[Senate Hearing 112-746]
[From the U.S. Government Publishing Office]
S. Hrg. 112-746
THE TRI-PARTY REPO MARKET: REMAINING CHALLENGES
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HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
ON
EXAMINING THE TRI-PARTY REPO MARKET
__________
AUGUST 2, 2012
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
MIKE CRAPO, Idaho, Ranking Republican Member
CHARLES E. SCHUMER, New York PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
HERB KOHL, Wisconsin JIM DeMINT, South Carolina
MARK R. WARNER, Virginia DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota
Kara Stein, Subcommittee Staff Director
Gregg Richard, Republican Subcommittee Staff Director
Catherine Topping, FDIC Detailee
(ii)
C O N T E N T S
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THURSDAY, AUGUST 2, 2012
Page
Opening statement of Chairman Reed............................... 1
Prepared statement........................................... 23
WITNESSES
Matthew J. Eichner, Deputy Director, Division of Research and
Statistics, Board of Governors of the Federal Reserve System... 3
Prepared statement........................................... 24
Responses to written questions of:
Chairman Reed............................................ 35
Karen B. Peetz, Vice Chairman, The Bank of New York Mellon....... 5
Prepared statement........................................... 28
Steven R. Meier, Executive Vice President, Chief Investment
Officer, State Street Global Advisors.......................... 7
Prepared statement........................................... 30
Thomas G. Wipf, Managing Director and Global Head of Bank
Resource Management, Morgan Stanley............................ 9
Prepared statement........................................... 32
Additional Material Supplied for the Record
Statement submitted by the Investment Company Institute.......... 38
(iii)
THE TRI-PARTY REPO MARKET: REMAINING CHALLENGES
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THURSDAY, AUGUST 2, 2012
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 9:01 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF SENATOR JACK REED
Chairman Reed. Let me call the hearing to order. I first
want to thank my colleague the Ranking Member, Senator Crapo,
and his staff for participating, and particularly at this early
hour. I have another hearing on Appropriations later, so we had
to move it up.
I want to thank the panel for being here, for your
excellent testimony, and also for cooperating with our time
shift.
Today our hearing is entitled ``The Tri-Party Repo Market:
Remaining Challenges''. Last week, Secretary Geithner presented
the Financial Stability Oversight Council's second annual
report to Congress. The Council is responsible for providing us
with a comprehensive, coherent overview of the health of our
financial system, a direct result of the Dodd-Frank Act in
terms of trying to alert Congress and the Nation to potential
systemic problems, giving us time to respond, not at the last
moment when we are in crisis mode.
The Council report identified structural vulnerabilities in
the short-term funding markets, particularly the tri-party
repurchase, or repo, market, as a continuing area of concern.
The report states that ``limited progress has been made in
substantially reducing the reliance of this market on intraday
credits or improving risk-management and collateral practices
to avoid fire sales in the event of a large dealer default.''
The Council also stated that the industry's suggestion that
it will take several more years to eliminate the intraday
credit associated with tri-party settlements was, in their
words, unacceptable and called for greater Government
involvement. And that is one of the reasons why we are
convening this hearing and asking experts to comment upon where
do we go from here.
In general, a repo or repurchase agreement is the sale of a
portfolio of securities with an agreement to repurchase that
portfolio at a later date; the economics of repos are similar
to that of short-term loans collateralized by long-term assets.
Tri-party repos are typically used by large securities firms
and bank holding companies with broker-dealer operations to
raise short-term financing from cash investors, such as money
market mutual funds. The dealer and the investor typically use
one of two clearing banks to settle their transactions.
This market is very large. Tri-party repos peaked at $2.8
trillion at the height of the crisis in 2008 and today are
roughly $1.8 trillion.
Three major weaknesses of the tri-party market were
highlighted by the 2008 financial crisis: the market's reliance
on intraday credit from the clearing banks, the procyclicality
of risk management practices, and the lack of effective plans
to support the orderly liquidation of a defaulted dealer's
collateral.
Motivated by these risks, in 2009 the Federal Reserve Bank
of New York formed an industry-led task force to address the
problems highlighted by the financial crisis. Although this
task force disbanded in early 2012, its work led to a number of
important changes, including: moving the daily unwind of some
tri-party repo transactions from 8:30 a.m. to 3:30 p.m. which
shortens the period of intraday credit exposure; implementing a
mandatory three-way trade confirmation between dealers, cash
investors, and the clearing banks, marking the first time this
$1.8 trillion market has had an established confirmation
process; publishing of a monthly report regarding activity in
the tri-party repo market, which includes the size of the
market, collateral breakdowns, dealer concentrations, and
margin levels. This report enhances the ability of supervisors
and market participants to assess trends and call attention to
emerging issues before they become systemic.
However, as I indicated before, in its 2012 report, the
FSOC found that limited progress has been made in substantially
reducing the reliance of this market on intraday credits or
improving risk management and collateral practices to avoid
fire sales in the event of a large dealer default. The Council
also stated that that the industry's suggestion that it will
take several more years to eliminate the intraday credit
associated with tri-party settlements was unacceptable.
Because FSOC has sounded an alarm about the tri-party repo
market and stated the need to move quickly in implementing
further reforms, we have convened this morning's hearing to
discuss the report, better understand the changes to this
market already in place, and explore what more needs to be
done.
Improving the tri-party repo market will make it safer, to
the benefit of all market participants. And I also want to
indicate, too, since mutual funds are a large part of this
market, to the extent that we can improve the quality of this
market, I think we will help in other areas as we all know
those serious discussions from SEC and others about further
changes to the money market fund market. But these are
interrelated issues, and a strong repo market will, in fact, I
think, help immensely with respect to the profitability and to
the stability of money market funds.
With that, let me introduce my Ranking Member for his
comments. Thank you.
Senator Crapo. Thank you very much, Senator Reed. I
appreciate your holding this oversight hearing, and I have a
prepared opening statement, but you just made all the points
that I had in my opening statement, so rather than repeat
them----
Chairman Reed. Not as well, but----
[Laughter.]
Senator Crapo. Rather than repeat them, maybe I will submit
my statement for the record and we can proceed.
Chairman Reed. Without objection.
Senator Crapo. I note that we have an outstanding panel
today, and I expect that we will be able to make some serious
and helpful progress on this issue, so I look forward to the
witnesses' testimony.
Thank you.
Chairman Reed. Thank you very much, Senator Crapo.
Let me introduce the panel and then recognize them. Our
first panelist is Mr. Matthew Eichner. Mr. Eichner is currently
Deputy Director of the Division of Research and Statistics at
the Federal Reserve Board, where he focuses on issues related
to securities markets and dealers in securities and
derivatives. Prior to joining the Board staff, Mr. Eichner was
an Assistant Director in the Division of Trading and Markets at
the Securities and Exchange Commission. Thank you.
Ms. Karen Peetz is the vice chairman with responsibility
for the Financial Markets and Treasury Services Group within
BNY Mellon. Ms. Peetz is a member of BNY Mellon's Executive
Committee, the organization's most senior management body which
oversees day-to-day operations. Before joining BNY Mellon, you
spent 16 years with JPMorgan Chase. Thank you.
Mr. Steven Meier is an executive vice president of State
Street Global Advisors and is the global cash chief investment
officer. He has more than 28 years of experience in the global
cash and fixed-income markets. He held senior positions in
trading and investment banking while working for Merrill Lynch
and Credit Suisse First Boston for nearly 12 years. Thank you,
Mr. Meier.
Mr. Tom Wipf is managing director and global head of bank
resource management for Morgan Stanley. He is responsible for
the firm's secured funding, securities lending, collateral
management, and counterparty portfolio management activities.
Tom has been with Morgan Stanley since 1986. He served as a
member of the Tri-Party Repo Infrastructure Reform Task Force
Committee, the private sector body sponsored by the Federal
Reserve Bank of New York to address reforms in the tri-party
repo market.
Thank you all. Your testimony will be made part of the
record. Not only feel free but please limit your comments to
roughly 5 minutes so we can proceed to questions.
Mr. Eichner, please.
STATEMENT OF MATTHEW J. EICHNER, DEPUTY DIRECTOR, DIVISION OF
RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL
RESERVE SYSTEM
Mr. Eichner. Thank you. Chairman Reed, Ranking Member
Crapo, and Members of the Subcommittee, thank you very much for
inviting me to appear before you today to discuss the tri-party
repo market. The Federal Reserve has a strong interest in the
smooth functioning and resiliency of this market for several
reasons:
First, the market serves as a tool for cash and liquidity
management as well as short-term borrowing for a wide range of
financial intermediaries, including money market funds,
insurance companies, banks, and securities dealers, all of
which play an important role in supporting the savings and
investment programs of households, small businesses, and
nonfinancial corporations.
Second, a number of entities subject to direct prudential
supervision by the Federal Reserve are significant
participants, including the holding companies of the two
clearing banks--JPMorgan Chase and BNY Mellon--as well as many
other bank holding companies.
Finally, tri-party funding materially supports the depth
and liquidity of a number of critical markets, including those
for U.S. Government securities in which U.S. monetary policy is
executed.
In light of the critical importance of the tri-party repo
market, the Federal Reserve has been and is committed to
working with market participants and other supervisory and
regulatory organizations to enhance the market's resiliency.
During the crisis, it became apparent that the design of the
market's infrastructure to settle transactions had fundamental
flaws that could lead to serious instability during periods of
market stress.
A particular weakness was the reliance on large amounts of
discretionary intraday credit extended by the clearing banks
which could create incentives for both clearing banks and
lenders, such as money market funds, to rapidly withdraw from
the market. In fact, such run dynamics were visible around the
time of the near failure of Bear Stearns in March 2008 and
again during the worsening of the crisis in mid-September of
that year after the bankruptcy of Lehman Brothers.
Some significant progress has been made subsequently to
address this vulnerability, but not as much--or as quickly--as
we believe that the seriousness of the situation warrants.
Clear vulnerabilities remain, even now that the tri-party
market is smaller than at its precrisis peak and, in general,
funds higher-quality collateral than was the case prior to the
crisis.
The Federal Reserve, therefore, continues to be fully
engaged on a number of fronts to promote further measures that
will more completely mitigate the risks. We are also working
with the Securities and Exchange Commission, which plays a key
role as the primary regulator of major participants in the tri-
party repo market, including broker-dealers and many cash
lenders, notably money market funds.
Following the financial crisis, an industry-led Tri-Party
Repo Infrastructure Reform Task Force was formed in 2009 as an
initiative of the Payments Risk Committee, a private sector
body convened by the Federal Reserve Bank of New York. The task
force included representatives of market participants, such as
cash lenders, dealers, clearing banks, and other service
providers, as well as industry groups representing both dealers
and investors.
In its May 2010 interim report, the task force dealt
directly with the issue of reliance on intraday credit
extension, creating a detailed plan for its practical
elimination by mid-2011. In fact, participants achieved some
important prerequisites to this goal last year. However, it
became clear last year that more fundamental changes to systems
at both clearing banks and on the part of other market
participants as well as associated adjustments to market
practices would take significantly longer to implement.
The Federal Reserve responded on several fronts to
meaningfully address the tri-party market's continued heavy
reliance on discretionary credit in 2011. Notably, the Federal
Reserve has used supervisory tools to encourage market
participants, over which it has direct authority, a group which
includes but is not limited to the clearing banks, to implement
the task force recommendations in a timely fashion.
While eliminating the daily unwind and reducing reliance on
intraday credit will materially reduce the potential for a
recurrence of many of the problems evident during the financial
crisis, other vulnerabilities will remain. A particular concern
of the Federal Reserve and also reflected in the Financial
Stability Oversight Council's most recent annual report
involves the challenge of managing the collateral of a
defaulting securities dealer in an orderly manner. A solution
to this so-called fire sale problem likely requires a market-
wide collateral liquidation mechanism, but the challenges in
designing and creating a robust mechanism are appreciable and
most surely need to be the focus of much additional study.
Given the importance of the tri-party repo market and the
potential consequences of its vulnerabilities, enhancing the
market's resiliency and its settlement system remains an
important regulatory and financial stability priority. Building
on the work of the task force, we believe that supervisory
efforts will yield substantial progress in eliminating the
reliance of the tri-party market on intraday credit, although
not perhaps as quickly as many of us had hoped, and in
improving risk management practices across a range of market
participants.
A significant remaining challenge, however, is the
development of a process to liquidate in an orderly fashion the
collateral of a defaulting dealer that would operate reliably
in the context of the settlement system organized around
clearing banks.
Thank you once again for the invitation to appear before
you today to share the perspectives of the Federal Reserve on
these important issues. I would be pleased to answer any
questions you may have.
Chairman Reed. Thank you very much.
Ms. Peetz, please.
STATEMENT OF KAREN B. PEETZ, VICE CHAIRMAN, THE BANK OF NEW
YORK MELLON
Ms. Peetz. Chairman Reed, Ranking Member Crapo, and Members
of the Subcommittee, my name is Karen Peetz, and I am vice
chairman of The Bank of New York Mellon and CEO of the
company's Financial Markets and Treasury Services businesses. I
appreciate the opportunity to appear before you today to
discuss the tri-party repurchase, or repo, market in the United
States.
I would like to begin by briefly describing the history and
operations of BNY Mellon as our business model is very distinct
from traditional retail or investment banks.
In contrast to most global banking organizations, our
business model does not focus on the broad retail market: We do
not offer credit cards, traditional mortgages, auto loans, or
similar products to retail consumers. Rather, we are a provider
of services that help major financial institutions access
funding and support the operational infrastructure of the
global capital markets.
Before I address the topic of today's meeting, let me begin
by stressing BNY Mellon's support for recent U.S. and
international regulatory reforms that have strengthened our
financial system, including the Dodd-Frank Act. We have
heartily endorsed meaningful reforms that will strengthen the
banking sector, guard against future systemic shocks, and
encourage economic expansion.
For the purposes of my testimony today, I will focus on
three issues: first, how the tri-party repo market operates;
second, BNY Mellon's role supporting the tri-party repo market;
and, third, ongoing reform efforts aimed at reducing risk.
Tri-party repo transactions are a type of repurchase
agreement involving a third party, the tri-party agent--the
function plaintiff BNY Mellon. The tri-party agent facilitates
settlement between dealers--or cash borrowers--and investors--
or cash lenders. The tri-party agent maintains custody of the
collateral securities, processes payment and delivery between
the dealer and the investor, and provides other services,
including settlement of cash and securities, valuation of
collateral, and optimization tools to allocate collateral.
According to the Financial Stability Oversight Council's
2012 Annual Report the current value of the tri-party repo
market is $1.8 trillion. BNY Mellon is a substantial tri-party
agent, with an approximately 80-percent market share. Our
involvement in a transaction commences after a broker-dealer
and a cash investor agree to a tri-party repo trade and send
instructions to BNY Mellon. These instructions represent the
parties' agreement concerning the tenor of the transaction, the
amount of cash lent, the value and type of collateral returned,
and the repo rate.
To facilitate the tri-party repo market, we extend secured
intraday credit to dealers to repay their investors from the
prior day's trades. If a dealer becomes distressed, we could
refuse to extend such credit and investors could withdraw from
the market. Both of these actions could lead to destabilization
in the economy. Once a tri-party trade settles, BNY Mellon is
no longer exposed to direct risk of the dealer or the
underlying securities. Thereafter, the ultimate risks
associated with a defaulting dealer who has pledged collateral
are with its cash investors.
After the financial crisis, the Federal Reserve asked
clearing banks, primary dealers, and investors to consider
policy options to address problems with tri-party repo
infrastructure that were revealed during the financial crisis,
which led to the creation of the Tri-Party Repo Infrastructure
Reform Task Force--in which BNY Mellon participated. The task
force published its final report in February of 2012
summarizing the current state of reform efforts.
With respect to reducing intraday credit provided by BNY
Mellon to facilitate the tri-party repo market, we are
implementing recommendations made by the task force. We have
moved to a later day unwind for most maturing tri-party repos,
reducing the intraday risk exposure window from 10 to
approximately 3 hours. We have instituted an ``auto
substitution'' process to allow dealers to replace needed,
pledged collateral by first overcollateralizing with cash.
Additionally, BNY Mellon introduced a three-way trade
confirmation process known as automated deal matching for
dealers, agents, and investors. The trade matching enhancements
allow BNY Mellon, as the clearing bank, to receive both the
dealer and cash investor's trade instructions separately and
match the required information fields systematically. These
measures have already significantly reduced intraday credit
exposure.
BNY Mellon is identifying asset classes eligible for
intraday credit associated with tri-party repo transactions,
and we are working with our clients to eliminate intraday
credit associated with less liquid forms of collateral. We
expect these measures to reduce intraday exposures by $230
billion by early next year. Moreover, we are developing the
technology for a systematic approach for reforming the entire
unwind process that will practically eliminate exposures by the
end of 2014. As we develop and implement these measures, we are
working closely with our clients and the Federal Reserve to
ensure that these changes are adopted in a manner and on a
timetable that does not unduly disrupt the market.
Specific to the pace of reforms, I would note that the
measures we have already implemented have materially reduced
intraday credit exposures.
Again, I thank you for the opportunity to testify before
you today and look forward to any questions you may have.
Chairman Reed. Thank you very much.
Mr. Meier, please.
STATEMENT OF STEVEN R. MEIER, EXECUTIVE VICE PRESIDENT, CHIEF
INVESTMENT OFFICER, STATE STREET GLOBAL ADVISORS
Mr. Meier. Chairman Reed and Senator Crapo, thank you for
the opportunity to appear before you today. My name is Steven
Meier, and I am the chief investment officer of global cash
management at State Street Global Advisors, the investment
management business of State Street Corporation. The Committee
has asked me to provide an investor's perspective on the tri-
party repurchase market settlement mechanism, with a specific
focus on the systemic risk reducing initiatives recommended by
the Federal Reserve Bank of New York's Tri-Party Repo
Infrastructure Reform Task Force.
State Street had the privilege of participating in this
task force and agrees with the initiatives put forward. We are
prepared to further adjust our operating model in order to
address the remaining systemic risk concerns. I hope my
testimony today will assist the Committee in its important
work.
Let me begin with a brief description of my background and
experience. I have over 28 years' experience in financial
services, with a focus on money markets, bonds, global cash,
and financing. Today I am an executive vice president of State
Street and chief investment officer of the cash asset class. I
am a member of SSgA's Senior Management Group and Investment
Committee and manage a team of 40 investment professionals
dedicated to cash and short-term asset strategies around the
world. Our clients include State and local governments, private
pension funds, corporations, endowments, and charitable trusts,
among others.
State Street is one of the world's leading providers of
financial services to institutional investors with nearly $22
trillion in assets under custody and administration and almost
$2 trillion of assets under management. SSgA manages global
cash and short-term assets of approximately $400 billion, of
which over $300 billion is denominated in U.S. dollars. Our
investment activities in the U.S. span a range of asset types,
including U.S. Treasury and Government agency debt, municipal
debt, unsecured bank and corporate obligations, asset-backed
securities, and other similar instruments including repurchase
agreements, which are a key focus and core competency at our
firm.
On behalf of our clients, SSgA is an investor and provider
of funding in these repurchase agreement transactions. Our
average total U.S. dollar repurchase transaction volume
outstanding consistently exceeds $100 billion, most of which
settle and are collateralized through the tri-party mechanism.
Collateralization provides diversification away from unsecured
credit exposure and a generally favorable risk/return dynamic.
The tri-party mechanism provides significant operational
efficiencies, settlement risk reduction, and collateral
diversification, delivering transaction scale and investment
capacity. Without these benefits, our repurchase agreement
investment activities would be a fraction of what they are
today.
Tri-party repurchase transactions provide asset managers an
excellent alternative for maintaining core portfolio liquidity
as well as an instrument to enhance returns through
transactions involving a broader range of collateral. Core
portfolio liquidity is typically maintained through repurchase
transactions collateralized with traditional forms of
collateral, including U.S. Treasury bills, bonds, and notes,
Government agency obligations, and Government agency mortgage-
backed securities. Core liquidity trades are executed for
tenors of 1 to 7 days.
In comparison, portfolio yield enhancement is often
achieved through repurchase transactions collateralized with
nontraditional or alternative forms of collateral, including
investment grade corporate bonds, money market instruments,
municipal obligations, asset-backed securities, high-yield
bonds, and equities. Yield enhancement trades are typically
executed for periods ranging from 1 week to 1 year.
SSgA has considerable resources committed to the ongoing
support of these transactions and managing the risks associated
with them, including dedicated senior portfolio managers,
specialized technology infrastructure, collateral analysts,
legal expertise, and senior management oversight. We actively
review, assess, and manage repurchase agreement collateral
daily.
Implementation of the task force recommendations has
resulted in considerable progress toward reducing the system
risk associated with these transactions. Through altering trade
processing timelines and protocols, the industry has achieved
real progress. However, there is still work to be done to
eliminate these risks. Additional systems enhancements and
trade processing efficiencies are required to reach this
objective and are in process.
It should be noted, however, the industry has made
significant progress in transaction risk mitigation through
ongoing task force discussions and findings. Specifically,
participants are now more aware of the need for counterparty
default contingency planning, the requirement of knowing both
your counterparty and your collateral, the benefits of maturity
extension, the required analysis and judgment concerning
collateral suitability, and the benefits of dynamic margining.
SSgA has a strong interest in ensuring that these important
money market investment arrangements and supporting settlement
mechanism continue to be viable aspects of the U.S. market.
Thank you for the opportunity to be here today to speak on
this subject. I would be pleased to answer the Committee's
questions.
Chairman Reed. Thank you very much.
Mr. Wipf, please.
STATEMENT OF THOMAS G. WIPF, MANAGING DIRECTOR AND GLOBAL HEAD
OF BANK RESOURCE MANAGEMENT, MORGAN STANLEY
Mr. Wipf. Thank you. Chairman Reed, Ranking Member Crapo,
and Members of the Subcommittee, thank you for inviting me to
appear before you today. My name is Thomas Wipf, and I am a
managing director at Morgan Stanley, responsible for the firm's
bank resource management. Thank you again for the opportunity
to discuss this very important issue in the markets for secured
funding.
As an active member participant in the work of the Tri-
Party Reform Committee, Morgan Stanley remains fully committed
to accomplishing the goals laid out by the committee within a
timeline that is ambitious and acceptable to all stakeholders.
Our firm views this work as a top priority and a critical path
in our own funding and liquidity strategy. As the committee's
recommendations continue to be processed, we have seen
meaningful benefits and risk reduction on a market-wide basis.
Morgan Stanley agrees with the Financial Stability Oversight
Council that more needs to be done and the delay in soundly
eliminating intraday credit risks is unacceptable.
Secured funding is an important funding source and a
foundational component of our centralized liability management
strategy. We are committed to and have taken significant steps
to put all the recommendations into practice at our firm. We
have heard clearly from the secured funding investor community
that the collateral management services provided by the
clearing banks are an important element of their collateral
valuation and risk management process.
The significant stability issues that appeared in 2008
provided the committee, our regulators, and all tri-party
market participants--bank dealers, cash investors, and the two
clearing banks--with a road map for reform. Many long-held
assumptions around durability, settlement, credit exposure,
agent versus principal relationships, and contingency planning
were proven wrong or overly optimistic during a period of
significant stress in the broad funding markets. The major
factors for the instability were the short tenor of funding,
particularly for less liquid assets; lack of transparency
regarding collateral for investors; insufficient
overcollateralization on less liquid assets; and uncertainty
regarding credit counterparties during the period between trade
maturity and settlement. Additionally, a heightened market-wide
aversion to counterparty risk contributed to the instability of
the platform.
We believe that the Tri-Party Reform Committee identified
all of these weaknesses and defined the issues requiring
remediation. In implementing these recommendations, we see the
remaining strategic issues falling into three categories:
complete clarity on the terms and limits for credit extension
between the clearing banks and the bank dealers by asset class;
full implementation of a transparent settlement process with a
clear timeline that enables all market participants to
understand and manage their settlement risk; and, third,
further building investor confidence and reducing intraday
credit risk by a meaningful and systematic reduction of
collateral turnover between trade execution and maturity.
Many of the challenges faced by the committee were a result
of mixing these issues. Credit extension, collateral
management, and settlements are separate and distinct issues
that all impact the tri-party funding market. The extension of
intraday credit is a major focus issue for the bank dealers and
the two clearing banks. While our investors are focused on the
collateral management services provided by the clearing banks,
the operational issues are relevant to all three parties to the
transaction.
Part of the challenge faced by the committee was to
separate these issues, and although there are certain
codependencies among them, we believe that the work ahead will
only be successful if the issues are treated individually going
forward.
At Morgan Stanley, we have taken a number of steps to
meaningfully reduce our daily settlement exposures ahead of the
committee's deadlines, most notably in the area of prudent
liability and collateral management. Our firm has taken
proactive steps to extend the maturity of our secured funding
liabilities in a rules-based governance process that requires
minimum term of maturities consistent with the fundability
characteristics of our assets. We additionally have imposed
investor diversification and maturity limits to reduce our
maturities with any given investor in a period and an overall
limit on maturities during any given period.
Our investors have focused on transparency of collateral, a
reduction in collateral turnover during the period of the
transaction, and clarity on their credit exposure through
execution, settlement, and maturity. We have seen through these
changes a firsthand and marked increase in pretrade collateral
due diligence by secured funding investors.
We fully acknowledge that there is considerable work
remaining for the industry that requires senior leadership
focus, commitment, and investment by all participants in the
market. We are committed to continuing to collaborate with
investors, the two clearing banks, and our regulators to
complete the remaining work streams and to advocate for a
timeline that is acceptable to all stakeholders.
Morgan Stanley's overarching goal in tri-party repo reform
is investor confidence. The meaningful reduction in intraday
credit extension, transparency in collateral and advance rates,
combined with a more sound and durable operational platform are
all positive steps toward this goal. We have prioritized our
resource commitments in the context of the tri-party reform
committee's agenda on initiatives designed to retain the
confidence of our secured funding investors, the cash
providers.
With lessons learned following the crisis, Morgan Stanley
has worked over the past several years to add significant risk
management enhancements to our secured funding program. As
mentioned above, we have added significant term to the
maturities in our secured funding liabilities, and since a
large portion of those liabilities come from investors who
utilize the tri-party repo platform, our pro forma and actual
intraday credit from our clearing banks has been meaningfully
reduced.
We have extended the weighted average maturity of our
secured funding book from less than 30 days to now well in
excess of 120 days. This is now a disclosure metric in our
public filings. Extending the maturity and limiting rollover
risk are the most powerful tactical steps that can be taken by
bank dealers immediately to reduce the intraday extension of
credit. Since the credit extension takes place at the maturity
of the trade, creating a longer and staggered maturity profile
can yield significant risk reduction.
The Tri-Party Reform Committee has worked to identify the
issues and put forth recommendations for the remediation of the
gaps that became apparent in 2008. Many of those
recommendations are now in practice or in scope on a clear
timeline. Many of the enhancements to the settlement and
confirmation processes have created increased stability and
added clarity. It is clear, however, that the main and most
important goal of reducing intraday credit extension has not
yet been achieved. It is also clear, however, that the
responsibility for this cannot be solely assigned to the two
clearing banks. We in the bank dealer community have to take
the immediate and incremental steps available through our
liability management practices to become a much bigger part of
the solution. There is no single operational solution or
systems development that can solve this issue completely. What
is required is collaboration between the bank dealers and the
two clearing banks to provide a set of strategic steps to begin
a tactical but meaningful reduction of intraday credit
extension in parallel to building operational and system
enhancements. We believe that the status quo is unacceptable,
and by beginning this reduction through prudent liability
management, we can reduce risk during the proposed buildout by
the clearing banks.
At Morgan Stanley, we have seen considerable results
achieved by working directly with our clearing banks to take
these tactical steps. Morgan Stanley is committed to taking the
steps necessary to build investor confidence in this important
funding channel. The markets' liquidity is provided by
investors who seek to have transparency to their collateral, a
clear understanding of the settlement process, and the
information they need in real time to make appropriate risk
decisions and to effectively manage their collateral and
counterparty exposures.
We have worked with the Tri-Party Committee and other
industry groups to move this reform forward. Morgan Stanley is
committed to achieving the entirety of goals laid out in the
committee's report and has invested and executed on changes to
our processes well in advance of the scheduled timelines with
the goal of meeting the needs of our investors. This work is a
top priority of our firm, and we will continue to work at both
an industry and a firm level along with our regulators to add
stability and durability to this funding platform.
Again, we are appreciative of the opportunity to discuss
these important issues and look forward to providing this
Committee with any level of detail and information that will be
helpful as you deliberate on the path forward.
Chairman Reed. Well, thank you very much for your excellent
testimony, and we will do 7-minute rounds, and I will yield at
the end of my time to Senator Crapo, and I suspect we have the
luxury of going back and forth a bit after that, too.
First, again, thank you, and let me recognize that there
has been progress made by the clearing banks, by the broker-
dealers, by the investors in terms of prudent steps to improve
the process. But the FSOC's--and it echoes something that Mr.
Wipf said, that the continued intraday trading activities is
still a severe problem; and, second, FSOC talked about the need
for increased Government involvement. This task force, as I
understood it, was the principal private actor with the
technical assistance of the Federal Reserve Bank of New York,
and that leads me to a question, and this is sort of echoing
from our discussion about the LIBOR, which is a question of who
was really in charge.
So with respect to this issue, does the New York Fed Bank
have the responsibility or authority to step in and be the
involved Government party? Or is it the Board of Governors or
is it the SEC or is it lots of people, and leading to the
conclusion everybody has a role but no one is in charge? Mr.
Eichner.
Mr. Eichner. Thank you, Senator Reed. Let me begin by
emphasizing I am here today speaking for the Federal Reserve
Board, but obviously the Federal Reserve Bank of New York and
the Federal Reserve Board have worked closely and
collaboratively on this tri-party issue.
In the wake of the most acute phase of the crisis, there
was a broad agreement that some steps needed to be taken and
that the risks that had become evidence during the crisis
needed to be addressed.
At that time we were not entirely clear as to what exactly
the right way would be to address those vulnerabilities.
One thing that was clear was that the tri-party market is
unusually large and unusually complex. It does not just have
broker-dealers, cash lenders, clearing banks, but all of the
above involved fundamentally in a daily settlement process that
is fairly complicated and has to be accomplished in a
reasonably tight timeframe.
We started out hoping that we could find an industry
solution, and as you suggested that involved bringing people
together in 2009.
As all of us in various ways have reflected in our
testimony, substantial progress was made through that process.
People have mentioned some of the specifics, but everybody also
has fundamentally recognized what I would like to emphasize
today, which is that we did not get to the end of that road.
This task force process did not get to the end of the road.
Despite the fact, for example, that the daily unwind now occurs
later in the day than it did several years ago, essentially all
of the $1.8 trillion tri-party market is still unwound every
day.
What we want to emphasize is that we began with an industry
process. We thought that the industry was best positioned to
think about what the right solution would be, but that we were
absolutely committed to progress being achieved here. And to
that point, when it became clear in the middle part of 2011
that the Tri-Party Task Force was not going to meet its public
commitment from 2010, despite significant progress having been
made, to practically eliminate intraday credit by the end of
2011, the Federal Reserve increased our involvement in the
process, and in particular brought supervisory tools to bear in
a very direct way. The details of that are described, for
example, in our July 18th press release.
Chairman Reed. I think this is an important point. Who is
in charge? If the FSOC is calling for greater Government
involvement to try to shepherd this private sector initiative,
which has been very productive to date, to a timely conclusion,
which several of the panelists have said must be done, who is
in charge? Who is the person who has got the mission to do
this, to get this done? Is it Mr. Dudley or is it Chairman
Bernanke or is it Chairman Schapiro? Or is it--who knows? Do
you have an answer?
Mr. Eichner. Yes, I think there are two answers. One is
sort of all of the above, right? There are authorities that
each of those individuals has that bring to bear on specific
participants in the market. That having been said, the 2010
Dodd-Frank Act did also create a Financial Stability Oversight
Council which does have a clear statutory responsibility to
deal with situations where things threaten, as you suggest
might be the case here----
Chairman Reed. I appreciate your comments, but I think this
is something that, as a result of this hearing, we need a
specific answer, because we do not want to be in a situation
again where everybody is involved but no one is responsible,
if, in fact, the FSOC, as you point out, has called for greater
Government involvement.
Let me move quickly, and I appreciate your response, but,
Ms. Peetz, what has been the stumbling block to prevent dealing
with the intraday trading issue? Mr. Wipf has been quite
specific. That is still a huge problem. Second, Mr. Eichner
just pointed out that even though the settlement date has been
moved back to 3:30, there is still--basically it is every day
you are rolling the dice in some respects. Can you elaborate?
Ms. Peetz. Yes, and I would absolutely reiterate what Mr.
Eichner said about the fact that we all need to work in
concert, and I believe actually that the Fed has provided great
leadership for this.
Our part of it that has provided a stumbling block is we
really are responsible to get a technology platform to enable
simultaneous settlement between new and expiring trades, and we
are working on that right now. So we can provide a platform so
that this all happens much more efficiently.
Chairman Reed. Would it be helpful if you were--well,
helpful at least to justify the funding, if you were sort of
required at a time certain to do it? Is that an issue?
Ms. Peetz. We have actually reduced the time already. We
were originally projecting to finish this at the end of 2016.
We have reduced that time, through a lot of extra investment in
technology, to 2014.
Chairman Reed. The tenor of some of the comments from the
panel but also from FSOC is even that 2014 deadline still
exposes the system to risks that should be mitigated.
Just a final point because my time has expired, and I will
recognize Senator Crapo. One of the aspects of the progress you
have made is the automatic substitution of collateral.
Previously I understood that individual broker-dealers could
come in and sort of rearrange their collateral at the end of
the day or during the day, causing delays and confusion, et
cetera. Is that still possible and is that still prevalent?
Ms. Peetz. No, actually, the addition of automated deal
matching plus that cash substitution for automatic substitution
has actually improved that significantly.
Chairman Reed. Thank you. And, again, that is a testament
and a tribute to what you all have done. I appreciate it.
Ms. Peetz. Thank you.
Chairman Reed. Thank you.
Senator Crapo. Thank you very much, Mr. Chairman.
I would like to understand the objective we are trying to
achieve here a little better. As I understand it, the entire
tri-party repo market is unwound every day still, if I
understand you correctly, Mr. Eichner. And, Ms. Peetz, you
indicated that simultaneous settlement is the ultimate
objective, if I understand it correctly. Explain to me, if you
would, Ms. Peetz--and others, I would welcome your putting your
input in here, too--how would it ideally work? How would the
market ideally work if we can achieve the objectives that the
task force is seeking to achieve?
Ms. Peetz. There would be several changes. This technology
would enable just the trades that are actually maturing to be
rolled, if you will, and so you would not have the intraday
required for the whole book. It would be just for that activity
that is changing. So that would reduce the amount of intraday
significantly.
You also would have higher-quality collateral, is another
aspect that we are working on, and asking dealers to prefund
that collateral that is not as high quality. And, also,
increasing the duration of tri-party transactions, so what we
call ``terming the book'' will be another concrete move toward
getting the risk out of the equation.
Senator Crapo. Thank you.
Anybody else? Mr. Eichner, did you want to----
Mr. Eichner. Yes, I would just say taking a more 10,000-
foot approach here that the critical problem in the market that
became evident during the crisis was that the locus of certain
risks was not fully understood in a consistent way by all
market participants. So when you say what is the key goal here,
the key goal here is to make sure that it is very clear who
bears risk at every single moment and that those risks then can
be priced into people's decisions.
Senator Crapo. Mr. Meier.
Mr. Meier. Senator, I would say from an investor's
perspective, we certainly support the elimination of the
process of unwinding trades every day, particularly term
trades. It certainly helps us to have more of a static pool of
assets, and as I said, we actively manage and stress-test those
assets daily. The fact that they do not change over and are
recollateralized after the close of the market certainly is a
benefit for investors.
Senator Crapo. Thank you.
Mr. Wipf.
Mr. Wipf. Yes, we would agree with that, and we think that
where some of these interests are very much aligned is bank
dealers funding their less liquid assets for the longer term
obviously makes sense, combined with the fact that reducing
this optimization that occurs every day on trades that are much
longer to maturity allows our investors to have a more stable
pool of collateral that they can risk manage on a much more
real-time basis. So by changing that collateral more
frequently, that presents a lot more revaluation and the like.
So to the extent that the intraday credit is drawn at the
point either at maturity or at these substitution points,
reducing that, stabilizing the pool is actually beneficial to
both investors and to the reduction of intraday credit risk.
Senator Crapo. Explain that a little better to me. One of
the points you made in your testimony was that the issue or the
risk related to collateral management or the turnover of
collateral is one of the big problems that we are trying to
deal with here. I do not quite understand how the collateral
turnover issue plays out. Could you explain that?
Mr. Wipf. Yes, it plays out in two forms. First, just at
the maturity of a trade, there is a credit extension, so it was
a trade that has been put on, it is now come due, it is due and
payable, at that point the collateral is coming back through
the clearing bank to the bank dealer who now has to take
intraday credit.
To the extent that those books have been moved out
considerably and that those maturities are staggered, the
amount of actual credit that is going to be extended can be
reduced. So, simply stated, if the entire book rolls over every
day and the liabilities are 1 day in nature, the amount of
credit is considerably higher than if the book has been put out
for 6 months or a year, additionally with the less liquid
assets, which present more risk, and we have seen, in working
with our clearing banks, the meaningful outcome of pushing
those maturities out has really benefited significantly in the
reduction of intraday credit.
Secondarily to that is this optimization or the
substitution of collateral at dealers need collateral back and
want to re-optimize that book. The frequency of that also
creates some intraday credit exposure as well. So when we think
about investor confidence, having a more stable pool of
collateral with our investors, giving up some of that ability
to optimize plays out both from an investor confidence
perspective and from a creditor perspective.
Senator Crapo. All right. Thank you.
The Basel III framework, as I understand it, includes two
new minimum standards for funding liquidity: one, the liquidity
coverage ratio, or LCR, which is intended to promote short-term
resilience to potential liquidity disruptions; and the other,
the net stable funding ratio, or NSFR, which is intended to
address liquidity mismatches and provide incentives for banks
to use stable sources to fund their activities.
To what extent will the new Basel liquidity standards
affect the tri-party repo market? I guess that question is for
any of you. Mr. Eichner.
Mr. Eichner. I will be happy to start. I think that gets to
really a very important point. We have talked here about sort
of three basic vulnerabilities. Senator Reed began by
reiterating those. One involves the funding profile of dealers.
Mr. Wipf has talked about that extensively as well.
The Basel III LCR and net stable funding ratio requirements
are surely going to provide additional impetus to dealers to
more effectively manage that risk. So it certainly directly
addresses that one vulnerability.
The second vulnerability is the one that we spent most of
the time talking about, namely, the settlement process and its
reliance on intraday credit, which remains, as we have
emphasized, still quite a concern.
The third vulnerability involves the liquidation of
collateral of a deal that faces distress or default.
The LCR and the NSFR are really focused on the first
question: dealer liquidity risk management and providing
additional incentives for that to be improved and strengthened.
Senator Crapo. All right. Thank you, Mr. Chairman.
Chairman Reed. Thank you very much.
Senator Merkley, questions, please.
Senator Merkley. Thank you very much, Mr. Chair, and thank
you all for testifying on this. The piece of this that I am
trying to get my hands around is the domino effect--that is,
when one firm is in trouble and has to sell a lot of assets
quickly, it creates a fire-sale price that drives down the
securities that have been used in other repo sections or deals,
immediately causing trouble in other institutions. And do we
feel like we are in any better position in regards to this
right now than we were, say, in 2008?
Ms. Peetz. Do you want to say anything?
Mr. Eichner. Sure. As emphasized in the FSOC report, and as
we have emphasized in various other fora as well, this remains
a very real concern. So we would certainly recognize the
tremendous progress that has been made and will continue to be
made on the intraday settlement issue. The collateral
liquidation issue, Senator Merkley, which you referred to, that
remains a task ahead of everybody sitting on this panel. We are
hopeful at the Federal Reserve that, like the intraday credit
issue, this will be something for which over time the industry
develops a consensus and then that consensus can be a route to
a solution, possibly with regulators urging along the way. But
in reality, this is something that remains yet to be done.
Ms. Peetz. I was just going to add that we are getting
increased transparency also among the players so that we will
be able to monitor and, in fact, the Fed is interested in
monitoring not only dealer-specific activity and investors, but
then collectively the market, and we are getting better and
better information for that.
Senator Merkley. As we get that better information, I
assume that the reason that repo plays such a large role is it
is some of the cheapest ways to borrow, and you obviously want
to borrow at the cheapest available cost. But at some point,
how much of kind of the source of credit can that be before it
becomes a huge systemic risk to significant institutions?
Ms. Peetz. I would say that that is another aspect that all
of us are looking at, which is should dealers have limits on
the amount that they can actually extend during the day. And
that is another thing that we are working in concert with the
industry as well as with the Fed to develop plans for that.
Senator Merkley. In terms of the limits on the dealers or
actually the limits on the amount of funds that a particular
institution can raise through repo transactions?
Ms. Peetz. It is a bit of both because you would analyze
the name and what they could withstand. And, of course, that
changes as the market changes, so we are building tools to do
that.
Senator Merkley. OK. Other insights on that?
Mr. Wipf. Yes, we would see this--again, getting back to
this liability, the topic of liability management, to the
extent that less liquid assets are funded for short periods,
that does present risk both to dealers and systemically.
To the extent that those are funded for longer periods of
time, we have seen several developments from the work of the
Committee. First, investor due diligence has gone up
considerably with the transparency that has come out. The
overcollateralization levels are significantly higher. But the
real risk happens to the extent that these books are maturing
too quickly, particularly in less liquid assets.
So as dealers are funding for longer periods of time
because the reduction of intraday credit is taking place, it
does require that the books are termed and staggered, with a
focus on less liquid assets. That provides a valuable commodity
of time that these adjustments can take place, not in a short
period of time but over periods of time that move to 3, 6, 9,
12 months as opposed to 7 days. And I think that is a very big
change, and I think the discussions about the liquidity
coverage ratio and the reduction of intraday credit extension
will force those issues. And, again, the benefit that we see to
investors is at that point the collateral becomes more stable,
the ability to value and to make choices and to do the due
diligence that Mr. Meier has laid out becomes a much easier
task over time.
Senator Merkley. Let me ask a little bit of a different
track question, and that is because your bank has been involved
in the arrangements made on the spot market to supply crude to
certain refineries and to buy refined products. And that has
struck me as some form of systemic risk given the volatility
that can occur in natural resource markets.
Does that play an interplay at all in terms of the
financing through repo?
Mr. Wipf. That is not an active asset in the repo market.
Senator Merkley. All right. Thank you.
Chairman Reed. Thank you very much.
Mr. Wipf, one of the points that Mr. Eichner made in his
prepared testimony--and I believe it is true--is that it is
still discretionary with the bank to extend credit on an
intraday arrangement. Is that correct?
Mr. Wipf. Yes, and I think at this point we have gone
through several work streams with our clearing bank to begin to
reduce the credit extended, particularly with a focus on less
liquid assets. So I think that there is a major work stream
underway at BNY Mellon with all the dealers. We can only speak
from our perspective on this, but there are some pretty clear
deadlines out there in terms of what that extension will be,
which will certainly move to a very direct asset-based model
very shortly.
Chairman Reed. But the clearing bank, for reasons--any
reason, hopefully a prudent research, could essentially say we
are not extending credit to the broker-dealer, which would
force you, for a broker-dealer like Morgan to somehow--how
would you deal with that?
Mr. Wipf. Reducing the amount of intraday credit extension
certainly can--as we mentioned, there is no operational
solution that will eliminate all of that. Ultimately there are
a few ways to pay for that. One is, if the books are funded too
short, you have to post up liquidity at maturity. So to the
extent that the bank will not extend it, the dealer would have
to replace that liquidity, or to reduce the activity that
matures; and, again, getting back to this terming and
staggering and reducing the amount that comes due on any given
day, particularly with a focus on less liquid assets. So those
two things--so terming out the book, there is a cost to that,
of course, because you are paying for a longer-duration
liability, and/or posting cash liquidity during the period of
that unwind between that, and I think that is the--that is how
it would be replaced, and we think that by taking the actions
that we have laid out, that can be reduced very dramatically as
well.
Chairman Reed. We are still in a position of sort of the
cascade effect that Senator Merkley referred to, whereas, if a
bank for their own prudent reasons decides not to extend the
credit, the dealer is now forced to take some--basically come
up with cash. If they do not have the cash, they are in a very
awkward position. That leads typically to a downward spiral
with respect to the whole system.
Mr. Wipf. Yes, and----
Chairman Reed. There is still that potential, but less so
today.
Mr. Wipf. We think it has been somewhat mitigated, but at
the point that that actually occurs, the bank, as we see it,
with a lot of the confirmation and the transparency around the
collateral and the term, will have a much clearer view of that
will have lots more early warning signals well in advance of an
event.
Chairman Reed. Ms. Peetz, with respect to this issue,
Morgan has taken these steps. Do you have the contractual
authority to require every one of your broker-dealers to sort
of step up to what you think is the appropriate standard in
terms of the way they operate, the way they--the tenor of their
arrangements, all these different aspects?
Ms. Peetz. Yes. How we facilitate that is through different
agreements, and the near-term activity that we are pushing on
at the moment is prefunding of DTCC collateral, and so there is
a separate agreement that each of the broker-dealers will now
sign with us to acknowledge that they understand how that has
changed. And so as this kind of continues to change, we will
amend those agreements, giving us that power.
Chairman Reed. Mr. Meier, you represent the investors side,
basically the people putting the cash up. And there has been a
report by Fitch Ratings that there is a higher amount of
structured finance paper pledged in these repo transactions,
which is not--let me assume not as liquid as some of the other
forms of paper that you have. And particularly in the case of
money market funds with the new rules, the 2a-7 rule about what
they can hold and what they cannot hold, is there a potential
problem here where they get the collateral back but it is
collateral that they cannot hold or they have to dispose of
immediately so it is basically we have to give it away almost
because--is that a dilemma that you face?
Mr. Meier. I think it is a real risk, Senator. I also read
the Fitch report yesterday, and I was disturbed, and I
mentioned it to Mr. Wipf, who had read it as well, that there
still is a lack of, I would say, proper diligence on the part
of investors really to really look at the types of collateral,
the suitability.
So, for example, in a money market fund, you know, our
position is the traditional collateral, treasuries, agencies,
mortgage-backed securities, are appropriate and suitable forms
of collateral. We do not go down in credit quality. We do not
take credit spread bonds, et cetera, into the money funds. And
I do think--I was actually encouraged. We had a meeting last
week with someone from the Federal Reserve Bank of New York and
the SEC asking all the right questions about, you know, our
activities as an investor, do we have default contingency plans
in place and what our thoughts are around suitability of
collateral, particularly from money market funds. Those
questions were asked by the SEC. So I think the right questions
are being asked.
What I would like to see is the Federal Reserve start to
audit default contingency plans and actually make sure that
people have a thoughtful process in terms of what they are
accepting as collateral and are they actually looking at it. We
can rely on the tri-party custodian banks to do that for us. We
do not. We do not feel that is appropriate. And we are very
thoughtful in terms of the process we go through when we
determine what are acceptable forms of collateral, even down to
CUSIP-specific levels with various counterparties.
Chairman Reed. But there still exists the possibility that,
either wittingly or unwittingly, a money market fund could have
the collateral in that transaction that the dealer put up is
something that would be very difficult for them to liquidate if
that became their only mechanism to pay back?
Mr. Meier. That is a real risk, Senator, yes.
Chairman Reed. Let me ask a final question before I
recognize Senator Crapo. There is an alternate, at least one
other alternate mode to this market, that is, to designate--
rather than having clearing banks, to have what would be known
technically as a financial market utility. Briefly, could you
all comment upon whether that has been looked at, the efficacy
of that, et cetera? And very briefly. Mr. Eichner.
Mr. Eichner. Sure. I would start right where Mr. Meier left
off in saying that we remain very concerned about this
collateral liquidation problem that you are discussing.
Obviously the largest concern is with respect to less liquid
collateral, but it is a concern even with more liquid
collateral in a market that is as large as the tri-party market
is.
We feel that even once the intraday credit issue has been
addressed by reaching the target state, as Ms. Peetz and others
have described, there is still more work to be done around
collateral liquidation. There are a number of models that might
work there. We think it can be done in the context of a
clearing bank system, although there are certain challenges
there because collateral liquidation systems in general rely on
a membership structure, in general rely on the ability to
mutualize risk, in general rely on the ability to assess
capital contributions. But we think that could work in the
context, nonetheless, of a clearing bank system.
We also think, though, that a utility is another
possibility and is going to be something that will have to be
looked at seriously and considered, as we move to this next
phase, once the target state with regard to the settlement
process has been reached.
Chairman Reed. Ms. Peetz, you have to have a chance to
answer this one.
Ms. Peetz. Thank you. No, I would agree with everything
that was said, that we have been discussing the topic, that
there are some significant obstacles regarding capitalization
and the sharing of risk. And we think that as we move toward
our 2014 state that we will not necessarily need a utility,
which is, I think, what you are getting at.
Chairman Reed. Mr. Meier, from your perspective, and then
Mr. Wipf.
Mr. Meier. Sure. Thank you, Senator. From my perspective, I
do not really support a utility, and I do believe in terms of
liquidating collateral, that is the job of the investment
manager. I do think you run the risk of rewarding those that
are less diligent and less thoughtful around the collateral
process.
From our firm's specific interest, we are both long and
short collateral, and that gives us a competitive advantage in
the marketplace in order to be able to provide funding against
credit product out the curve, and that we lend securities to,
say, Morgan Stanley and we take in securities from Morgan
Stanley in repurchase agreements. If there is a problem in the
marketplace, we go through a liquidation process. We net down
those exposures, and we actually feed or optimize those buy-ins
and liquidations into the marketplace. So we do think that is
one of the key risk drivers, risk mitigants that we have as an
organization that benefits our clients.
Chairman Reed. Mr. Wipf, just quickly.
Mr. Wipf. From a dealer perspective, our view on this is
that we are--our overarching goal is investor confidence, and
what we have heard from our investors clearly is that the
collateral management services provide by the clearing banks
are an extremely important part of their risk management.
As we view this, what we want is a safe and sound platform
that accomplishes that, but, you know, the overriding vote we
are going to get here is what do our investors need to see in
terms of collateral management, and whoever can provide that,
we obviously need to be agnostic to that. And then in terms of
how we think of this, you know, we have to work on the intraday
credit work with our clearing banks. So we see these, again, as
two issues with the overarching goal being heightened investor
confidence.
Chairman Reed. Thank you.
Senator Crapo.
Senator Crapo. Thank you, Mr. Chairman. I do not have any
further questions. I do want to thank the panel for not only
their oral presentations here but their written testimony. I
found it very helpful, and I am encouraged by what I hear about
the fact that we may be able to make some good progress in
resolving this.
You and I may need to sit down and talk about the first
question you asked about who is in charge and what the Federal
response is.
Chairman Reed. I think that is a very critical question,
particularly given the last several months of our experience
here.
Let me just, if I may for just a moment, you know, we are
looking at sort of the potential triggering event for market
behavior, which is dysfunctional, that a dealer fails, et
cetera. We have got huge issues in Europe with respect to the
stability of their banks, et cetera. And it raises a question,
frankly: Is 2014 too long? We have given ourselves apparently
sort of this timetable. I know you have pulled it back from
2016. But if there was a financial crisis even greater than the
present one in Europe, putting pressure on, would it result in
undue pressure so that you would have to in certain cases, you
know, not--you know, it is discretionary not sort of to extend
credit, forcing dealers to come up with the credit in a market
that is just chaotic? All of this goes to the point of do we
have until 2014. I do not know if you have a comment or anyone
has a comment.
Mr. Eichner. As Chairman Bernanke and other policy makers
at the Federal Reserve have pointed out, this remains a real
concern here. That having been said, we also recognize the
importance here of moving in a deliberate fashion, recognizing
that this is a really complicated market that has real
implications across the economy. We want to move in a way and
see the industry move in a way that gets to the target state
but does not do so in an unnecessarily or even a necessarily
disruptive way.
We would be uncomfortable with 2014 if this were just 2014,
and, you know, we will tell you when we are there. One of the
things that the Federal Reserve has done since the task force
process bogged down a bit in 2011 and by bringing some
supervisory tools to bear is we have asked the market
participants, including the clearing banks but others as well
over which the Federal Reserve has direct supervisory
authority, for very detailed timelines with milestones along
the way.
We do not want to be told, yes, we will get this done in
2014, trust us. What we want to see is a very clear path to
getting all of this done by 2014, but with many intermediate
steps and pieces of risk reduction that occur along the way,
and that is the way that we get comfortable with 2014 in light
of the environment that we are now operating in.
Chairman Reed. Anyone else, any other comments?
Mr. Wipf. What we would say from our perspective at Morgan
Stanley is that, to the extent that this flows through where
investors have real clarity on what they have and we have real
clarity as bank dealers with our clearing banks on what our
clearing bank will do during normal and stressed market
environments in terms of whatever the intraday lending is and
against what assets they are at a very specific level, the
accountability then, again, falls back to the bank dealer about
prudent liability management.
So, you know, as it works through to the due diligence
around the collateral from an investor perspective, clarity
between the clearing bank and the bank dealers in terms of what
everyone can expect during times of stress in normal operating
environments and then prudent liability management resting
clearly with the dealers we think is the best outcome. And on
the way to that, that is how we think that we can get to 2014.
Chairman Reed. Well, I want to thank you all. Again, just
echoing the comment Senator Crapo made, I do think we need to
get a much more definitive, clarifying sort of notion of who is
in charge here from the Federal perspective. That is one of the
lessons we have learned over the last couple of years. When
everyone is in charge, no one is in charge. So we would like to
see--we will follow up, but I thank you for excellent
testimony, both your written testimony and your oral testimony,
and I thank Senator Crapo and my colleagues.
If there are no further questions, we will, in fact, keep
the record open because there could be some of my colleagues
who have additional questions. We would ask my colleagues to
submit those questions no later than next Thursday, August 9th,
and then we would ask you to respond as quickly as possible to
the questions if you are given some.
Thank you very much. With that, the hearing is adjourned.
[Whereupon, at 10:09 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN JACK REED
I want to welcome everyone to our hearing this morning entitled
``The Tri-Party Repo Market: Remaining Challenges''.
Last week, Secretary Geithner presented the Financial Stability
Oversight Council's second annual report to Congress. The Council is
responsible for providing us with a comprehensive, coherent overview of
the health of our financial system.
The Council's report identified structural vulnerabilities in the
short-term funding markets, particularly the tri-party repurchase
(repo) market, as a continuing area of concern. The report states that:
``limited progress has been made in substantially reducing the reliance
of this market on intraday credits or improving risk-management and
collateral practices to avoid fire sales in the event of a large dealer
default.'' The Council also stated that the industry's suggestion that
it will take several more years to eliminate the intraday credit
associated with tri-party settlements was ``unacceptable'' and called
for greater Government involvement.
In general, a repo or repurchase agreement is the sale of a
portfolio of securities with an agreement to repurchase that portfolio
at a later date: the economics of repos are similar to that of short-
term loans collateralized by long-term assets. Tri-party repos are
typically used by large securities firms and bank holding companies
with broker-dealer operations to raise short-term financing from cash
investors, such as money market mutual funds. The dealer and the
investor typically use one of two clearing banks to settle the
transaction.
This market is very large. Tri-party repos peaked at $2.8 trillion
at the height of the crisis in 2008 and are $1.7 trillion today.
Three major weaknesses of the tri-party market were highlighted by
the 2008 financial crisis:
the market's reliance on intraday credit from the clearing
banks,
the procyclicality of risk management practices, and
the lack of effective plans to support the orderly
liquidation of a defaulted dealer's collateral.
Motivated by these risks, in 2009 the Federal Reserve Bank of New
York formed an industry-led Task Force to address the problems
highlighted by the financial crisis. Although this Task Force disbanded
in early 2012, its work led to a number of important changes,
including:
moving the daily unwind of some tri-party repo transactions
from 8:30 a.m. to 3:30 p.m., which shortens the period of
intraday credit exposure;
implementing a mandatory three-way trade confirmation
between dealers, cash investors and the clearing banks, marking
the first time this $1.7 trillion market has had an established
confirmation process;
publishing of a monthly report regarding activity in the
tri-party repo market, which includes the size of the market,
collateral breakdowns, dealer concentrations, and margin
levels. This report enhances the ability of supervisors and
market participants to assess trends and call attention to
emerging issues before they become systemic.
However, in its 2012 Report, the FSOC found that ``limited progress
has been made in substantially reducing the reliance of this market on
intraday credits or improving risk-management and collateral practices
to avoid fire sales in the event of a large dealer default.'' The
Council also stated that that the industry's suggestion that it will
take several more years to eliminate the intraday credit associated
with tri-party settlements was ``unacceptable.''
Because FSOC has sounded an alarm about the tri-party repo market
and stated the need to more quickly implement additional reforms, we
have convened this morning's hearing to discuss the report, better
understand the changes to this market already in place, and explore
what more needs to be done.
Improving the tri-party repo market will make it safer, to the
benefit of all market participants. I look forward to hearing from all
our witnesses on this important part of our financial markets.
______
PREPARED STATEMENT OF MATTHEW J. EICHNER
Deputy Director, Division of Research and Statistics, Board of
Governors of the Federal Reserve System
August 2, 2012
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, thank you for inviting me to appear before you today to
discuss the tri-party repurchase agreement (repo) market.
The Federal Reserve has a strong interest in the smooth functioning
and resiliency of this market for several reasons. First, the market
serves as a tool for cash and liquidity management as well as for
short-term borrowing for a wide range of financial intermediaries,
including money market funds, insurance companies, banks, and
securities dealers, all of which play an important role in supporting
the savings and investment programs of households, small businesses,
and nonfinancial corporations. Second, a number of entities subject to
direct prudential supervision by the Federal Reserve are significant
participants, including the holding companies of the two clearing
banks, JPMorgan Chase and BNY Mellon, as well as many other bank
holding companies. Finally, tri-party funding materially supports the
depth and liquidity of a number of critical markets, including those
for U.S. Government securities in which U.S. monetary policy is
executed.
In light of the importance of the tri-party repo market, the
Federal Reserve has been and is committed to working with market
participants and other supervisory and regulatory organizations to
enhance the market's resiliency. During the crisis, it became apparent
that the design of the market's infrastructure to settle transactions,
in particular, had fundamental flaws that could lead to serious
instability during periods of market stress. Some significant progress
has been made subsequently by market participants to address these
shortcomings. The tri-party repo market is now smaller than its peak
and in general funds higher-quality collateral than it did prior to the
crisis. However, not as much progress has been made--or made as
quickly--as we believe is warranted given the seriousness of the
situation, and certain clear vulnerabilities remain. The Federal
Reserve continues to be fully engaged on a number of fronts to promote
measures that will further mitigate these risks.
I would now like to describe in greater detail the underlying
vulnerabilities in the tri-party repo market, the risk mitigation
accomplished since the financial crisis, and the significant work that
still remains. In offering this perspective, I think it will become
clear that the very importance of the tri-party repo market--which is
currently the locus of funding for some $1.8 trillion in securities
held by securities dealers, down from $2.7 trillion in 2007--
complicates the task of enhancing its resiliency. As in the case of a
busy highway that must be rebuilt while traffic continues to flow,
fundamental changes to the tri-party infrastructure must be
accomplished in a manner that allows the market to continue to function
without introducing new risks as market participants adjust. Further
complexities are introduced by the diversity of participants in this
market, which connects institutional investors of many types that have
surplus cash with dealers who need funding for their securities
portfolios. These different classes of entities, although tied together
through the tri-party infrastructure, have very distinct institutional
priorities, operational needs, and regulatory requirements.
Tri-Party Repos and the Financial Crisis
A tri-party repo, like other repurchase agreements, is a form of
secured borrowing in which one party effectively lends cash against the
securities collateral of the other party. As the name suggests, a tri-
party repo is distinguished by the involvement of a third party, a
clearing bank that provides custody and settlement services related to
the transaction. Of particular importance, the triparty repo settlement
process in the United States evolved over time to rely on the extension
of very substantial amounts of intraday credit by the clearing banks.
While securities are funded each evening with cash provided by the
lenders in the tri-party repo market, each day almost all trades are
``unwound,'' with cash being returned to the accounts held by lenders
at their clearing bank. The clearing bank, protected by a lien on the
securities, provides funding for the collateral during part of the day.
This unwind, which is reversed at the end of each trading day with a
``rewind,'' permits borrowers in the tri-party repo market--generally
securities dealers--to have full and unimpeded access to their
securities inventory for routine operational purposes, notably
delivering and receiving securities, while ensuring that tri-party
lenders at all times hold either cash in their accounts at the clearing
bank or a perfected security interest in specific collateral. Under
this settlement process, almost all trades are unwound each day whether
the trades are maturing or have remaining terms. Thus, almost the
entire value of this market is funded each day through the extension of
intraday credit by a clearing bank. Further, these extensions of
intraday credit by the clearing banks are not contractually committed,
but rather wholly discretionary. In short, a clearing bank can decide
at any time to stop providing intraday credit to a securities dealer.
The reliance on discretionary intraday credit in the tri-party
settlement process poses difficult dilemmas for cash lenders,
borrowers, and clearing banks during periods of market stress. As a
result, securities dealers may experience a sudden and acute loss of
funding. A clearing bank may be reluctant to unwind the tri-party
trades of a securities dealer and extend credit if the bank perceives a
material risk to the financial viability of the dealer, or even if
market sentiment regarding the dealer is merely deteriorating in a way
that could deter cash lenders from providing sufficient new funding to
support a rewind at the end of the day. On the one hand, such a
decision by a clearing bank not to unwind would likely push the
securities dealer into immediate default and would certainly impair its
ability to operate normally. On the other hand, the clearing bank
unwinding the tri-party trades of an apparently weakened securities
dealer has potentially serious implications as well. If the securities
dealer subsequently fails to attract sufficient new cash from lenders
to fully finance its securities inventory, the clearing bank faces a
material, albeit secured, credit exposure to that dealer. This
situation could call the clearing bank's own viability into question,
impair its ability to settle transactions for other dealers, and
potentially spread distress across broader markets.
In essence, a clearing bank is inclined to provide intraday credit
to a dealer only when it is confident that sufficient incremental
funding from cash lenders will materialize to make the rewind possible.
And cash lenders will only enter new trades that provide incremental
funding to a dealer if they are confident that their transactions will
be unwound at maturity by the clearing bank. So, if concerns rise
markedly about the financial condition of one or more securities
dealers, the instantaneous transfer of the risk of a default that
occurs twice each trading day--the first time through the unwind to the
clearing bank and the second time through the rewind to the cash
lenders--creates incentives for both the clearing bank and cash lenders
to ``get out first,'' leaving the tri-party repo market highly
vulnerable to runs.
The fundamental susceptibility to runs stemming from this
settlement process was exacerbated during the financial crisis by other
compounding factors, which included weaknesses in the risk-management
practices of many market participants. Some dealers were heavily
reliant on triparty financing with very short tenor--which entailed
significant potential rollover risk--on the assumption that this
funding would be durable during a stress event. And some cash lenders
were apparently not fully aware of the discretionary nature of intraday
credit or of the consequences of a decision by a clearing bank to
decline to provide such funding. In particular, in the event that a
clearing bank declined to provide intraday credit to support the unwind
of a securities dealer's tri-party trades, no mechanism existed then or
now to orchestrate an orderly liquidation of the collateral to repay
the lender. The absence of such a process raised the specter of a
``fire sale'' of securities by cash lenders who could find themselves
taking possession of collateral they had limited operational capacity
to manage or that might place them in violation of their portfolio
composition guidelines. Concerned that other firms similarly situated
would quickly liquidate large volumes of collateral and cause market
dislocations, each cash investor would, quite rationally, try to sell
first with predictable, but possibly dire, consequences. These
compounding factors--the weaknesses in risk management and the absence
of a mechanism to assist with the orderly liquidation of tri-party
collateral--further increased the vulnerability of the tri-party repo
market to runs.
In fact, runs did occur, and they played out with surprising speed
around the time of the near failure of Bear Stearns in March 2008 and
again during the worsening of the crisis in mid-September of that year
after the bankruptcy of Lehman Brothers. Indeed, the Federal Reserve
implemented the Primary Dealer Credit Facility in March 2008, and
expanded its scope in September 2008, in part to stabilize the tri-
party repo market in the face of rapid erosion of investor and clearing
bank confidence. While this facility proved to be a critical crisis-
management tool, the fact that it was necessary underscored the need
for fundamental changes to market conventions and practices.
The Task Force
Following broad recognition of the vulnerabilities associated with
discretionary intraday credit, an industry-led Tri-party Repo
Infrastructure Reform Task Force was formed in 2009 as an initiative of
the Payments Risk Committee, a private-sector body convened by the
Federal Reserve Bank of New York. \1\ The task force included
representatives of market participants, such as cash lenders, dealers,
clearing banks, and other service providers, as well as industry groups
representing both dealers and investors. The Federal Reserve and
agencies with regulatory authority over other market participants
served in an advisory capacity. Not surprisingly, a key focus of the
task force's efforts was the reduction in reliance on intraday credit
in the settlement process. But the group also considered some related
vulnerabilities, including the risk-management practices of both
securities dealers and cash lenders.
---------------------------------------------------------------------------
\1\ Information on the Tri-Party Repo Infrastructure Reform Task
Force is available on the Federal Reserve Bank of New York's Web site
at www.newyorkfed.org/tri-partyrepo.
---------------------------------------------------------------------------
In its May 2010 interim report, the task force dealt directly with
the issue of reliance on intraday credit extension, creating a detailed
plan for its ``practical elimination'' by mid-2011. \2\ In fact,
participants achieved some important prerequisites to this goal last
year. Clearing banks developed tools that will allow automated
substitution of collateral, and hence access to securities for routine
operational purposes without requiring a daily unwind of a dealer's
entire tri-party book. A process was implemented to support the three-
way confirmation of trades, ensuring that nonmaturing trades could be
readily identified as such by the clearing bank, and eventually not
unwound on a daily basis. Further, the unwind, while still very much a
part of the settlement process, was moved from early morning to mid-
afternoon, allowing clearing banks more time to make an informed
decision regarding the extension of intraday credit. While not directly
related to the reduction of reliance on intraday credit, the task force
also played an important role in improving the transparency of the tri-
party repo market for market participants and the public, working with
staff at the Federal Reserve Bank of New York in a process that
culminated in the publication, beginning in June 2010, of key monthly
statistics on the types of collateral funded and applicable terms. \3\
---------------------------------------------------------------------------
\2\ See, Federal Reserve Bank of New York (2010), ``Tri-Party Repo
Infrastructure Reform'', white paper (New York: FRBNY, May),
www.newyorkfed.org/banking/nyfrb_tri-party_whitepaper.pdf.
\3\ Information on the Tri-Party Repo Margin and GCF Repo
Statistics is available on the Federal Reserve Bank of New York's Web
site at www.newyorkfed.org/tri-partyrepo/margin_data.html.
---------------------------------------------------------------------------
These significant achievements notwithstanding, it became clear
last year that more-fundamental changes to systems at both clearing
banks and on the part of other market participants, as well as
associated adjustments to market practices, would take significantly
longer to implement. The task force, in its final report issued in
early 2012, acknowledged that the work had entered a new phase and
described in greater detail the ``target state,'' a safer and more
robust settlement process for the tri-party repo market that would not
rely on significant discretionary intraday credit. \4\
---------------------------------------------------------------------------
\4\ See, Tri-Party Repo Infrastructure Reform Task Force (2012),
``Tri-Party Repo Infrastructure Reform Task Force Releases Final
Report'', press release, February 15, www.newyorkfed.org/tri-partyrepo/
pdf/PR_l20215.pdf; the report is also available directly at
www.newyorkfed.org/tri-partyrepo/pdf/report_120215.pdf.
---------------------------------------------------------------------------
Federal Reserve Use of Supervisory Authorities
The Federal Reserve, while acknowledging the contributions and
achievements of the task force, responded on several fronts to the
inability of the industry to meet its commitment to meaningfully
address the tri-party repo market's heavy reliance on discretionary
intraday credit in 2011. Notably, the Federal Reserve has used
supervisory tools to encourage market participants over which it has
direct authority to implement the task force recommendations in a
timely fashion. If adopted uniformly across the market, these
recommendations should materially reduce reliance on discretionary
intraday credit. While a great deal of focus is appropriately on the
clearing banks, given their pivotal role in the settlement process, the
active engagement of all market participants is critical to reaching
the goal of material risk reduction. To this end, the largest
securities dealers affiliated with bank holding companies have recently
been asked to submit to the Federal Reserve detailed execution plans
and timelines for the necessary changes to systems and processes. At
the same time, the Federal Reserve is pressing them to work with
lenders to achieve more-timely and more-accurate trade confirmations,
which are critical to ensuring that the coming process changes are
effective in reducing the use of intraday credit, and thus risk. \5\
---------------------------------------------------------------------------
\5\ See, Federal Reserve Bank of New York (2012), ``Update on Tri-
Party Repo Infrastructure Reform'', statement, July 18,
www.newyorkfed.org/newsevents/statements/2012/0718_2012.html.
---------------------------------------------------------------------------
On another front, the Federal Reserve is working with regulators of
other important market participants. As I described earlier, there are
a wide range of participants in the tri-party repo market, only some of
whom are subject to direct Federal Reserve oversight. A particular
strength of the task force process was the involvement of essentially
all important classes of market participants and their regulators. With
that process now concluded, the Federal Reserve is committed to finding
other ways to continue and expand these interactions. Such an inclusive
approach is essential if key changes to the settlement process that
require adjustments in the behavior of all market participants are to
be effectively implemented. Not only securities dealers affiliated with
bank holding companies but also other broker-dealers as well as cash
lenders, such as money market funds, must modify systems and protocols
consistent with the requirements of the target state. To this end,
engagement with the Securities and Exchange Commission has been and
will continue to be particularly important given its role as the
primary regulator of broker-dealers and many cash lenders, notably
money market funds.
Given the broad interest in the tri-party repo market and the
complexities involved in reaching the target-state settlement system,
the Federal Reserve considers it critical that the general public have
the opportunity to follow progress, including by tracking relevant
metrics of risk reduction associated with the gradual decline in
reliance on intraday credit. In addition, the Federal Reserve is
committed to providing information on its initiatives related to the
tri-party repo market. With these aims in mind, the Federal Reserve
Bank of New York recently launched a Web site that will serve as a
portal for a range of information related to the tri-party repo market.
\6\
---------------------------------------------------------------------------
\6\ Information on Tri-Party Repo Infrastructure Reform is
available on the Federal Reserve Bank of New York's Web site at
www.newyorkfed.org/banking/tpr_infr_reform.html.
---------------------------------------------------------------------------
The Problem of Fire Sales
While eliminating the daily unwind and reducing reliance on
intraday credit will materially reduce the potential for a recurrence
of many of the problems evident during the financial crisis, other
vulnerabilities will remain. A particular concern of the Federal
Reserve, and also reflected in the Financial Stability Oversight
Council's most recent annual report, involves the challenge of managing
the collateral of a defaulting securities dealer in an orderly manner.
\7\ Larger dealers finance portfolios of securities that can easily
exceed $100 billion and would be difficult to liquidate even under
favorable market conditions without causing dislocations. As I noted
earlier, the situation could be further complicated by the fact that
many cash lenders are highly risk averse, subject by regulation or
prospectus to stringent limitations on their portfolio holdings, and
may have limited operational capacity to manage collateral. As a
result, they would likely be inclined to quickly liquidate securities
that they had obtained from a failed dealer, creating the potential for
a fire sale that could destabilize markets and propagate shocks across
the financial system.
---------------------------------------------------------------------------
\7\ See, Financial Stability Oversight Council (2012), 2012 Annual
Report (Washington: FSOC), www.treasury.gov/initiatives/fsoc/Pages/
annual-report.aspx.
---------------------------------------------------------------------------
A solution to this fire sale problem likely requires a marketwide
collateral liquidation mechanism. The challenges in designing and
creating a robust mechanism--which would almost certainly need the
capacity to fund a significant volume of collateral for some period of
time--are appreciable, and include assuring adequate liquidity
resources even under adverse market conditions and developing rules for
the allocation of any eventual losses across market participants. Such
capabilities typically exist today in the context of clearing
organizations that have a formal membership structure, which allows for
capital assessments and the sharing, or ``mutualization,'' of potential
losses. How this model might be adapted to a market more loosely
organized around clearing banks, particularly in which certain less-
liquid collateral types continue to be funded, remains unclear and will
surely need to be the focus of much additional study.
Conclusion
Given the importance of the tri-party repo market and the
vulnerabilities that were so evident during the financial crisis,
enhancing the market's resiliency and its settlement system is an
important regulatory and financial stability priority. Building on the
work of the task force, we believe that supervisory efforts will yield
substantial progress in eliminating the reliance of the tri-party repo
market on intraday credit, although perhaps not as quickly as many of
us had hoped, and in improving risk-management practices across a range
of market participants. A significant remaining challenge, however, is
the development of a process to liquidate in an orderly fashion the
collateral of a defaulting dealer that would operate reliably in the
context of a settlement system organized around clearing banks.
Thank you once again for the invitation to appear before you today
to share the perspectives of the Federal Reserve on these important
issues. I would be pleased to answer any questions you may have.
______
PREPARED STATEMENT OF KAREN B. PEETZ
Vice Chairman, The Bank of New York Mellon
August 2, 2012
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, my name is Karen Peetz, and I am Vice Chairman of The
Bank of New York Mellon and CEO of the company's Financial Markets and
Treasury Services businesses. I appreciate the opportunity to appear
before you today to discuss the tri-party repurchase--or ``repo''--
market in the United States.
I would like to begin by briefly describing the history and
operations of BNY Mellon, as our business model is very distinct from
traditional retail or investment banks. BNY Mellon was formed in 2007
as a result of the merger between The Bank of New York and Mellon
Financial Corporation. The company has a rich and distinguished history
that is inextricably woven into the broader history of the United
States. The Bank of New York was founded in 1784 by Alexander Hamilton,
and with its predecessors, BNY Mellon has been in business for 228
years, making it one of the oldest continuously operating financial
institutions in the world.
In contrast to most global banking organizations, our business
model does not focus on the broad retail market--we do not offer credit
cards, traditional mortgages, auto loans or similar products to retail
consumers. Rather, we are a provider of services that help major
financial institutions access funding and support the operational
infrastructure of the global capital markets. BNY Mellon operates two
primary businesses: investment servicing and traditional asset
management. Through our various clearance, advisory, global markets,
treasury services and asset management platforms, we facilitate the
trading, settlement and distribution of client assets around the world.
Before I address the topic of today's hearing, let me begin by
stressing BNY Mellon's support for recent U.S. and international
regulatory reforms that have strengthened our financial system,
including the Dodd-Frank Wall Street Reform and Consumer Protection
Act. BNY Mellon has a long history of working with the Government to
help steady financial markets, often providing the benefit of the
expertise we have developed from our unique role in the markets to the
Government regarding the structure of support facilities.
In addition, the nature of our business allowed us to see first-
hand how insufficient capital and liquidity at some institutions
contributed to the financial crisis. Since the Dodd-Frank Act was
enacted, we have worked with our global and domestic prudential
supervisors to provide meaningful feedback on regulatory proposals and
explain how proposed rules may affect critical aspects of the financial
system. We have heartily endorsed meaningful reforms--including
enhancing the quality and quantity of bank capital--that will
strengthen the banking sector, guard against future systemic shocks,
and encourage economic expansion.
For the purposes of my testimony today, I will focus on three
issues:
How the tri-party repo market operates;
BNY Mellon's role supporting the tri-party repo market; and
The performance of the tri-party repo market during the
financial crisis and ongoing reform efforts.
Before addressing the intricacies of the tri-party repo market, I
would like to start with a general explanation of the repurchase market
and why it exists. A ``repo'' is a sale of securities by a dealer to an
investor, accompanied by a contract to repurchase the securities for an
agreed upon price at a later date. These arrangements are entered into
by dealers who have liquidity needs and investors looking to put cash
holdings to good use (often investment managers for endowments, pension
funds, and municipalities, money market mutual funds, custodial banks
investing cash collateral on behalf of their securities lending
clients, and other asset managers). The repo market is a major source
of funding for the financial institutions that drive business and
finance globally and is an integral part of ensuring that the financial
system is able to work for downstream customers.
Functionally and economically, repos operate like secured loans. On
any given day, a cash investor (the lender) extends funds to a dealer
(the borrower) at an agreed rate--the ``repo rate''--and the dealer
provides the investor with securities as collateral. As the Federal
Reserve Bank of New York (the ``FRBNY'') has explained, ``[t]he
proceeds of the initial securities sale can be thought of as the
principal amount of the loan, and the excess paid by the cash borrower
to repurchase the securities corresponds to the interest paid on the
loan, also known as the repo rate.'' \1\
---------------------------------------------------------------------------
\1\ ``Tri-Party Repo Infrastructure Reform'', The Federal Reserve
Bank of New York, p. 5 (2010).
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Tri-Party Repo and BNY Mellon Operations
Tri-party repo transactions are a type of repurchase agreement
involving a third party, the tri-party agent--the function BNY Mellon
serves--who facilitates settlement between dealers (cash borrowers) and
investors (cash lenders). The tri-party agent maintains custody of the
collateral securities, processes payment and delivery between the
dealer and the investor and provides other services, including
settlement of cash and securities, valuation of collateral, and
optimization tools to allocate collateral.
The tri-party repo market has grown and evolved over the years, in
response to market and economic factors that made the structure a more
attractive mechanism for meeting the market's funding needs. The use of
a tri-party agent has enabled the market to operate more efficiently by
reducing settlement risk and related costs, allowing for collateral
recall, providing independent collateral verification and monitoring
and standardizing transaction agreements. According to the Financial
Stability Oversight Council's (the ``FSOC'') 2012 Annual Report the
current value of the tri-party repo market is $1.8 trillion.
BNY Mellon is a substantial tri-party agent, with an approximately
80 percent market share. Our involvement in a transaction commences
after a broker-dealer and a cash investor agree to a tri-party repo
trade and send instructions to BNY Mellon. These instructions represent
the parties' agreement concerning the tenor of the transaction, the
amount of cash lent, the value and type of collateral returned, and the
repo rate.
To facilitate the tri-party repo market we extend secured intraday
credit to dealers to repay their investors from the prior day's trades.
If a dealer becomes distressed we could refuse to extend such credit
and investors could withdraw from the market. Both of these actions
could lead to destabilizations in the economy. Once a tri-party trade
settles, BNY Mellon is no longer exposed to direct risk of the dealer
or the underlying securities. Thereafter, the ultimate risks associated
with a defaulting dealer who has pledged collateral are with its cash
investors.
Tri-Party Repo Reform and the Financial Crisis
Few parts of the United States financial system were untouched by
the global financial meltdown from 2007-2009; therefore, it is
unsurprising that the tri-party repo market experienced strain. The
crisis revealed that the market could experience systemic problems:
dealer defaults could leave investor counterparties or the tri-party
agent holding collateral that was increasingly illiquid, leading to a
seizing up of the financial markets.
In light of our role as tri-party agent, we are uniquely positioned
to work with the Federal Reserve to identify ways to take risk out of
the way this market operates. We have been in continual discussions
with supervisors and clients regarding measures to reduce and
eventually eliminate our exposure to intraday credit risk, as well as
to help address broader structural concerns with the tri-party repo
market.
After the financial crisis, the Federal Reserve asked clearing
banks, primary dealers, and investors to consider policy options to
address problems with tri-party repo infrastructure that were revealed
during the financial crisis, which led to the creation of the Tri-Party
Repo Infrastructure Reform Task Force \2\--in which BNY Mellon
participated. The Task Force published its final report in February
2012 summarizing the current state of reform efforts. In addition to
identifying the measures I describe below as important steps, the Task
Force noted other achievements that increased transparency, enhanced
data reporting and strengthened cash investor stress testing practices.
The report recognized that additional measures to further reduce
intraday credit to broker-dealers would be necessary.
---------------------------------------------------------------------------
\2\ The Task Force on Tri-Party Repo Infrastructure Reform was
formed by the Payments Risk Committee, a private sector body sponsored
by the FRBNY. The Task Force included representatives from a diverse
group of market participants. Federal Reserve and SEC staff
participated in meetings of the Task Force as observers and technical
advisors. Task Force on Tri-Party Repo Infrastructure, Payments Risk
Committee, p. 1 (2010).
---------------------------------------------------------------------------
In addition to our work on the Task Force, BNY Mellon has been
working with our regulators and our clients to address practices within
the market that require strengthening. We have focused our own internal
reform efforts on reducing the provision of intraday credit and
influencing collateral standards.
With respect to reducing intraday credit provided by BNY Mellon to
facilitate the tri-party repo market, we are implementing
recommendations made by the Task Force. We have moved to a later day
unwind for most maturing tri-party repos, reducing the intraday risk
exposure window from 10 to approximately 3 hours. We have instituted an
``auto substitution'' process to allow dealers to replace needed,
pledged collateral by first over-collateralizing with cash.
Additionally, BNY Mellon introduced a three-way trade confirmation
process known as automated deal matching for dealers, agents and
investors. The trade matching enhancements allow BNY Mellon, as the
clearing bank, to receive both the dealer and cash investor's trade
instructions separately and match the required information fields
systematically. This automated matching process provides dealers and
investors with an efficient and consolidated view of trade
instructions, terms and modifications to ensure accuracy and
transparency.
BNY Mellon is also identifying asset classes eligible for intraday
credit associated with tri-party repo transactions and we are working
with our clients to eliminate intraday credit associated with less
liquid forms of collateral. We expect these measures to reduce intraday
exposures by $230 billion by early next year. Moreover, we are
developing the technology for a systematic approach to reforming the
entire unwind process that will practically eliminate exposures by the
end of 2014. As we develop and implement these measures, we are working
closely with our clients and the Federal Reserve to ensure that these
changes are adopted in a manner and on a timetable that does not unduly
disrupt the market.
Last, I would note that on July 18, The Federal Reserve Bank of New
York released a statement acknowledging its efforts to use the
supervisory process to effect reductions in intraday credit and
implement other risk management reforms detailed in the Task Force's
recommendations. A day earlier, the FSOC issued its annual report,
which sounded similar themes. The report raised the intraday credit
concern I have described and stated that reforms should proceed
expeditiously. I can assure you that we are partnering with the Federal
Reserve on these efforts and are committed to enhancing tri-party
operations to reduce systemic risk. Specific to the pace of reforms, I
would note that the measures we have already implemented are materially
reducing intraday credit exposures.
Conclusion
BNY Mellon strongly believes that the tri-party repo market is a
crucial component of the global financial system's infrastructure. We
are committed to continuing to develop meaningful reforms that limit
systemic risk and enable market participants to efficiently and
effectively fund their operations.
Again, I thank you for the opportunity to testify before you today
and look forward to any questions you may have.
______
PREPARED STATEMENT OF STEVEN R. MEIER
Executive Vice President, Chief Investment Officer, State Street Global
Advisors
August 2, 2012
Chairman Reed and Members of the Subcommittee on Securities,
Insurance, and Investment: Thank you for the opportunity to appear
before you today. My name is Steven Meier and I am the Chief Investment
Officer, Global Cash Management, for State Street Global Advisors
(SSgA), the investment management business of State Street Corporation
(State Street).
The Committee has asked me to provide an investor's perspective on
the tri-party repurchase market settlement mechanism, with a specific
focus on the systemic risk reducing initiatives recommended by the
Federal Reserve Bank of New York's Tri-Party Repo Infrastructure Reform
Task Force. I hope my testimony will assist the Committee with its
important work.
State Street had the privilege of participating in this Task Force
to provide investor insight into the functioning of these arrangements
and the benefits of such transactions for our clients. State Street
agrees with the risk reducing initiatives put forward by the Task Force
and is prepared to adjust our operating model in order to address the
concerns raised by the Federal Reserve Bank of New York and others,
including the Financial Stability Oversight Council in its most recent
report.
Background and Experience
Let me begin with a brief description of my background and
experience. I have more than 28 years' experience in financial
services, with a focus on traditional money markets, fixed income,
global cash, and financing. Today, I am an Executive Vice President of
State Street and Chief Investment Officer of the cash asset. I am a
member of SSgA's Senior Management Group and Investment Committee. I
have the responsibility of managing a team of nearly 40 investment
professionals dedicated to cash and short-term asset strategies across
seven currencies located in six investment sites around the world. Our
clients include State and local governments, private pension funds,
corporations, endowments, charitable trusts, foreign central banks, and
sovereign wealth funds.
State Street is one of the world's leading providers of financial
services to institutional investors with nearly $22 trillion in assets
under custody and administration, and almost $2 trillion of assets
under management. As of the end of June 2012, SSgA managed global cash
and short-term assets and strategies of approximately $400 billion, of
which over $300 billion is denominated in U.S. dollars. Our cash and
short-term investment activities in the U.S. span a range of asset
types, including U.S. Treasury and Government agency debt, municipal
debt, unsecured bank and corporate obligations, asset-backed
securities, and other similar instruments including repurchase
agreements. In accordance with our client risk tolerance and return
objectives, repurchase agreements are a key area of focus and a core
competency at our firm.
Repurchase Agreement Transactions
In a typical repurchase transaction, an investor transacts directly
with a bank or broker-dealer that is looking to borrow short-term
funding collateralized with assets to secure the trade. In a tri-party
repurchase transaction, a third party acts as an agent to facilitate
trade settlement and collateralization. On behalf of the client assets
that it manages, SSgA is an investor and provider of funding in a
repurchase agreement transaction. SSgA's average total U.S. dollar
repurchase transaction volume outstanding consistently exceeds $100
billion, most of which settle and are collateralized through the tri-
party mechanism. While these transactions involve counterparty credit
risk, the collateralization of the trades provides diversification away
from unsecured credit obligations and a generally favorable risk/return
dynamic. The tri-party mechanism provides significant operational
efficiencies and settlement risk reduction, while also delivering
transaction scale and investment capacity. Without these benefits of
scale and efficiency provided by this important settlement mechanism,
our repurchase transaction investment activities would be a fraction of
what they are today. A diminished capacity in this core money market
asset would likely cause investors to raise their holdings of unsecured
debt, with increased exposure to potential credit loss and asset price
volatility.
Tri-party repurchase transactions provide asset managers an
excellent alternative for maintaining core, low-risk daily portfolio
liquidity, as well as an instrument to enhance returns through term
repurchase transactions involving a broad range of collateral. Core
portfolio liquidity is typically maintained through repurchase
transactions collateralized with ``traditional'' forms of collateral
including U.S. Treasury Bills, Notes and Bonds, Government agency
obligations, and Government agency mortgage-backed securities. These
core liquidity trades typically are executed for tenors of 1 to 7 days.
In comparison, portfolio yield enhancement is often achieved through
repurchase transactions that are collateralized with ``nontraditional''
or ``alternative'' forms of collateral, including investment grade
corporate bonds, money market instruments, municipal obligations,
asset-backed securities, high yield bonds and equities. These yield
enhancement trades are typically executed for periods ranging from one
week to one year. SSgA has considerable resources committed to ongoing
support of these transactions and managing the risks associated with
them, including dedicated senior portfolio managers, specialized
technology infrastructure, operational personnel, designated collateral
analysts, legal expertise, risk managers, and senior management
oversight. We actively review, assess, stress test, and manage
repurchase transaction collateral daily.
Task Force Recommendations
The ongoing implementation of the Task Force recommendations has
resulted in considerable progress toward reducing the system risk
associated with these transact ions. Through altering transaction
processing timelines and protocols, the industry has been able to
achieve real progress. However, there is still work to be done to
eliminate these risks. Additional systems enhancements and trade
processing efficiencies and timing disciplines are required to reach
this objective and are in-process.
It should be noted, however, the industry has made significant
progress in transaction risk mitigation through ongoing Task Force
discussions and findings, Specifically, participants are now more aware
of the need for counterparty default contingency planning, the
requirement of knowing both your counterparty and your collateral, the
benefits of maturity extension, required analysis and judgment
concerning collateral suitability, the need for focus on detailed
repurchase transaction collateral schedules and the benefits of dynamic
margining. Enhanced awareness and transparency of these issues all
contribute toward an informed marketplace and a consistent source of
funding and investment returns. SSgA, on behalf of its clients, has a
strong interest in ensuring that these important money market
investment arrangements and supporting tri-party settlement mechanism
continue to be a viable and vibrant aspect of the money and capital
markets. I look forward to further industry progress on improving the
efficient functioning of this key market mechanism.
Thank you again for the opportunity to be here today to speak on
this subject. I would be pleased to answer the Committee's questions.
______
PREPARED STATEMENT OF THOMAS G. WIPF
Managing Director and Global Head of Bank Resource Management, Morgan
Stanley
August 2, 2012
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, thank you for inviting me to appear before you today. My
name is Thomas Wipf and I am a Managing Director at Morgan Stanley and
responsible for the firm's Bank Resource Management including Secured
Funding, Securities Lending, and Counterparty Portfolio Management.
Thank you again for the opportunity to discuss this very important
issue in the markets for secured funding.
As an active member participant in the work of the Tri-Party Reform
Committee (Committee), Morgan Stanley remains fully committed to
accomplishing the goals laid out by the Committee within a timeline
that is ambitious and acceptable to all stakeholders. Our firm views
this work as a top priority and critical path in our own funding and
liquidity strategy. As the Committee's recommendations continue to be
processed, we have seen meaningful benefits and risk reduction on a
market wide basis. Morgan Stanley agrees with the Financial Stability
Oversight Council that more needs to be done and the delay in soundly
eliminating intraday credit risks is ``unacceptable.''
Secured funding is an important funding source and a foundational
component of our centralized liability management strategy. We are
committed to and have taken significant steps to put all the
recommendations into practice at our firm. We have heard clearly from
the secured funding investor community that the collateral management
services provided by the clearing banks are an important element of
their collateral valuation and risk management process.
The significant stability issues that appeared in 2008 provided the
Committee, our regulators and all market participants (bank dealers,
cash investors, and the two clearing banks) with a road map for reform.
Many long held assumptions around durability, settlement, credit
exposure, agent versus principal relationships and contingency planning
were proven wrong or overly optimistic during a period of significant
stress in the broad funding markets. The major factors for the
instability were the short tenor of funding particularly for less
liquid assets; lack of transparency regarding collateral for investors;
insufficient overcollateralization on less liquid assets; and
uncertainty regarding credit counterparties during the period between
trade maturity and settlement. Additionally, the overall reduction of
counterparty risk as well as a heightened market wide aversion to
counterparty risk contributed to the instability of the platform. We
believe the Tri-Party Reform Committee identified these weaknesses and
defined the issues requiring remediation. In implementing these
recommendations, we see the remaining strategic issues falling into
three categories:
Complete clarity on the terms and limits for credit
extension between the clearing banks and the bank dealers by
asset class
Full implementation of a transparent settlement process
with a clear timeline that enables all market participants to
understand and manage their settlement risk and
Further building investor confidence and reducing intraday
risk by a meaningful and systematic reduction of collateral
turnover between trade execution and maturity
Many of the challenges faced by the Committee were a result of
mixing the issues. Credit extension, collateral management and
settlements are separate and distinct issues that all impact the Tri-
Party funding market. The extension of intraday credit is a major focus
issue for the bank dealers and the two clearing banks. While our
investors are focused on the collateral management services provided by
the clearing banks, the operational issues are relevant to all three
parties to the transaction. Part of the challenge faced by the
Committee was to separate these issues although there are certain
codependencies among them. We believe that the work ahead will only be
successful if the issues are treated individually going forward.
At Morgan Stanley, we have taken a number of steps to meaningfully
reduce our daily settlement exposures ahead of the Committee's
deadlines, most notably in the area of prudent liability and collateral
management. Our firm has taken proactive steps to extend the maturity
of our secured funding liabilities in a rules based governance process
that requires minimum term of maturities consistent with the
fundability characteristics of our assets. We additionally have imposed
investor diversification and maturity limits to reduce our maturities
with any investor in a given period and an overall limit on maturities
during any given period. Our investors have focused on transparency of
collateral, a reduction in collateral turnover during the period of the
transaction and clarity on their credit exposure through execution,
settlement and maturity. We have seen firsthand a marked increase in
pretrade collateral due diligence by secured funding investors.
We fully acknowledge there is considerable work remaining for the
industry that requires senior leadership focus, commitment and
investment by all participants in this market. We are committed to
continuing to collaborate with investors, the two clearing banks and
our regulators to complete the remaining workstreams and to advocate
for a timeline that is acceptable to all stakeholders. Morgan Stanley's
overarching goal in Tri-Party reform is investor confidence. The
meaningful reduction in intraday credit extension, transparency in
collateral and advance rates combined with a more sound and durable
operational platform are all positive steps toward this goal.
Nevertheless, from our firm's perspective, we have prioritized our
resource commitments in the context of the Tri-Party reform committee's
agenda on initiatives designed to retain the confidence of our secured
funding investors, the cash providers.
With lessons learned following the crisis, Morgan Stanley has
worked over the past several years to add significant risk management
enhancements to our secured funding model. As mentioned above, we have
added significant term to the maturities in our secured funding
liabilities and since a large portion of those liabilities come from
investors who utilize the Tri-Party repo platform, our pro forma and
actual intraday credit from our clearing banks has been meaningfully
reduced. Since 2008 we have extended the weighted average maturity of
our secured funding book from less than 30 days in 2008 to now well in
excess of 120 days. This is now a disclosure metric in our public
filings. Extending the maturity and limiting rollover risk are the most
powerful tactical steps that can be taken by bank dealers immediately
to reduce the intraday extension of credit. Since the credit extension
takes place at the unwind of the trade, creating a longer and staggered
maturity profile can yield significant risk reduction.
The Tri-Party Reform Committee has worked to identify the issues
and put forth recommendations for the remediation of the gaps that
became apparent in 2008. Many of those recommendations are now in
practice or in scope on a clear timeline. Many of the enhancements to
the settlement and confirmation processes have created increased
stability and added clarity. It is clear, however, that the main and
most important goal of reducing intraday credit extension has not yet
been achieved. It is also clear, however, that the responsibility for
this cannot be solely assigned to the two clearing banks. We in the
bank dealer community have to take the immediate and incremental steps
available through our liability management practices to become a bigger
part of the solution. There is no single operational solution or system
development that can solve this issue completely. What is required is
collaboration between the bank dealers and the two clearing banks to
provide a set of strategic steps to begin a tactical but meaningful
reduction of intraday credit extension in parallel to building
operational and system enhancements. We believe that the status quo is
unacceptable and by beginning this reduction through prudent liability
management, we can reduce risk during the proposed build out by the
clearing banks. At Morgan Stanley, we have seen considerable results
achieved by working directly with our clearing banks to take
significant tactical steps to reduce our reliance on intraday credit.
Morgan Stanley is committed to taking the steps necessary to build
investor confidence in this important funding channel. The markets'
liquidity is provided by investors who seek to have transparency to
their collateral, a clear understanding of the settlement process and
the information they need in real time, to make appropriate risk
decisions and to effectively manage their collateral and counterparty
exposures.
We have worked with the Tri-party Committee and other industry
groups to move this reform forward. Morgan Stanley is committed to
achieving the entirety of goals laid out in the Committee's report and
has invested and executed on changes to our processes well in advance
of the scheduled timelines with the goal of meeting the needs of our
investors. This work is a top priority of our firm and we will continue
to work at both an industry and a firm level along with our regulators
to add stability and durability to this funding platform.
Again, we are appreciative of the opportunity to discuss these
important issues and look forward to providing this Committee with any
level of detail and information that will be helpful as you deliberate
on the path forward.
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM MATTHEW J. EICHNER
Q.1. We heard testimony from the witnesses about some broker-
dealers' continued reliance on tri-party repo financing for
less liquid collateral and the challenges such collateral would
present for risk-averse investors such as money market funds in
the event of a large dealer default. In discussing the need for
counterparty default contingency planning, Mr. Steven Meier,
who represented State Street Global Advisers at the hearing,
recommended that the Federal Reserve audit the contingency
plans of all the market participants to make sure they have
addressed the requirement of collateral suitability. What steps
is the Federal Reserve taking to monitor the actions of market
participants around collateral liquidation plans? Should the
Federal Reserve do more?
A.1. The Federal Reserve continues to be very concerned about
the possibility that a default by a dealer of significant size
would lead to a rapid and potentially disorderly liquidation of
collateral, including but not limited to less-liquid
securities, by risk-averse tri-party cash investors. In fact,
we have continued to highlight both in our public
communications and in our supervisory conversations with bank-
affiliated participants in this market that, even after the
current program aimed at materially reducing reliance of the
tri-party market on large amounts of discretionary intraday
credit from the clearing banks is fully implemented, this
``fire sale'' problem will remain an issue to be addressed.
While we are monitoring the default contingency plans of
those firms we supervise, robust firm-specific plans do not
fully guard against this risk. We continue to believe that
successfully addressing the fire sale problem will require
development of some type of market-wide mechanism or process to
ensure a coordinated, orderly liquidation of collateral by
investors in the wake of a dealer's default. The challenges in
designing and implementing a robust mechanism are appreciable.
One key challenge is to establish adequate capacity for market
participants to hold and finance collateral for a time even
under adverse market conditions. Another is the need to develop
prespecified rules to govern how any losses on the assets would
be allocated among market participants in the event that these
occur. Of course these issues have been successfully addressed
in other contexts. Backup liquidity sources and loss allocation
have long been features of a number of financial market
utilities that govern other payment and settlement processes.
Our view is that the best way forward would be for market
participants to join together to develop a process or mechanism
to ensure the orderly liquidation of collateral by creditors of
a defaulted dealer, to eliminate the risk of fire sales. We are
certainly open to models meeting these challenges that are
constructed around the current market structure, with a key
role in the settlement process played by the two clearing
banks. But, in the event that a satisfactory model cannot be
devised by the market, we believe other solutions should be
considered, including those that would involve the
establishment of a single marketwide platform to manage the
collateral of a defaulting dealer. Any solution is likely to be
a very challenging undertaking, in light of the formidable
substantive issues and the diverse group of market participants
that would need to be involved. We think it is important for
market participants to begin working on such a mechanism now,
as a solution may take considerable time to design and
implement. In the interim, the Federal Reserve is very actively
monitoring the operational and risk management capacities of
institutions subject to its supervision that would be relevant
in the event of a dealer's default on its tri-party repo
obligations, notably the holding companies of the two clearing
banks. Note that the Federal Reserve does not have direct
supervisory authority over some of the largest cash lenders or
broker-dealers in this market.
Q.2. If a large bank offering tri-party repo clearing were to
suddenly fail for some reason unrelated to repo markets, is
there a plan for how to keep the tri-party repo market from
freezing up and allow it to continue operating? Why or why not?
A.2. In the event that either of the two tri-party clearing
banks was to suddenly fail, the options for avoiding
significant short-term disruptions would be limited. This
remains the case even after the inclusion in the Dodd-Frank Act
of provisions that provide some potentially important
additional tools to facilitate the orderly liquidation of
certain financial institutions affiliated with banks, including
their ultimate holding companies. The critical role of the
clearing banks in the tri-party settlement process could
probably not be immediately assumed by other institutions. For
this reason, the Federal Reserve, along with other relevant
supervisors, focuses continuously on both the financial and
operational condition of such firms. Concerns about the
centrality of these institutions to the orderly functioning of
financial markets also motivated the enactment in 2010 of
statutory requirements that these firms be subject to enhanced
prudential standards, including risk-based capital, liquidity,
and leverage requirements. The Federal Reserve is now in the
process of developing and implementing these standards.
Q.3. As the primary regulator of broker-dealers and many cash
lenders, notably money market funds, how can the SEC use its
supervisory powers to help improve the resiliency and stability
of the tri-party repo platform?
A.3. The most important single step that the SEC can take to
enhance resiliency in the tri-party repo market is to move
forward expeditiously with meaningful reforms that would reduce
the vulnerability of money market funds, which currently
provide about one-third of all tri-party financing, to
destabilizing runs. Rapid redemptions from money market funds
by highly risk-averse investors responding to the first mover
advantage conferred by the use of a rounding mechanism to
maintain a stable share price can quickly create stress in the
tri-party market and in the financial system as a whole, as was
observed during the financial crisis. The importance of
effectively addressing the susceptibility of money market funds
to runs cannot be overstated, and the SEC is, by virtue of its
longstanding experience with regulating investment companies
and existing statutory authority with respect to money market
funds, uniquely well-positioned to take action.
In addition, the SEC has been helpful in encouraging
broker-dealers, the borrowers in the tri-party market, to
actively manage their funding risk, for example using longer-
dated transactions to finance less-liquid positions and by
avoiding large volumes of transactions all maturing
simultaneously. Recent proposed rules issued by the SEC for
comment that would, inter alia, impose liquidity requirements
on large broker-dealers that, if finalized, would represent a
significant step in the right direction.
Additional Material Supplied for the Record
STATEMENT SUBMITTED BY THE INVESTMENT COMPANY INSTITUTE
The Investment Company Institute \1\ is pleased to provide this
written statement in connection with the Subcommittee's hearing on the
tri-party repo market.
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\1\ The Investment Company Institute is the national association
of U.S. investment companies, including mutual funds, closed-end funds,
exchange-traded funds (ETFs), and unit investment trusts (UITs). ICI
seeks to encourage adherence to high ethical standards, promote public
understanding, and otherwise advance the interests of funds, their
shareholders, directors, and advisers. Members of ICI manage total
assets of $13.1 trillion and serve over 90 million shareholders.
---------------------------------------------------------------------------
Registered investment companies--including mutual funds, ETFs,
closed-end funds, and UITs (collectively, ``registered funds'')--have a
significant interest in the subject of this hearing. Tri-party repo is
a key source of short-term financing for a wide range of borrowers such
as banks and brokerage firms. \2\ The Federal Reserve Bank of New York
(the ``FRBNY'') reports that as of June 2012, borrowers financed $1.8
trillion through this market. \3\ Likewise, cash investors such as
corporations, State and local governments, financial institutions, and
registered funds use this market to invest short-term cash. Among
registered funds, money market funds have the largest presence in this
market with $519 billion invested in repos in June 2012, while stock
and bond funds invested an additional $96 billion. Most of these repos
are tri-party repo.
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\2\ The Federal Reserve Bank of New York's white paper on tri-
party repo provides a comprehensive description of the repo market.
See, ``Tri-Party Repo Infrastructure Reform'' (May 17, 2010), available
at http://www.newyorkfed.org/banking/nyfrb_tri-party_whitepaper.pdf.
\3\ See, ``Tri-Party Repo Statistics as of 06/11/2012'', available
at http://www.newyorkfed.org/tri-partyrepo/pdf/jun12_tpr_stats.pdf.
---------------------------------------------------------------------------
The ICI and several representatives from ICI member firms
participated on a special Task Force on Tri-Party Repo Infrastructure
(the ``Task Force''), which was formed in September 2009 under the
auspices of the Payments Risk Committee, a private sector body
sponsored by the FRBNY. The Task Force recently concluded its work,
highlighting a number of areas in which significant progress was made
to meaningfully reduce both the potential for systemic risk and the
magnitude of the risk associated with the tri-party repo
infrastructure. \4\
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\4\ See, ``Task Force on Tri-Party Repo Infrastructure Payments
Risk Committee'', Final Report (February 15, 2012), available at http:/
/www.newyorkfed.org/tri-partyrepo/pdf/report_120215.pdf.
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These reforms include increased transparency, significant reduction
in the extension of intraday credit by the clearing banks, improved
collateral substitution and management practices, and best practices
for cash investors for disposing of securities in the event of a
failure of a tri-party repo counterparty. Each of these reforms is
described briefly below.
Increasing Market Data for Repos. Beginning in May 2010, the FRBNY
began publishing market data on the tri-party repo market on its web
site. \5\ This data highlights the overall size of the market,
collateral, concentrations, and margin requirements that exist within
the market. This reporting has provided greater transparency into the
broader market, giving all market participants and regulators the
ability to monitor repo exposures and highlight repo market trends.
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\5\ See, http://www.newyorkfed.org/banking/tpr_infr_reform.html.
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In addition, in response to a Task Force recommendation, dealers,
cash investors, and tri-party repo clearing banks are now fully
implementing three-way trade confirmations. These added operational
enhancements allow the tri-party clearing banks and regulators to
monitor ``real-time'' credit exposures. It also provides the tri-party
repo clearing banks an additional level of transparency within the repo
market and reduces the risk of the occurrence of failed or intraday
defaulted repo trades for all market participants. \6\
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\6\ In addition to the increased transparency in the tri-party
repo market, registered funds are required to provide additional
disclosure about their repo activities. This disclosure appears in the
fund's prospectus and statement of additional information, both of
which are available to investors, regulators, and the public. Twice a
year, registered funds also prepare financial statements that are filed
with the Securities and Exchange Commission (SEC) and sent to
shareholders. In addition to the semi-annual financials in these
shareholder reports, registered funds also file Form N-Q after the
first and third quarters, which include a detailed listing of the
fund's portfolio.
Money market funds have additional disclosure requirements. They
are required to post their portfolio holdings on their Web sites each
month within five business days after month end. Money market funds
also are required to file Form N-MFP with the SEC on a monthly basis.
This provides details on the fund and its portfolio holdings (including
detail on each security held as collateral), and has given regulators
and the public significantly enhanced transparency with respect to
money market funds' role in tri-party repos.
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Delaying the ``Unwind.'' Changes have recently been implemented to
cause the daily ``unwind'' of most tri-party repo transactions to move
from early morning to mid-afternoon, greatly reducing the duration of
intraday credit extensions by the tri-party repo clearing banks to the
dealers. The delay in the unwind has been very significant, in that the
tri-party banks now have much greater clarity into the ability of
borrowers to finance their repo book. The situation was much more
opaque with a morning unwind. Work on this front continues, with the
ultimate goal of reducing credit extensions by the tri-party repo
clearing banks to the dealers to no more than 10 percent of a dealer's
notional tri-party book.
Improving Collateral Substitution/Collateral Management. Both tri-
party repo clearing banks have recently implemented automated
collateral substitution capabilities as a result of recommendations
from the Task Force. The introduction of such automated systems has
allowed cash investors and other industry participants to monitor and
manage their intraday collateral positions and ensure that their repo
exposures are adequately collateralized on a ``real-time'' basis.
Industry participants continue to actively work with the tri-party repo
clearing banks to build out the capabilities of this technology and
improve the transparency and the efficiency of this important
monitoring system. The ability to efficiently substitute collateral
helps to prevent disruptions to regular market activity as dealers have
full access to their positions throughout the day.
SEC guidelines require that registered funds involved in a repo
transaction receive at least 100 percent of the value of the cash
invested. In practice, virtually all investors over-collateralize repos
at levels ranging from 102 to 110 percent, demonstrated by the
collateral haircut data published monthly by the FRBNY. The tri-party
clearing banks price the collateral on at least a daily basis using
various independent pricing sources, which ensures centralized and
consistent valuation across all market participants. The clearing banks
continually review the pricing sources to ensure that the repo
transactions are marked-to-market daily and are adjusted so that the
obligations remain fully collateralized at all times.
Dealing With the Potential for Counterparty Defaults. Money market
funds are distinct from other lenders in the repo market in that they
are required to determine that counterparties present ``minimal credit
risk,'' assuring that the funds are only dealing with the highest
quality counterparties. Nevertheless, money market funds and other
registered funds share the common goal of minimizing counterparty risk
in tri-party repo, and have strongly supported the Task Force's efforts
in this regard.
And as a result of the recommendations from the Task Force, the
repo markets are better prepared to deal with potential dealer
defaults. The tri-party clearing banks are working toward adopting
``waterfall'' recommendations of the Task Force that will mandate the
priority of payments or distribution of assets in the event of a
default. In addition, various industry groups continue to work with the
tri-party repo clearing banks and industry participants to develop a
process for the orderly liquidation of collateral. For example, in
consultation with its members, the ICI published a checklist for cash
investors in the event of the insolvency of a tri-party repo borrower.
\7\ This checklist includes preliminary steps that registered funds
investing in tri-party repo should have in place as well as actions
that would need to be taken in the event of a default, including
guidelines on collateral valuation, board notification, and regulatory
filings.
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\7\ See, Investment Company Institute, ``Checklist for Fund
Investors of Repurchase Agreement in the Event of Dealer Insolvency'',
available at http://www.ici.org/policy/current_issues/
11_mmf_repo_checklist.
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With the ongoing implementation of these and other Task Force
recommendations, the tri-party repo markets are better prepared to deal
with potential defaults. As the Task Force's final report noted,
additional work is needed to put in place the infrastructure to meet
the Task Force's goal of ``the practical elimination of intraday credit
associated with the settlement of tri-party repo transactions.'' ICI
and its members continue to support that important goal.
In any event, market participants and regulators have become much
more attuned to the risks of overreliance on short-term financing. Cash
investors and borrowers regularly engage in discussions about the
degree to which borrowers are relying on the repo markets, and
regulators are encouraging banks and other borrowers to extend the
terms of their borrowing to reduce their reliance on short-term
financing. \8\ These efforts have reduced the chances that a firm's
inability to access the short-term markets would lead to its immediate
collapse, as was the case with Bear Stearns and Lehman Brothers.
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\8\ See, e.g., ``FRBNY Update on Tri-Party Repo Infrastructure
Reform'' (July 18, 2012) (``Broker-dealers are expected to reduce their
reliance on short-term tri-party repo financing, particularly for less
liquid assets, to achieve the necessary reductions in the usage of
intraday clearing bank credit.''), available at http://
www.newyorkfed.org/newsevents/statements/2012/0718_2012.html.
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We appreciate the opportunity to share our views with the
Subcommittee on the tri-party repo market, and we look forward to
working with Congress in addressing these important issues in a manner
that benefits the millions of American investors who rely on registered
funds to achieve their investing goals.