July 22, 2013 / 7:33 PM / 6 years ago

U.S. SEC urges money funds to be prepared for tri-party repo defaults

WASHINGTON, July 22 (Reuters) - U.S. securities regulators are warning the $2.6 trillion money market fund industry to be careful of the risks in the so-called repo market, part of the unregulated shadow banking system that large investment banks use to fund their business.

The U.S. Securities and Exchange Commission on July 17 quietly issued new guidance to money funds that spells out the risks they could face if borrowers in the tri-party repurchase market collapse.

“There are a variety of ways in which a money fund and its adviser may be able to prepare for handling a default of a tri-party repo held in the fund’s portfolio,” the SEC wrote. “Such advance preparation could be part of broader efforts by the money market fund and its adviser to follow best practices in risk management.”

In a four-page document, the SEC urges funds and advisers to review master repurchase agreement documentation to see if there are any procedures to handle defaults, and if necessary, prepare draft templates in advance.

It also calls for funds to consider the operational aspects of managing a repo, and to contemplate whether there are any legal issues that could arise in the event of a repo default.

The SEC’s guidance comes at a crucial time for the money fund industry. The SEC is weighing controversial new rules that seek to reduce the risk of runs on money funds by panicked investors - a scenario that took place during the financial crisis.

The Federal Reserve is separately eyeing a new rule that would force investment banks that rely on risky short-term funding such as found in the repo markets to hold more capital.

In a repo agreement, a fund can buy a security from a bank, which in turn agrees to buy it back after a pre-agreed time-frame, typically weeks or months. That way, the deal provides the bank with short-term cash.

The third party in a tri-party repo is the clearing bank.

But in 2008, the collapse of Lehman Brothers caused major problems for one of the largest money funds, exposing potential systemic weaknesses in the short-term lending market.

Panicked investors rushed to pull out their money from the Reserve Primary Fund, a large prime institutional fund, after learning it was exposed to collapsed bank Lehman Brother’s short-term debt.

The fund eventually “broke the buck” when its net asset value fell below $1 per share, and the U.S. government was forced to create a temporary program to guarantee money market funds.

Although money market funds and the repo market both experienced major shocks during the crisis, the 2010 Dodd-Frank law did not address these two areas.

As a result, the Financial Stability Oversight Council, a body of regulators chaired by the Treasury Secretary, has been advocating for new rules for both money funds and repos.

In previous annual reports, the FSOC has labeled money funds and repo markets as areas of emerging risks.

Regulators say they fear money market funds could be at risk in the event that a financially stressed broker-dealer needs to quickly sell assets it can no longer finance.

If the dealer’s securities decline in value and they cannot return the money from a repo transaction, then creditors could initiate a run.

Last November, when a deadlocked SEC could not come to a consensus on money fund reforms, the FSOC stepped in and issued its own proposal in an effort to spur the SEC to act.

In June, under the leadership of new SEC Chair Mary Jo White, the SEC finally proposed new rules that could require large institutional prime funds to offer a floating, instead of a fixed, net asset value.

But little so far has been done on repo markets and the potential risks that may be posed by defaults.

The SEC’s guidance appears to be an early step toward addressing the issue.

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