The SEC has chimed in on tri-party liquidation; joins the Fed on this important topic

The SEC has chimed in on tri-party liquidation, releasing a Guidance Update (July 2013, Number 2013-13) “Counterparty Risk Management Practices with Respect to Tri-Party Repurchase Agreements”. They raise some serious issues about tri-party repo. It’s not just the Fed banging the drum anymore.

Conventional wisdom has been that when looking at repo exposure, if the cash lender is OK with the counterparty risk, they don’t pay too much attention to the collateral. At best, cash lenders will be happy with broad collateral rules – nothing too specific. We have heard more than once that when collateral rules get too granular, cash lenders — lacking the infrastructure to get too deep into the collateral specifics — are overwhelmed with the detail and things come to a grinding halt.

But the SEC is saying something else — MMFs should start to focus on the collateral more seriously. And they are specifically addressing money market funds since they (the MMFs) are a significant investor in tri-party repo.

The SEC says:

“…There are a variety of ways in which a money market fund and its adviser may be able to prepare in advance for handling a default of a tri-party repo held in the fund’s portfolio…Review the master repurchase agreements and related documentation to consider any specified repo default procedures…”

Sounds pretty innocuous. The SEC suggests that if there are notifications to be made, have templates at the ready.

“…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. If they are not capable, funds may want to consider what systems changes or temporary measures could allow for such capabilities and what other operational impacts may flow from the fund holding the collateral, as opposed to the repo…”

This is where they start to get serious about funds needing to understand what happens if they end up owning the collateral. But wait…there is more.

“..Consider, to the extent possible, whether there are potential legal considerations under the Investment Company Act 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 under the Investment Company Act of 1940.5…”

And

“…Funds also may want to determine whether the defaulted repo would be subject to any automatic stays under either the U.S. Bankruptcy Code or federal banking laws and regulations…”

The question of what collateral the MMFs may end up owning in a default scenario versus what paper they can invest in has been one of those issues no one wants to ask for fear that the answer is “if you can’t own it, you have no business taking it as collateral”. First, the systems enhancements necessary to make that work are substantial. And broker/dealers, if they were limited on their MMF tri-party to, say, paper under a year or two to maturity, would find themselves caught in a real bind. But the SEC looks like they just opened Pandora’s Box.

Considering automatic stays will lead to one thing: uncertainty as to when collateral can be liquidated. That means either avoiding less liquid paper, figuring out what hedging strategies might look like, and/or (in response the higher VaR that comes when liquidation periods are lengthened) raising haircuts overall.

Cash lenders in the good ‘ole days of tri-party knew with reasonable certainly that the daily unwind was going to get them off the hook. Now that the unwind/rewind window is smaller and ultimately going to “an operational moment in time”, cash lenders will be at risk for a lot more (time) than they were used to. Risk management and systems will need to follow.

A link to the SEC Guidance Update is here.

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