianceonFederalReserveliquidity,andthereforetheTaskForceisnotincludingarecommendationregardingtheLSU.CentralCounterpartyAnotherfarreachingconceptisthenotionofacentralcounterpartyorCCPfortripartyrepotransactions.AttheheartoftheCCPideaistheconceptofmutualizationofanylossesabovethemarginschargedbytheCCP.Theseareexpectedtobehigherthanthosechargedinbilateraltransactions.ThemutualizationcouldoccuracrosstheDealercommunity,oracrosssomecombinationofDealersandCashInvestors,andwouldnotnecessarilyimplyanychangeininfrastructurerelativetothatmaintainedbythetwoClearingBanks.BecausetheCCPstandsinasthecounterpartyfacingCashInvestorsinitstripartytransactions,inprincipleitcouldfinancetheliquidationofcollateralassociatedwithadefaultedDealersimplybyundertakingnewtripartytransactions.AslongasthecreditqualityoftheCCPitselfwasnotinquestion,thisapproachwouldthereforehavepotentialtoaddressconcernsbothwithrespecttothefiresaleliquidationofcollateralandwithrespecttothestabilityoftripartyfinancing.Thecostsandcomplexityoftheissuesinvolved,however,especiallypriortotheoperationalenhancementsneededtoeliminatetheneedforintradaycredit,leadtheTaskForcetoavoidmakingaspecificrecommendationregardingacentralcounterparty.Recommendation12.
Allmarketparticipantstocontinueexploringadditionalconceptsthathavethepotentialtoaddtothestabilityandresilienceoftripartyrepofinancingand/orreducethepotentialforcollateralfiresalesintheeventofaDealerdefault.(Ongoing)
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Section8: TransparencyThetripartyrepomarkethashistoricallyseenonlylimiteddisclosuresregardingtheaggregatesizeofthemarket,collateraltypes,andmarginlevels.Thislackoftransparencycontributestomarketuncertaintyduringtimesofstressandalsomayhavecontributedtounderestimatesoftheextentofprocyclicalityinherentinprecrisismarginlevelsandinthesystemicriskpotentialofthetripartyrepomarketoverall.Recommendation13.
Initiatemonthlypublication,viatheFederalReserve,ofaggregatestatisticsontripartyrepocollateralandCashInvestormarginlevels,withdisclosurebyassetclass,basedoninformationprovidedbytheClearingBanks.(SeeTable1forapilotversion.)(30Jul2010)
Thepilotversionofthereportdoesnotyetincludeterminformation,howevertheplanistoprovidethisonceitisavailableandreviewedbytheTaskForce.CollateralValuationAshighlightedinthediscussionofmarginingpractices,marginswillonlybeeffectivetotheextenttheyarebeingappliedinconjunctionwithanaccuratepriceforthesecuritiesheldascollateral.IfinaccuratepricesarebeingsuppliedbythirdpartyvendorstheClearingBank/CashInvestormaybeexposedtoasituationwherethemarketvalueofcollateralisinsufficienttocoverthereponotional.Thiscouldpotentiallyresultinunsecuredcounterpartycreditexposureresultingfromcollateralvaluationrisk.InordertominimizethecollateralvaluationrisktheTaskForcebelievesthevaluationprocessrequiresrobust,reliableandindependentpricingsources.Managingcollateralvaluationriskrequiresthatparticipantsunderstandthenatureandtypeofsourcesthatarebeingusedtogetherwithassociatedmethodologies,inparticularwheremodelbasedpricesarebeingused,aswellastheassumptionsandinputsourcesassociatedwiththosemodels.TheremayalsobesomecollateraltypeswherecollectiveeffortsbyDealerscouldfurtherenhancethetransparencyofvaluation.Forexample,insomemarkets,thirdpartyserviceshaveenabledanonymouscompilationofmarksappliedandtherebyprovidedadditionalusefulinformationontherangeandcentraltendencyofsuchmarks.Giventhelossofliquidityandtheincreaseinvaluationuncertaintythatsomecollateraltypesexperiencedduringthecrisis,theremayalsobebenefitinexploringwhetheradditionalinformationontherangeandnatureofvaluationscouldbeusefulinmeasuringtheextentofvaluationuncertainty.CashInvestorswouldalsobenefitfromunderstandingasrapidlyaspossiblewhenandwherevaluationuncertaintyisincreasing.Lastly,inthecurrentenvironment,therearemanyassetclassesforwhichthevendorsprovidepricingasofthepreviousdayscloseofbusiness.Inavolatilemarket,thisstalepricingcanmisstatethecurrentvalueoftheassets.Asaresult,thereisaneedtoevaluatethepossibilityofprovidingsamedaypricingvaluationsacrossawiderrangeofassetsincludedwithinthetripartyrepomarket.Forallthesereasons,theTaskForcebelievesthatitisdesirabletoestablishafocusedworkinggroupofvaluationspecialiststolookattheseandotherissuesandtomakerecommendations.Recommendation14.
TheTaskForcewillestablishaworkinggroupofvaluationspecialistsacrosstripartyrepomarketparticipantstoevaluatecollateralpricingmethodsandmakerecommendationsforimprovements,includingthefeasibilityofsamedaypricing.(15Oct2010)
Onaregularbasis,bothDealersandCashInvestorsshouldbecomparingortestingvaluationsprovidedbyClearingBanks.CashInvestorsshouldtestthevendorpricesprovidedbytheClearingBanktodetermineifthelevelofovercollateralizationisappropriate.RunningindependentpricinganalysiscanhelpCashInvestorsidentify 28of43
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potentialissuesandcorrectthem.CashInvestorsshouldbeabletopricethecollateraltheyreceiveandshouldvalidatetheirpriceswithClearingBanksandDealers.ThissupportsvalidatingthepricesusedbyClearingBanksandincreasespricetransparencyacrossthetripartyrepomarket.DealersshouldlikewiseincludeacomparisonofvaluationsaspartoftheirregularinteractionswithClearingBanks.ThiscouldincludeestablishingbilateraltolerancelevelsthattriggergreaterreviewordiscussionbetweentheDealerandtheClearingBank.Recommendation15.
CashInvestorstoregularlyvalidatetripartycollateralforpricing,appropriateness,andclassification.DealerstoregularlycomparecollateralmarksontheirownbooksandrecordswithvendorpricesprovidedbytheClearingBanks.(Ongoing)
AspecialcaseariseswhentheDealersmarksforagivensecurityaremateriallybelowthepricesprovidedbytheClearingBanks,whichobtainthemfromthirdpartyvendors.Insuchcases,DealersshouldhighlightthevariationstoCashInvestorsandClearingBankstoensurethatrepotransactionsarenotfinancingsecuritiesatlevelsthatwouldimplyamaterialshortfallofmargin,assumingtheDealersvaluationisthecorrectone.Recommendation16.
DealerstoinformCashInvestorsandClearingBanksincaseswheretheDealersmarksaremateriallybelowthevendorpricesprovidedbytheClearingBank.(Ongoing)
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Section9: AssessmentAsdiscussedinSection1ofthisReport,therecentcreditcrisishighlightedmaterialweaknessesintheU.S.tripartyrepomarketthatexposedtheglobalfinancialmarketstosystemicrisk.Theseweaknessescanbegroupedintothefollowingcategories:
OperationalArrangements:ThedailyunwindprocessresultedinthetwoClearingBanksextendingupto$2.8trilliondollarsinintradayfunding.Thisalsoresultedinuncertaintyastowherethecreditexposureresidedthroughouttheday.
DealerLiquidityRiskManagement:ExamplesincludeDealersrelianceonveryshortdatedrepofinancing,aswellasDealersrelianceonuncommittedfundingtosupportthedailyunwindprocess.
MarginingPractices:ProcyclicalmarginingpracticesresultedinalossofliquidityforDealersinastressedmarket.
ContingencyPlanning:InsufficientpreparationformarketparticipantstocopewithaDealerdefault.
Transparency:Themarketgenerallylackedtransparencyintermsofmarketdepthandrisk.Inaggregate,theproposalsthataredetailedinthisReportwilldrasticallyreduce,althoughnoteliminate,manyoftheserisks.Thefollowingparagraphswillsummarize,throughspecificexamples,wherethisriskisreduced.ThepracticaleliminationofthedailyunwindsfornonmaturingtradeswillreducetheintradaycreditbytheClearingBankstolessthan10%9.Atitspeak,thiswouldhaveresultedina$2.5trillionreductioninClearingBankscreditrisk.Furthermore,bypotentiallyresettingthemarketstandardforunwindingmaturingtradesuntillaterintheday,theClearingBanksremainingcreditriskwillbefurtherreducedtoanafternoonwindowperiodinagivendaywithregardstotheunwindprocessformaturingtrades10.InordertoimproveCashInvestorscapacitytomanageaDealerdefault,theRecommendationsinthisReport(1)encourageamoreriskbased,nonprocyclicalmarginingprocessthatwillimprovetheexpectedrecoveryrateinadefaultscenario,and(2)provideanindustrynettingmechanismandsupportanoptionalliquidationagent.Theseenhancementswillimprovetheresiliencyoftheproductasparticipantswillhavegreateraccesstoafullyfunctionaloperationalprocessforcollateralliquidation.FromaDealersperspective,althoughtheamountofintradayfundingrequiredfromtheClearingBanksislimited,atransitionfromuncommittedfundingfacilitiestocommittedfundingfacilitieswouldgreatlyreduceaDealersliquidityrisk.Additionally,bythemarketmovingtoariskbased,nonprocyclicalmarginingprocesstheDealerswillbelesslikelytoseeamassivewithdrawaloffundingastheyenterastressedenvironment.Lastly,theindustryisundertakinganefforttoimprovemarkettransparency.Thistransparencywillcomeinvariousforms:(1)theindustrysfirstmonthlypublicationwhichdetailstheoverallsizeanddepthoftheU.S.tripartyrepomarket,(2)TriPartyRepoBestPracticesguidanceforCashInvestorswhichwilleducateallmarketparticipantsastotherisksoftheproductandthebestpracticestomanagetheserisks,(3)athreeway,realtimetradeconfirmationprocess,and(4)practicaleliminationofthedailyunwindprocesswhichwillensureclarityonintradayexposures.Thiswillsubstantiallyenhancetheabilityforsupervisorsandmarketparticipantstoassesstrendsandcallattentiontoemergingissuesbeforetheybecomesystemicinnature.
9The10%representstheestimatedportionofaDealer'sbookthatmaturesorreceivesinitialfundingonagivenday.10ClearingBanksmayadditionallyprovidesomeintradaycreditrelatedtocashsubstitutionspriortotradematurity.Wedonotexpecttheseamountstobematerial. 30of43
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ItisimportanttonotethattheTaskForcewasnotmandatedtoopineontheliquidityriskmanagementpracticesofthevariousDealers.AlthoughtheReporthastouchedbrieflyonsomegeneralbestpracticesonthistopic,italsoseemsclearthatupcomingregulatorychanges(e.g.BaselIII,etc)willfurtherreduce,althoughnoteliminate,theprobabilityofaDealerdefaultbyincreasingcapitalandliquiditystandardsgenerally.Thestandardsproposedinrelationtoliquidityareparticularlyrelevantastheyarelikelytomeanthatlowerqualitycollateralfundedviashortdatedrepomustbematchedbyliquidassetswithinthefirmsliquiditybuffer.Thebenefitsofthesemodificationsareillustratedbythefollowingsimplifiedtransactionexamplesthatcompare(1)thecurrenttripartyframework,and(2)theframeworkafterimplementationofallproposals:Example#1:BusinessAsUsualScenarioRepoTradeIsExtended11
Assumptionso Dealerhasasingle,$1.0bnrepomaturingtodayo DealerandCashInvestoragreetoenterintoanew$1.0bnrepopriortothemorningdeadlineo Thecollateralallocationisstatic(e.g.nocollateralsubstitutionsarerequired)
CurrentMarketProcesso TheClearingBankisnotnotifiedofthenewtradedetailso TheClearingBankextendsa$1.0bnintradayloantotheDealeraspartofthedailyunwind
processo TheClearingBankcreditsa$1.0bndepositintotheCashInvestorsaccounto TheDealerisreliantonadiscretionarylineofcreditfromtheClearingBanktomanagethe
operationalflowsonthistradeo Attheendoftheday:theClearingBankreallocatesthecollateraltotheCashInvestor;
withdrawsthecashdepositfromtheCashInvestorsaccount,andclosesouttheintradayloantotheDealer
o CashInvestorscreditriskistransferredbetweensecuredDealerriskandunsecuredClearingBankdepositrisk.ThetimingofthisrisktransferisunknowntoCashInvestorthroughouttheday
PostTaskForceImplementation
o TheDealer,CashInvestor,andClearingBankconfirmthedetailsofthenewtradeviathethreeway,realtimeconfirmationprocess
o Thetradeisnolongersubjecttothedailyunwindo TheClearingBankwillnotneedtoextendanycredittotheDealerinthecontextofthisexampleo TheCashInvestorhasrepoexposuretotheDealerallday
Example#2:BusinessAsUsualScenarioRepoTradeMatures Assumptions
o Dealerhasasingle,$1.0bnrepomaturingtodayo TheDealerandCashInvestorareunabletoagreeonanewrepotradeo Thecollateralallocationisstatic(e.g.nocollateralsubstitutionsarerequired)o InthePostImplementationTaskForcescenario,theoriginaltradewillbesubjecttotheEndof
DaySettlementtimediscussedinSection4oftheReport.
CurrentMarketProcesso Inthemorning,theClearingBankextendsa$1.0bnintradayloantotheDealeraspartofthe
dailyunwindprocesso TheClearingBankcreditsa$1.0bndepositintotheCashInvestorsaccount
11Withtheexceptionoftheconfirmationprocess,anonmaturingtermtradewillhavesimilarmechanics 31of43
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o TheDealerisreliantonadiscretionarylineofcreditfromtheClearingBanktomanagetheoperationflowsonthistrade
o CashInvestorwithdrawsthiscashinthemorningleavingtheClearingBankwithsoleexposuretotheDealer
o Attheendoftheday,theDealerrepaysthe$1.0bntotheClearingBanktocloseouttheintradayloan
PostTaskForceImplementation
o AttheendofthebusinessdayandsubjecttothetermsofthecommittedfundinglineinplacebetweentheDealerandtheClearingBank12,theClearingBankextendsa$1.0bnloantotheDealer,andcredits$1.0bnofcashintotheCashInvestorsaccount
o FromtheDealersperspective,theintradayloaniscommittedsubjecttothetermsoftheagreement
o TheCashInvestorwithdrawsitscashattheendofthedayo TheDealerwillrepaytheintradayloanpriortotheendoftheday
Example#3:DealerStressScenario($1.0bnrepotradedoesnotmatureduetoDealerdefault) Assumptions
o Dealerhasasingle,$1.0bnrepomaturingtodayo InthePostImplementationTaskForcescenario,Dealerisunabletomeetthetermsofits
committedintradayfundingfacilityfromtheClearingBank(e.g.unabletopostthenecessarycollateral),andtheDealerisunabletorepaytheprincipalamountdue
CurrentMarketProcess
o Duetothestressinthemarket,thereisgeneraluncertaintyastohowtheunwindprocesswillwork: TheClearingBankmayormaynotunwindthistrade TheDealerdoesnothaveanyclarityastowhetherthetradewillunwind TheCashInvestordoesnotknowif/howthematuringtradewillbeunwound IfthetradeisnotunwoundandtheDealerdefaults,thereisuncertaintyregardingthe
liquidationprocess
PostTaskForceImplementationo Attheendoftheday,theClearingBankmakesamargincalltotheDealer;Dealerisunableto
meetthecallo PerthetermsofthecommittedfundingfacilitytheClearingBankwillnotunwindthematuring
trade(i.e.nocreditwillbeextendedtotheDealer,collateralwillremainintheCashInvestorsaccount).Asaresult,theCashInvestorwillretainitsrisktotheDealer
o Attheendoftheday,iftheDealerhasnotrepaidtheprincipaldue,thecollateralliquidationprocesswillbegin Theindustrynettingprocesswouldpairofftradestoreducetheinventorythatwillbe
deliveredtotheCashInvestors Ifelected,theremainingcollateralafternettingwillbetransferredtothethirdparty
liquidationagentwhowillactonbehalfoftheCashInvestor Ingeneral,theCashInvestorwillbebetterpreparedtomanagethisscenarioduetotheir
improvedcontingencyplanning
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Section10: NextStepsUponthepublicationofthisReporttheTaskForcesoriginalmandatewillbecompleted.However,inordertomaintainthecurrentmomentumthroughtoexecution,theTaskForceproposestotakeownershipoftheimplementationphasefromacollectiveindustryperspective.ThisproposalisintendedtocombinethebenefitsofcontinuitywiththeflexibilitytoevolvetheTaskForceandtheindividualsthatareparticipating.TheTaskForcealsorecognizesthatothergroupingsmayintimebeseenasmorenaturalpointsofgovernanceforcertainissuesdiscussedinthisReport.Nevertheless,theTaskForcebelievesthegreaterconcernintheshortrunmustbetomaintainmomentumanddrivetheoperationalimprovementsneededinthetripartyrepoinfrastructure.Accordingly,thefocusoftheTaskForcesnextphasewillconsistof:(1)theexecutionofitsRecommendations,inparticulartheindustryactionplantoimprovetripartyrepooperationalarrangements,and(2)analyzingandadaptingtheseRecommendationsbaseduponpotentialregulatorydevelopmentsandresponsestotheFederalReservesWhitePaper.TheTaskForcewillmaintainaworkinggroupfocusedprimarilyonoperationalinfrastructureimprovementsandwillestablishasecondworkinggrouponvaluationissuesasoutlinedintheRecommendations.TheTaskForcewillalsocontinuetoseekinputfrommarketparticipantsnotdirectlyrepresentedontheTaskForce.TheTaskForcewishestothankallmarketparticipantsandstaffatofficialagencieswhoprovidedinputorotherwisecontributedtothisReport.AfulllistingoftheTaskForcemembersandthosewhocontributedtoitsworkstreamsisincludedasAnnex4oftheReport.
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Section11: AnnexesAnnex1MinimumParametersRequiredforTradeMatchingAminimumnumberofparametersmustagreeinorderforabookedtradetobematched.Theseparametershavebeenlistedanddefinedbelow.Therearecertaineconomictermsofarepotrade,suchastheactualbenchmarkused,whichmaynothavebeendefinedintheinitialbooking,butwhicharenotrequiredforasuccessfulmatch.Allfieldslistedbelowmustbepopulated,atleastwithdefaultvalues.Nofieldscanbeblankunlessotherwisenotedbelow.1. Buyerlegalentity.TheBuyerslegalname.Fortheinitialmorningtrades,priortobeneficialownersub
accountallocationsbeingready,theBuyerslegalnamemaybelongtothetopaccountowner,theinvestmentadvisor,oranotheraffiliatedentityrepresentingtheeventualbeneficialowner(s).Intheafternoon,onceallocationsareavailable,thisfieldwouldbepopulatedwithbeneficialownerslegalname.
2. Sellerlegalentity.TheSellerslegalentityname.3. Transactiontype.(Repo,B/P,[other])ThedefaultwouldbeRepo.4. Tradedate.(MM/DD/YYYY)Thedatethetradestermsareagreed.5. Settlement/startdate.(MM/DD/YYYY)ThedateonwhichtheBuyerscashbeginsfundingtheSellers
inventory.6. Currency.(CCY)ThiswilldefaulttoUSD.7. Principal.Thesizeoftherepofinancing,listedintheunitsofCCY.8. Ratetype.(fixedorfloating)9. Rate.(NNNNbps)IfRatetypeisfixed,thefixedrateisentered.IftheRatetypeisfloating,theapplicable
spreadtothebenchmarkwouldbeincluded.Thebenchmarkwouldbeincludedinasubsequentcommunication.
10. Maturitydate.(MM/DD/YYYY)Thedatewhenatradematures,whetheritisanovernighttradeoratermtradelongerthanovernight.OpentradeswillhaveastandardrepresentationTBDinthisfield.
11. Collateraltypeidentification.TheSellerandBuyerwillinputthesameidentifiertorepresentthecollateralagreedtounderthetrade.TheClearingBankwillneedtobeabletorecognize,attheveryleastatahighlevel,whatthiscollateralbasketis(e.g.,Treasuries,commonequities,etc.)inordertodoallocations.Note:thismayrequireastandardcollateralclassificationacrossallmarketparticipants,aswellasmorestandardcollateralschedules.
12. Blocktradeidentification.ThisfieldisnecessarytobepopulatedbytheMatchingServiceinorderforsubsequentallocationstobeneficialownersubaccountscancancelandreplacetheoriginalearlymorningtopaccounttrades.Thiswillonlybeusedfortradesthathaveafternoonallocations.
13. Initial/RevisedBreakdown.(Willbecomefinalbreakdownifnosubsequentsubmissionreceivedat"endofday"tobedefined)
14. Morning/Afternoonsettlement.(Ifconventionisadoptedbyindustry)15. RolledTrade.(Y/N)
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Annex2SummaryofWorkoftheLegalSubcommitteeoftheTaskForceonTriPartyRepoInfrastructureOverviewUndertheleadershipoftheFederalReserveBankofNewYork,theLegalSubcommitteeoftheTriPartyRepoTaskForceincludedlegalrepresentativesfromCashInvestors(assetmanagers/repoBuyers,Dealers(repoSellers),andClearingBanks.TheworkoftheLegalSubcommitteefocusedontryingtoprovidelegalsolutionstothefollowingtwochallengesinthetripartyrepomarket:
1. Confirmingthelegalcertaintyregardingrepocommitmentsmadeearlyinthedaybetweenvariousfundsand/orjointaccount(s)andtheirDealercounterparties(onaprincipaltoprincipalbasis)whilemaintainingflexibilitytochangeallocationstospecificprincipalsaftertheoverallcommitmentisestablished;and
2. EliminatingthedailyunwindofcashandcollateralcurrentlyperformedbytheClearingBanksinrespectoftermrepurchasetransactionsand,tothegreatestextentpossible,eliminatingthedailyunwindofcashandcollateralperformedbytheClearingBanksinrespectofallotherrepurchasetransactions.
TheproposaloftheLegalSubcommitteeisdescribedbelow,inbroadterms.Thisproposalisintendedtocoveralltypesofrepurchasetransactions,includingtransactionswhichinvolvejointtradingaccountsaswellastransactionsinvolvinggovernmentandnongovernmentsecurities,withtheunderstandingthattherewillnolongerbedailyunwindsfortermrepurchasetransactions.Inaddition,theLegalSubcommitteethoughtitwasimportanttonotethateachtimeaCashInvestorandaDealerenterintoanewrepur