Standard & Poor's Ratings Service published a research piece yesterday entitled, "Lifting The Veil: Increasing Transparency And Resilience For Banks, Nonbanks, And Investors In The Triparty Repurchase Agreement Market." The press release says, "Reform in the $1.8 trillion triparty repurchase agreement (repo) market in the U.S. attempts to correct the deficiencies that the financial crisis exposed in an important funding market for banks and nonbanks, said an article published today, titled "Lifting The Veil: Increasing Transparency And Resilience For Banks, Nonbanks, And Investors In The Triparty Repurchase Agreement Market." It quotes author Devi Aurora, "Although the triparty repo market has functioned well as a key but largely invisible part of the financial architecture under normal conditions, the Lehman bankruptcy and ensuing financial crisis exposed significant deficiencies. And the resulting systemic contagion has put triparty repo reform near the top of the list of the regulatory reform agenda."

The paper explains, "The $1.8 trillion dollar U.S. triparty repurchase agreement (repo) market is a large and important short-term financing channel for most financial intermediaries. Although the triparty repo market has functioned well as a key but largely invisible part of the financial architecture under normal conditions, the Lehman bankruptcy and ensuing financial crisis exposed significant deficiencies. And the resulting systemic contagion has put triparty repo reform near the top of the list of the regulatory reform agenda."

It continues, "In order to minimize systemic funding and liquidity disruptions from future dealer distress, the Federal Reserve (Fed) has asked market participants to implement a plan for triparty repo market reform, prompting a series of corrective actions to date among participants. In our view, these operational reforms are designed to overturn the false sense of safety that existed before the crisis, leading to a system in which repo borrowers built up growing exposure to less-liquid collateral. Repo lenders failed to price risks accurately, instead relying implicitly on intraday credit extension from the two clearing banks, JPMorgan Chase and Bank of New York Mellon. The high level of financial distress following the Lehman failure also revealed significant risk-management flaws among financial market participants (regulated banks and others) who perhaps did not recognize the true extent of their interconnectedness and were, therefore, inadequately prepared to cope with dramatic fluctuations in collateral values stemming from a large dealer default. In our view, regulatory attempts to intensify oversight and transparency over the triparty repo market, as well as improved accounting disclosure requirements, will strengthen the risk-management practices for all financial market counterparties, including banks."

The paper's overview tells us, "Collateral composition changes toward agency and Treasury securities in the U.S. triparty repo market, combined with risk-aversion since the crisis, have, in our view, lowered the potential systemic risk of disorderly liquidation of collateral in the near term. Longer-term, we still see risks in the triparty repo market from a systemic shock or a large dealer default, and we believe this leaves open the possibility of a fire sale of repo collateral, which could significantly decrease market values. Clearing banks have made tangible operational improvements to reduce their intraday credit exposure and have articulated a timetable for further progress, and our ratings of the two clearing banks incorporate our expectation that they will meet their goals in reducing these intraday exposures."

It adds, "Regulations to bolster resilience among money market funds--key providers of funding in the triparty repo market--have been tightened and continue to be evaluated for additional enhancements, but the credit quality of the counterparty continues to play an integral role in the ability of a money market fund to maintain principal value. We do not foresee any near-term ratings impact on broker-dealers, although the risk remains that tighter requirements may, over time, create incentives for smaller independent broker-dealers to choose to diversify funding into adjacent markets."

S&P's report, authored by Aurora, Peter Rizzo and Jonathan Nus, continues, "As part of ongoing surveillance of our banking industry country risk assessment (BICRA) for the U.S., we monitor key initiatives that have the potential to affect the financial sector. Post triparty reform, how banks and nonbanks manage funding stress in the aftermath of a dealer default informs our systemwide view of industry risk. We believe governments have had--and will continue to have--an important role in containing systemic risk where failure to do so could jeopardize financial stability. In the U.S., the introduction of aggressive government backstops--such as the Federal Reserve's Primary Dealer Credit Facility (PDCF) program introduced after Bear Stearns experienced distress in March 2008 and closed in February 2010--was critical to directly providing securities dealers--for the first time in history--with a recourse to liquidity in exchange for a wide variety of collateral, thereby preventing the market deterioration in certain collateral types from infecting other market participants. We continue to view government support as important to our ratings for the two clearing banks."

S&P tells us, "A repurchase agreement is essentially a short-term collateralized loan (typically overnight, although term repos may extend as long as about two years), or an arrangement whereby financial institutions place their securities as collateral with cash-rich lenders, with a commitment to repurchase them at a specified future date at a fixed price. The cash lender receives a return (interest income) for this exchange, or has the right to sell the collateral (securities) if the repo counterparty defaults or otherwise becomes insolvent. The distinguishing feature of triparty repo is that a custodian or clearing bank acts as intermediary between the two parties."

Under "Link With Money Market Funds," the report says, "Because of their role as key intermediaries of short-term funding for financial institutions, we see an important link between money market fund reform and triparty repo reforms. In response to the 2008 financial crisis, the SEC amended regulations for money market funds in 2010 (Rule 2a-7 of the Investment Company Act of 1940) to decrease money market portfolios' average maturities, increase liquidity, enhance transparency, and improve credit quality. Additionally, the rules now require money market funds to evaluate the creditworthiness of the counterparty in order to limit exposure to less-creditworthy institutions. A fund adviser must determine if the counterparty is a creditworthy institution, separate from the value of the collateral supporting the counterparty's obligation under the repo agreement."

It explains, "In practice, most money market funds were already conducting these evaluations, so the new rules didn't have much of an impact on money market fund repo investments. The reduction to 5% from 10% of money market fund illiquid investments permitted under the new rule did have a meaningful effect on the industry, however. While most money market fund repo investments mature in one day, repos that mature in more than seven calendar days and do not have an unconditional put at par to the counterparty are considered illiquid, because they are not marketable securities, and no secondary market exists for such agreements. The reduction in allowable illiquid investments reduced the amount of term repo (repo maturing in more than one day) among money market funds, especially amounts exceeding seven days, in order to comply with the new rules and meet other liquidity metrics."

S&P adds, "Despite the work toward and discussion of triparty repo reform, we believe the collateralization policies of most money market funds have not materially changed. Daily collateral valuation and the overcollateralization levels (haircuts) have generally remained consistent with market averages, in our view. A key issue for money market funds is whether or not they can actually hold the collateral backing the repos in the event of dealer stress. Generally speaking, if a repo counterparty were to default, the collateral posted to support these agreements would not meet the eligibility requirements for investments under the new regulations (rule 2a-7). It would either have a longer maturity than the rules permit or could be of a quality or type of investment that is not eligible."

They write, "Given that, money market funds would have to immediately liquidate the collateral in order to maintain compliance with rule 2a-7. Because of this, and the potential for delay in the liquidation of collateral given the lack of precedent for dealing with a defaulted counterparty in 2a-7 money market funds, our criteria for rating money market funds calls for investments in counterparties with a short-term rating of at least 'A-1'. Additionally, money market funds facing a defaulted dealer and finding themselves in a fire sale of collateral may experience a decrease in its marked-to-market NAV--which could lead to the fund breaking the buck (when net asset value falls below $1)."

Finally, S&P states, "Triparty repo reform in the U.S. attempts to correct the deficiencies that the financial crisis exposed in an important funding market for banks and nonbanks. Since then, we have noted several favorable developments. First, a change in collateral composition toward high-quality securities lowers the near-term risk of disorderly liquidation of collateral in the event of a dealer default. We expect this preference to continue in the coming months. Second, clearing banks have made concrete progress in lowering intraday credit exposure and made a plan for further reduction. Our ratings analysis of the clearing banks incorporates our expectation that they will meet their goals in reducing these intraday exposures. Third, we expect improved accounting disclosure requirements and transparency to promote better risk-management practices and greater financial stability for all financial market counterparties, including banks. The rating impact for other financial market counterparties is limited for now, in our view. However, as the triparty repo reform agenda evolves further, we see some potential for smaller independent broker-dealers to choose to diversify funding away into adjacent markets. Nevertheless, even with these plans to reduce clearing banks' intraday credit, we see risks in the triparty repo market from a systemic shock or a large dealer default, and we believe this leaves open the possibility of a fire sale of repo collateral, which could significantly decrease market values. Additionally, money market funds facing a defaulted dealer and finding themselves in a fire sale of collateral may experience a decrease in their marked-to-market NAV, which could lead to the fund breaking the buck."

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