The SEC’s Division of Investment Management recently issued a guidance focusing on money market funds’ counterparty risk management practices in regards to tri-party repos. This guidance follows the Financial Stability Oversight Council’s (FSOC) May 2013 Annual Report, which had highlighted the concern that the tri-party repo market remains vulnerable to runs by lenders in cases where concerns arise regarding the financial condition of borrowers such as securities broker-dealers, who rely heavily on this channel for short-term funding. A repo, also known as a repurchase agreement, is an agreement to purchase securities for cash, combined with an agreement to resell those securities at a specified price and time. A tri-party repo is a repo where a clearing bank acts as a third-party agent to provide collateral management services and to facilitate the exchange of cash against collateral between the two repo counterparties. This SEC staff memo is addressed specifically to money market funds because these funds have more significant portfolio holdings of tri-party repos than other types of mutual funds.
The SEC’s guidance encourages money market funds and investment advisers to consider the legal and operational steps they may need to take if a repo counterparty fails and the repos it issued default. The guidance includes a checklist that the Investment Company Institute prepared for funds holding repos in case of a repo counterparty insolvency. It suggests that fund’s advisers should prepare in advance for a default, including the following steps:
- Review the master repurchase agreements and related documentation to consider any specific repo default procedures. If these procedures to call for notification, the fund should consider having templates of notifications or other documents prepared in advance.
- Consider operational aspects of managing a repo default. For example, funds can evaluate whether the systems at the fund or its custodian are appropriately holding, valuing, trading and accounting for the collateral underlying the fund’s repos.
- Consider whether there are potential legal considerations under the Investment Company Act of 1940 or otherwise that the fund could consider in advance or will need to evaluate at time of any repo default.