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The Financial Stability Oversight Council released its 2012 Annual Report recently, and the recommendations, unsurprisingly, included "Reforming Structural Vulnerabilities in Wholesale Short-Term Funding Markets." The Annual Report says, "Stable wholesale short-term funding markets are a critical component of a well-functioning financial system, but if they suffer disruptions, these markets can rapidly spread shocks across financial institutions. The Council continues to be particularly focused on the structural vulnerabilities in money market funds (MMFs) and the tri-party repo market, as follows."

It explains, "The Council continues to support the implementation of structural reforms to mitigate run risk in MMFs. Specifically, these reforms are intended to address the structural features of MMFs that caused a run on prime MMFs and the freezing of the short-term credit markets after the Reserve Primary Fund was unable to maintain a stable net asset value (NAV) in September 2008. In 2010, the SEC adopted MMF reforms designed to make MMF portfolios more resilient by improving credit quality standards, reducing maturities, and -- for the first time -- instituting liquidity requirements. The 2010 reforms appear to be working as designed and meeting the intended goals."

FSOC continues, "However, the SEC's 2010 reforms did not address -- and were not intended to address -- two core characteristics of MMFs that continue to contribute to their susceptibility to destabilizing runs. First, MMFs have no mechanism to absorb a sudden loss in the value of a portfolio security, without threatening the stable $1.00 NAV. Second, there continues to be a "first mover advantage" in MMFs, which can lead investors to redeem at the first indication of any perceived threat to the value or liquidity of the MMF."

The Report explains, "Chairman Shapiro recommended two alternative reforms to address these remaining structural fragilities. They are (1) a mandatory floating NAV; and/or (2) a capital buffer to absorb losses, possibly combined with a redemption restriction to reduce the incentive to exit the fund. The Council supports this effort and recommends that the SEC publish structural reform options for public comment and ultimately adopt reforms that address MMFs' susceptibility to runs."

It adds, "In addition, the OCC issued a proposed rulemaking in April 2012 that would partially align the requirements for short-term bank common and collective investment funds (STIFs) with the SEC's revisions to Rule 2a-7 under the Investment Company Act. In an effort to impose comparable standards on comparable financial activities, the Council further recommends that, where applicable, its members align regulation of cash management vehicles similar to MMFs within their regulatory jurisdiction to limit the susceptibility of these vehicles to run risk."

On the Tri-Party Repo Market, FSOC's Annual Report says, "The elimination of most intraday credit exposure and the reform of collateral practices in the tri-party repo market continues to be an area of intense focus for the Council. The Tri-Party Repo Infrastructure Reform Task Force was formed in September 2009 in response to the financial crisis. Before being disbanded in February 2012, the Task Force accomplished a number of changes in process and practice that laid a foundation for future risk reduction, including: (1) moving the daily unwind of some repos from 8:30 a.m. to 3:30 p.m., which shortens the period of credit exposure; (2) introducing automated collateral substitution; and (3) introducing three-way trade confirmation functionality. While important, these changes do not meaningfully reduce reliance on intraday credit from the clearing banks."

Finally, the FSOC comments, "The industry has indicated that elimination of the intraday credit associated with tri-party settlement will be a multi-year effort. The Council views this proposed timeline as unacceptable to achieve timely substantive reductions in risk. The Council recommends that the industry implement near-term steps to reduce intraday credit usage within the next 6 to 12 months and an iterative strategy over six-month increments to continue both to reduce intraday credit substantially and to implement improvements in risk-management practices across all market participants. In addition, the Council recommends that regulators and industry participants work together to define standards for collateral management in tri-party repo markets, particularly for lenders, such as MMFs, that have legal or operational restrictions on the instruments that they can hold."

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