The Financial Stability Oversight Council, or FSOC, released its 2014 Annual Report yesterday, which includes sections on wholesale funding, tri-party repo, and of course money market mutual funds. (See pages 3, 8, 57-61, 81-82, 100-101, 108, and 113.) The report says of the "Short-Term Wholesale Funding Markets," "The influx of customer deposits in recent years has afforded banks the opportunity to reduce their dependence on short term wholesale funding. Although the usage of commercial paper (CP), repo, time deposit, and other sources of wholesale funding fell this past year, financial institutions without access to customer deposits and prohibited from using customer cash and securities for proprietary purposes, such as broker-dealers, remain dependent on wholesale markets for funding. Since the Council's inaugural annual report nearly three years ago, the structural vulnerabilities of the tri-party repo markets have been highlighted. This past year witnessed important progress in tri-party repo reform. For example, through supervisory authority, the Federal Reserve has worked with the two clearing banks and market participants to greatly improve operational efficiencies and controls in the management and transfer of tri-party repo collateral. As a result, intraday credit exposure was reduced below the 10 percent goal for one clearing bank while the other is expected to have less than 10 percent of this exposure by the end of 2014."

It continues, "In addition, reform efforts continue for MMFs, with the SEC releasing a proposed rulemaking in June 2013. Currently, the SEC is assessing comment letters and other data and information to determine the best approach to prevent possible runs on MMFs in the event of a severe liquidity or credit shock to MMFs, such as occurred during the financial crisis. Until structural reforms are adopted, the potential for run risk remains significant. Similarly, the possibility of tri-party repo collateral fire sales still poses significant risks for the financial system. Policymakers continue to examine ways to minimize potential tri-party repo spillover effects if such fire sales were to occur."

FSOC discusses "Reforms of Wholesale Funding Markets and "Tri-party Repo," writing, "In its 2013 annual report, the Council highlighted three vulnerabilities in the tri-party repo market: Heavy reliance by market participants on intraday credit extensions from the clearing banks. Weakness in the credit and liquidity risk management practices of many market participants. Lack of a mechanism to ensure that tri-party repo investors do not conduct disorderly, uncoordinated sales of their collateral immediately following a broker-dealer's default."

They tell us, "Significant progress has been made over the past year in reducing market participants' reliance on intraday credit from the clearing banks. The share of volume funded intraday by the clearing banks fell from 92 percent in December 2012 to under 20 percent in December 2013, and is projected to fall below the Tri-Party Repo Infrastructure Reform Task Force's goal of 10 percent by December 2014. Both clearing banks have re-engineered the settlement process in ways that require much less intraday credit extension and have increased the price of credit they still provide. Market participants now face stronger incentives to manage their risk prudently; many dealers have extended the weighted-average maturity of their tri-party repo funding thereby sharply reducing their rollover risk exposure."

FSOC adds, "The risk of fire sales of collateral by creditors of a defaulted broker-dealer, many of whom may themselves be vulnerable to runs in a stress event, remains an important financial stability concern given the destabilizing effect such sales may have on markets and their potential to transmit risk across a wide range of participants. The Council recognizes that regulatory reforms implemented since the crisis, such as increases in the amount of capital, liquidity, and margin changes for U.S. broker-dealers, may help to mitigate the risk of default. However, the Council advises all U.S. regulators of firms that rely on this market for funding to assess whether additional steps may need to be taken to further increase tri-party repo borrowers' protection against funding runs in the broader context of liquidity regulation. The Council also urges coordination between market participants and financial regulators to address the risk of post-default fire sales of assets by tri-party repo investors."

The Annual Report writes about "Money Market Funds," "In June 2013, the SEC proposed rules to reform the structure of MMFs in order to make them less susceptible to runs. The SEC's proposal includes two principal changes that could be adopted alone or in combination. One alternative would require a floating net asset value (NAV) for prime institutional MMFs. The other alternative would allow the use of liquidity fees and redemption gates in times of stress. The proposal also includes additional diversification, disclosure, and stress testing measures that would apply under either alternative. The SEC's proposed reforms would supplement the MMF reforms adopted by the SEC in 2010 that were designed to improve the risk-limiting conditions on MMFs by, among other things, instituting minimum liquidity requirements, reducing MMFs' weighted-average maturities, and enhancing the credit quality of holdings."

It explains, "In November 2012, the Council, under Section 120 of the Dodd-Frank Act, issued a proposed recommendation that the SEC implement structural reforms to mitigate the vulnerability of MMFs to runs. That proposed recommendation included three alternatives for public consideration: (1) a floating NAV; (2) a stable NAV with a NAV buffer of up to 1 percent and a minimum balance at risk of roughly 3 percent of a shareholder's account value; and (3) a stable NAV with a 3 percent NAV buffer in addition to other measures, including more stringent diversification, liquidity, and disclosure requirements."

FSOC tells us, "When making the proposed recommendation, the Council stated and reiterates today that the SEC, by virtue of its institutional expertise and statutory authority, is best positioned to implement reforms to address the risk that MMFs present to the economy. The Council does not expect that it would issue a final Section 120 recommendation to the SEC, if the SEC moves forward with meaningful structural reforms of MMFs. The Council understands the SEC is currently in the process of reviewing public comments on its proposed reforms, and the Council recommends that the SEC move forward and adopt structural reforms designed to address MMF run risk."

Finally, the report adds, "The Council recommends that its member agencies examine the nature and impact of any structural reform of MMFs that the SEC implements to determine whether the same or similar reforms are appropriate for other cash-management vehicles, including non-Rule 2a-7 MMFs. Such an examination would provide for consistency of regulation while also decreasing the possibility of the movement of assets to vehicles that are susceptible to large-scale runs or otherwise pose a threat to financial stability."

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