FRB Report_100517-Clearing Banks as Loan Funders-BONY

TaskForceonTriPartyRepoInfrastructurePaymentsRiskCommitteeReportMay17,2010

The Task Force on TriParty Repo Infrastructure was formed in September 2009 under the auspices of thePaymentsRiskCommittee,aprivatesectorbodysponsoredbytheFederalReserveBankofNewYork. TheTaskForcemembership includesrepresentativesfrommultipletypesofmarketparticipantsthatparticipate inthetriparty repo market, as well as relevant industry associations. Federal Reserve and SEC staff participated inmeetingsoftheTaskForceasobserversandtechnicaladvisors.

TriPartyRepoInfrastructure TaskForceReport

TableofContentsSection1: IntroductionandSummary...................................................................................................... 3 Section2: SummaryListofTaskForceRecommendations.......................................................................11 Section3: Background............................................................................................................................14 Section4: OperationalArrangements .....................................................................................................15 Section5: DealerLiquidityRiskManagement .........................................................................................19 Section6: MarginingPractices................................................................................................................21 Section7: ContingencyPlanning .............................................................................................................25 Section8: Transparency .........................................................................................................................28 Section9: Assessment ............................................................................................................................30 Section10: NextSteps..............................................................................................................................33 Section11: Annexes .................................................................................................................................34

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Section1: IntroductionandSummaryInthefallof2009,toaddressthesystemicriskthathadbecomeevidentduringthefinancialcrisis,theFederalReserveaskedmarketparticipantstoreviewandmakerecommendationsregardingopportunitiesforimprovementtothetripartyrepoinfrastructure.TheTaskForceonTriPartyRepoInfrastructurewasformedandthisReportcontainsitsfindingsandrecommendations.TheReportandtheworkunderlyingithavebeendevelopedthroughthejointeffortofalargenumberofmarketparticipants,representingmultipletypesoffinancialinstitutionsthatparticipateinthetripartyrepomarket.TheworkoftheTaskForcewasthesubjectofaworkshopinFebruary2010attendedbyrepresentativesfrommorethan100differentorganizations.FederalReserveandSECstaffattendedTaskForcemeetingsandprovidedclarificationofrelevantpolicyconcernsandpositions.However,itisimportanttomakeclearthattheconclusionsoftheTaskForceareitsown.Noendorsementofitsconclusionshasbeensoughtorreceivedfromanyregulatoryauthority.TheTaskForceisawareofandsupportstheFederalReservessimultaneousissuanceofaWhitePaperthatprovidesitsperspectiveontheissuescoveredintheTaskForceReportandrequestspubliccomment.Itisimportanttoemphasizethatthetripartyrepomarketandthemarketsfortheunderlyingcollateralaredynamic.TaskForcemembersarecommittedtoongoingindustryassessmentoftheissuesaddressedinthisReport.DescriptionofTriPartyRepoMarketThetripartyrepomarketislargeandimportant,butnotverywellunderstood.ItrepresentsasignificantpartoftheoverallU.S.repomarket,inwhichmarketparticipantsobtainfinancingagainstcollateralandtheircounterpartiesinvestcashsecuredbythatcollateral.LargeU.S.securitiesfirmsandbanksecuritiesaffiliatesfinancealargeportionoftheirfixedincomesecuritiesinventories,aswellassomeequitysecurities,viathetripartyrepomarket.Thismarketalsoprovidesavarietyoftypesofinvestorswiththeabilitytomanagecashbalancesbyinvestinginasecuredproduct.ThetripartylabelreferstorepotransactionsthatsettleentirelyonthebooksofoneoftwoClearingBanksintheU.S.market:BankofNewYorkMellon(BNYM)andJPMorganChase(JPMC).TheClearingBankisthusathirdpartyinvolvedintherepotransactionbetweenaDealer(party,notnecessarilyaBrokerDealer,borrowingcashagainstsecuritiescollateral)andaCashInvestor(partylendingcashagainstsecuritiescollateral).1Theattractivenessofthetripartyrepomarketisdrivenbythetreatmentofrepurchasetransactionsinbankruptcy,theuseofsecuritiesascollateral(includingdailymarginingandhaircuts),andthecustodianservicesoftheClearingBankswhichprovideprotectionsthatdonotexistforbilateralrepoinvestorsorunsecuredcreditors.Asaresult,theU.S.repomarketcontributessignificantlytotheliquidityandefficiencyoftheU.S.TreasuryandAgency(includingAgencyMBS)securitiesmarkets,whichcollectivelymakeupapproximately75%ofthetotalcollateralintheU.S.repomarket.TheimportanceoftheU.S.repomarketisunderscoredbythefactthatitisthemarketinwhichtheFederalReserveoperationallyimplementsU.S.monetarypolicy.Thetripartyrepostructuredevelopedinthemid1980sinresponsetothedesirebyCashInvestorstohavecollateralheldbyathirdpartyagent.ThetripartymarketcontinuedtogrowastheClearingBanksinvestedininfrastructureadvancementsthatallowedDealersandCashInvestorstooptimizetheiruseoftheplatform.Atpeaklevelsin2008,over$2.8trillioninsecuritieswerebeingfinancedthroughtheU.S.tripartyrepomarket.TheU.S.repomarketingeneralandthetripartyrepomarketinparticularhaveprovidedimportantbenefits(e.g.flexibilityandreducedfundingcostsduetocreditprotectionsandoperationalefficiencies)tothefinancialsystem

1Forclarityandconsistency,thisReportusesthecapitalizedtermsClearingBank,Dealer,andCashInvestorthroughouttheReporttorefertothesethreepartiestoatripartyrepotransaction. 3of43


andhavehelpedtoreducethecostofborrowingfortheU.S.Treasury,therebyloweringdebtservicecostsbornebytaxpayers.2Atseveralpointsduringthefinancialcrisisof20072009,thetripartyrepomarkettookonparticularimportanceinrelationtothefailuresandnearfailuresofCountrywideSecurities,BearStearns,andLehmanBrothers.Thepotentialforthetripartyrepomarkettoceasefunctioning,withimpactstosecuritiesfirms,moneymarketmutualfunds,majorbanksinvolvedinpaymentandsettlementsglobally,andeventotheliquidityoftheU.S.TreasuryandAgencysecurities,hasbeencitedbypolicymakersasakeyconcernbehindaggressiveinterventionstocontainthefinancialcrisis.SummaryofRecommendationsBasedonitsanalysis,theTaskForceidentifiedthefollowingareaswhereimprovementsareneeded:

OperationalArrangementsLargelytoobtainoperationalefficiencies,currentarrangementsincluding

thedailyunwindofalltransactionsregardlessoftermrequiremassiveamountsofintradaycredittobeprovidedbythetwoClearingBanks.Thelackofclearunderstandingconcerningtheultimateallocationofcreditandliquidityrisksamongrepomarketparticipantsweakenedincentivestomanageandconstrainthoserisks.

DealerLiquidityRiskManagementSomeDealersdidnotproperlyanticipatethepotentialforsecuredfinancingtobeunavailable,evenforhighqualitycollateral.SomeDealersbecameexcessivelyreliantonshorttermrepofinancing,especiallyinregardtocollateraltypesthatwereorbecameilliquidandsubjecttovaluationuncertainty,contributingtogreaterleverageinthesystem.

MarginingPracticesMarketparticipantsinmanycasesdidnotanticipatetheextenttowhichmarketconditionscouldworsenanddidnotsetmarginsaccordingly,leadingtoprocyclicalincreasesinthosemarginswhenconditionsdidworsenduringthecrisis.MostCashInvestorsdidnotanticipatethepotentialforlossesascollateralpricesdeclined.

ContingencyPlanningInmanycases,CashInvestorswereunpreparedtocopewiththeconsequencesofaDealerdefault,inparticularthepotentialneedtomanageandliquidatecollateralsecuringadefaultedrepoposition.Insomecases,CashInvestorsfinancedassetsthattheywouldnotnormallyholdoutright.

TransparencyTherewasinsufficienttransparencywithrespecttomanyaspectsofthetripartymarket,includingitsaggregatesizeandcomposition,theextentofconcentrations,andtypicallevelsofmargin.ThiscontributedtothebuildupofexposuresandthelackofpriorconcertedactiontoaddresstheissuesidentifiedinthisReport.

ThedetailedrecommendationscontainedinthemainbodyoftheReportaddressalloftheseareas.OperationalArrangementsFirstandforemost,theTaskForcehasfocusedonthespecificactionsneededtofundamentallystrengthentheoperationalarrangementsattheheartofthetripartyrepomarket.TheseactionsarenecessarytoreducethemarketsrelianceonintradaycreditprovidedbytheClearingBanksandclarifythecreditandliquidityrisksbornebymarketparticipants.Substantialefforthasbeenundertakentoidentifytheprecisestepsnecessaryandthekeydependenciesinvolved.TangiblestepshavebeentakenandintradayexposuresarelowerthanattheoutsetoftheTaskForceswork.Thepercentageoftripartyrepotradesunwoundonadailybasisdecreasedanaverageof

2BenefitsofthetripartyrepomarketarediscussedintheFRBNYWhitePaperontheTriPartyRepoInfrastructureReformTaskForce. 4of43


10%fromSeptember2009toMarch2010.3TheTaskForcebelievesthattheobjectiveshouldbethepracticaleliminationofintradaycreditprovidedbytheClearingBanks,definedbytheTaskForceasapointbeyondwhichtheresidualamountsofintradaycreditextensionsarebothsmallandcanbegovernedbytransparentbilateralarrangements,knowninadvancetoparticipants.Thekeyoperationaladvancementneededtoachievethisobjectiveisautosubstitution,whichwillallowfortheautomatedsubstitutionofsecuritiescollateralsupportingatripartyrepotransaction,whilethattransactionremainsinplace.BothClearingBankshavecommittedtoimplementthisfunctionalitybyFebruary2011.TheTaskForcebelievesachievementofthepracticaleliminationobjectivecanandshouldbeachievedwithinsixmonthsfollowingtheimplementationofautosubstitution,implyingatargetdateofmidyear2011.AlongsidethisefforttoradicallyreducetheamountofintradaycreditprovidedbyClearingBanks,theTaskForcebelievesitiscriticaltoreinforcethatCashInvestorsareatriskiftheirrepocounterpartydefaults.Clarityinthisrespecthelpstoensurestrongincentivestomitigaterisksandtoundertakeappropriatecontingencyplanning.DealerLiquidityRiskManagementTripartyrepoactivitymustbeanessentialfocusforliquidityriskmanagement.Dealersshouldnotassumethatsecuredfinancingisinherentlystable.SinceCashInvestorsareatriskiftheDealerdefaults,DealersshouldrealizethatsomeCashInvestorsmayreduceand/oreliminatefundingasthecreditqualityoftheDealerdeteriorates,despitetheexistenceofcollateral.Assuch,Dealersshouldaccountforthelossofsecuredfundingwithintheirliquidityriskmanagementplansandliquiditystresstests.Dealerliquiditybuffersshouldbesizedaccordingly.Hadsuchanapproachbeeninplaceconsistentlyacrosstheindustryduringthecrisis,itismuchmorelikelythatilliquidcollateralwouldhavebeenmatchedbyacorrespondingliquiditybuffer,limitingthepotentialsystemicimpactofthelossofthatfinancing.Inaddition,Dealersshouldlengthenandstaggerthematurityprofileoftheirfinancing,seektocombineshorttermandlongtermfinancingwiththesamecounterpartyandshouldcontinueexploringalternativemechanismsthatmaybeabletoachievemoredurablefinancingofcertaintypesofsecurities.TheTaskForcesupportstheincreasedemphasisonliquidityriskmanagementbysupervisorsandregulators.Theserecommendationsonliquidityriskmanagementechothoseofmanyotherreportsandpapersanalyzingaspectsofthefinancialcrisis.TheTaskForcebelievesthattherecommendationsinthisareahaveparticularrelevancefortripartyrepotransactions.MarginingPracticesMarginingpracticesmustbebroadlystrengthenedinthewakeofthecrisis.TheReportoutlinesanumberofmarginingbestpracticesbutstopsshortofrecommendingonespecificapproach.Marketparticipantsshouldundertakestatisticalanalysisandstresstestingofcollateralpricemovementsthatallowsthemtoassessthepotentialforlossesatdifferentlevelsofmarginsandtomakedecisionsbasedontheirappetiteandcapacitytoabsorblosses.CashInvestorsshouldseekinformationthatallowsthemtoassessthepotentialconcentrationofrepocounterpartieswithrespecttoaparticulartypeofsecurity;wheresuchinformationisnotforthcoming,theyshoulduseaggregatemarketinformationand/ormakeconservativeinferences.Marginprocyclicalityreferstotheprocessbywhichmarginlevelsarereducedingoodtimesandincreasedinbadtimes.Procyclicalitycannotbefullyeliminated,sincequantitativemeasuresusedtoguidemarginlevelsfluctuateovertime.Nevertheless,improvementscanbemade.Theapproachtomarginingshouldbeunderstoodacrossmarketparticipants.Marginagreementsshouldavoidprecipitousandunanticipatedincreasesinmargins.Marginsshouldbesetinaccordancewithregulatoryliquidityriskmanagementandmarginriskmanagementstandards.Theregularpublicationofmarginlevelsinthetripartyrepomarketandqualitativesurveysofcredit3FiguresarebasedonaggregatesprovidedbytheClearingBanks. 5of43


terms,asproposedinarecentBISreportonmarginrequirementsandhaircuts,canaidmarketparticipantsinsettingappropriatemarginlevels.ContingencyPlanningCashInvestorsshoulddevelopliquidationplansforthemanagementandliquidationofrepocollateralintheeventofaDealerdefault.Theseplansshouldcoverbothpracticalaspectssuchascustodialarrangements,aswellasstresstestsofpotentiallossesduetocollateralpricemovementsandstresstestsofpossibleliquidityneeds.ExplorationofadditionalliquiditytoolsandmechanismsbyCashInvestorsshouldalsobeconsidered.CashInvestorsshouldregularlyreviewtheirliquidationplanswiththeirseniormanagementandboardsasappropriatedependingonthenatureoftheorganization.CashInvestorsshouldbeabletodemonstratethatpotentialstressscenariosontheirsinglelargestrepocounterpartywillnotleadtodestabilizinglosses,evenwhenassociatedcollateralvaluationsaresubjectedtoreasonablyseverestresstests.Additionally,DTCCand/orotherinterestedprovidersshouldexplorethedevelopmentofacollateralliquidationmanagerservicethatwouldbemadeavailabletoabroadrangeofmarketparticipantsonavoluntarybasis,aswellastoolsthatwilllegallysupportoffsettingofsecuredexposuresrelatedtothedefaultingparty.ImpedimentstotherapidinitiationofliquidationplansbyCashInvestorswouldincreaseuncertaintyandsystemicrisk.Therefore,theTaskForcebelievesthatSIPC(SecuritiesInvestorProtectionCorporation)shouldagreenottoimposeastayonrepocounterpartiesexercisingtheircontractualremedies.ThisisconsistentwiththeapproachthatSIPChastakeninpriorDealerdefaults.TransparencyThetripartyrepomarketrequiresgreatertransparency.TheTaskForcehasworkedcloselywiththeFederalReservetodevelopatemplateforregularpublicationofkeyinformationprovidedbytheClearingBanks.ApilotversionofthistemplatewithactualdataasofApril2010isincludedonthefollowingpageandisdiscussedintheReport.Thisshowstheaggregatesizeofthetripartymarket,brokendownbyassetcategory,withassociatedmeasuresofDealerconcentration.ThesecondtablereportsonmarginhaircutlevelsreportedbytheClearingBanksforeachassetcategory.MeasuresofDealerconcentrationarealsoincludedonananonymousbasis.Transparencyofcollateralvaluationisanessentialcomponentofsecuredfunding.Collateralthatispronetoilliquidityandsignificantuncertaintiesinvaluationaddstosystemicriskwhenfundedintheovernightrepomarket.Marketparticipantsshouldevaluatetheprudenceoffundingthistypeofcollateralintheshorttermrepomarkets.TheTaskForcewillestablishaworkinggroupofvaluationspecialistsacrosstripartyrepomarketparticipantstoevaluatecollateralpricingmethodologiesandmakerecommendationsforimprovements,includingthefeasibilityofsamedaypricing.

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Table1TripartyRepoStatisticsasofApril9,2010

SeeAnnex3forExplanatoryNotes

CompositionandConcentrationofTriPartyRepoCollateral

ABS(Investmentandnoninvestmentgrade) 41.7 2.4% 45%AgencyCMOs 112.7 6.6% 46%AgencyDebentures(includingstrips) 179.5 10.5% 33%AgencyMBS 584.9 34.2% 45%CMOsPrivateLabelInvestmentgrade 25.2 1.5% 48%CMOsPrivateLabelNoninvestmentgrade 18.9 1.1% 47%CorporatesInvestmentgrade 79.6 4.7% 39%CorporatesNoninvestmentgrade 34.7 2.0% 54%Equities 73.3 4.3% 59%MoneyMarkets 27.4 1.6% 74%USTreasuriesexcludingstrips 474.4 27.7% 39%USTreasuryStrips 38.7 2.3% 46%Other 19.5 1.1%Total 1,710.5 100% 38%

Asset Group Collateral Value ($ billions) Share of TotalConcentration by

Top 3 Dealers

DistributionofInvestorHaircutsinTriPartyRepo

10th Percentile Median

90th Percentile

ABS(IGandnonIG) 41.7 0% 5% 8%AgencyCMOs 112.7 2% 3% 5%AgencyDebentures(includingstrips) 179.5 2% 2% 5%AgencyMBS 584.9 2% 2% 4%CMOsPrivateLabelInvestmentgrade 25.2 2% 5% 7%CMOsPrivateLabelNoninvestmentgrade 18.9 0% 8% 8%CorporatesInvestmentgrade 79.6 2% 5% 8%CorporatesNoninvestmentgrade 34.7 5% 8% 15%Equities 73.3 5% 8% 20%MoneyMarkets 27.4 2% 3% 5%USTreasuriesexcludingstrips 474.4 2% 2% 2%USTreasuryStrips 38.7 2% 2% 2%Other 19.5Total 1,710.5

HaircutsAsset Group Collateral Value ($ billions)

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AssessmentofRecommendationImpactTherecommendationssummarizedaboveanddetailedintheReportareambitious,farreaching,andwillsubstantiallymitigatethesystemicriskpotentialassociatedwiththetripartyrepomarket.

ThroughthepracticaleliminationofintradaycreditextendedbytheClearingBanks,anypotentialthreattothesolvencyofeitherClearingBankduetothisexposure,howeverremote,islikewiseremoved.Thisaloneisasubstantialmitigationofsystemicrisk.

Byclarifyingtheresponsibilityforcreditandliquidityrisksamongtripartyrepoparticipants,incentives

forrobustriskmanagementarestrengthened.o Goodincentivesworkbestwhensituatedwithinahighlytransparentenvironmentwithwell

articulatedexpectationsandfrequentopportunitiesforeffectivebenchmarkingbyauthoritieswiththepowertocompelchangesinbehavior.

o TheTaskForcerecommendationsintheareasofcontingencyplanning,marginpracticesandvaluation,andtransparencyaremeanttoprovidetheseadditionalsupportmechanismsforstrongriskmanagementpractices.

TheTaskForcesrecommendationstobringgreatertransparencytothetripartyrepomarketviaregularreportingofvolumes,marginlevels,andrelativeconcentrationsbyassetcategoryandacrossDealerswillsubstantiallyenhancetheabilityforsupervisorsandmarketparticipantstoassesstrendsandcallattentiontoemergingissuesbeforetheybecomesystemicinnature.

TheimplementationbyDealersofstrongerliquidityriskmanagementpractices,asrecommendedbynumerousotherreportsandsupervisoryreviews,hasanumberofimportantbenefitsinregardtotripartyrepotransactions,andmustproceedhandinhandwiththeotherrecommendationstoreducethesystemicriskpotential.

o Forexample,feedbackbetweenforcedsalesandassetpricedeclinesandthelossorchangeinthetermsofshortdatedrepofinancingcanbemitigatedeitherbyanextensioninthematurityofthatfinancingorbysizingliquiditybufferstoabsorbthelossofrepofinancingonlessliquidcollateral.

o Intheextremecasewheremarketsareunderseverestress,thereisapotentialforasuddenpullbackinrepoavailabilitytobecomeaselffulfillingsolvencyeventastheimpactedDealerisforcedtoselllargeamountsofilliquidassetsunderextremetimepressure.ThispotentialisagainmitigatedifthepullbackinrepofinancingcanbemetviasaleofhighqualityassetsfromtheDealersliquiditybuffer.

o ThisstrongerapproachtoliquidityriskmanagementimpliesthatincaseswhereaDealersdefaultisprecededbyaperiodofdeterioration,thereshouldbegreaterscopetoreducethesizeoftherepobookinadvanceofdefaultandthereforetheamountofcollateralthatCashInvestorswouldneedtoliquidateatthepointofdefault.

TheTaskForcebelievesthatthecombinationofmeasuresitisrecommendingwillreducethescopeforDealerstousethetripartyrepomarketasamechanismtofinanceexcessivelevelsofilliquidcollateral.

Inspiteofthesesubstantialimprovements,theTaskForcebelievesitisimportanttobeclearaboutwhatitsrecommendationswillnotdo.

Theserecommendationswillnotmaketripartyrepofinancingstableinthefaceofeventsthatgiverisetoconcernswithcounterpartycreditstanding.

o DiscussionswithintheTaskForceemphasizedrepeatedlythatsomeCashInvestorsfocusprincipallyonDealercreditquality.AnytimeaDealersfinancialconditionisvisiblyweakened,tripartyrepofinancingmaybesubjecttowithdrawal.

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o Attheheightofthefinancialcrisis,contagionconcernsaffectedcounterpartyriskassessmentsbymanymarketparticipants.

o However,theTaskForcebelievesthatsomeCashInvestorswillbecomemorecomfortableinrelyingontripartycollateralasacreditriskmitigantduetoriskbasedmarginingandimprovedtransparency.Thiswillimprovethestabilityofthisfinancing.

ImplementationoftheTaskForcesrecommendationswillnoteliminatethepossibilityofthesaleoflargeamountsofrepocollateralduetoaDealerdefault.However,theTaskForcerecommendationsmaychangethemannerinwhichastressscenarioinvolvingDealerswouldevolve.

o Improvementsintransparencyandinriskmanagementpracticesbyallparticipants,aswellasongoingenhancementstotheregulatoryframework,shouldimprovetheresiliencyofaDealertoawithdrawalofrepofinancingfollowingaweakeninginitsfinancialcondition.

o Therewillalsobemuchgreaterclarityregardingthestatusofexposuresonanintradaybasisandimportantlywhowillbeartheexposuresintheeventofadefault.

TheTaskForceconsideredandrejectedrecommendingthemandatoryusebyallCashInvestorsofa

singleliquidationagentinsuchcircumstancestoeffectacoordinatedliquidation.o CashInvestorsrepresentedontheTaskForcewereconcernedthatsuchanapproachwould

resultinsuboptimaloutcomesrelativetoallowingCashInvestorsflexibilityinchoosinghowtomanagethissituation.Theybelievedthatamandatoryapproachwouldresultinlessvaluefortheirconstituents.

o TaskForcediscussionsfocusedontheimportanceofaccesstofundingasthecriticalprerequisitetoavoidfiresaleimpacts.4Centralizingtheliquidationproblemdoesnotaddresstheunderlyingproblemofwheresuchfundingwouldcomefrom.TheTaskForcedidnotbelieveitwasappropriatetoassumethataFederalReserveorotherofficialliquidityfacilitywouldbemadeavailabletoacentralizedliquidationagentandthepremiseofthefiresaleconcernispreciselythatprivatemarketfundingisnotavailable.

o TheTaskForcebelievesthatabetterbalancewillbeachievedbyrecommendingthatCashInvestorsplaninadvanceforaDealerdefaultandmanagetheirexposurestoindividualDealersinlightofthepotentialimpactofsuchadefaultontheiroverallportfolioliquidity.

AdditionalConceptsandTopicsTheTaskForcediscussedseveralconceptsthathavebeenputforwardaspossibleideasthatcouldbeconsideredinthefuture.

Theseincludethefollowingconcepts.

o ALiquidityStabilizationUtility(LSU)thatwouldfunctionasabankwiththeexplicitpurposeofprovidingliquidityagainstcollateraltoCashInvestorsafteraDealerdefault.

o CashInvestorsobtainingcommittedlinesofcredit.o Acentralcounterpartyfacilitythatwouldsubstituteitscreditstandingforthatofindividual

Dealersinthetripartymarket.o AnEmergencyBankthatatroubledDealercouldtransferitsrepoportfolioto,possibly

supplementedbyanadditionalguaranteefund.

TaskForcediscussionshighlightedanumberofchallengeswitheachoftheseconceptsandaccordinglytheTaskForceisnotendorsinganyoftheseconcepts.

4SeeBrunnermeierandPedersen,MarketLiquidityandFundingLiquidity,ReviewofFinancialStudies2009,Vol.22,No.6,pp.22012238,foraneconomicanalysisofthislinkage. 9of43


Asnotedearlier,theTaskForceisawareandhighlysupportiveoftheFederalReservesplantosimultaneouslyissueaWhitePaperthatrequestsfurthercommentontheseandanyotherissuesraisedbytheTaskForcesReportandrecommendations.

ConclusionThefollowingSectionsoftheReportspelloutthespecificrecommendationsindividuallyandthenaddresstheissuesandrecommendationsineachareaoftheTaskForceswork.TheTaskForceisconvincedthattheserecommendationscanandshouldbeimplementedandthattheywillcollectivelymakeamaterialdifferenceintheextentofsystemicriskpotentialassociatedwiththetripartyrepomarketinfrastructure.TheTaskForcegreatlyappreciatesthetimeandeffortsofallwhocontributedtoitsdiscussions.

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Section2: SummaryListofTaskForceRecommendationsOperationalArrangementsTheTaskForceRecommendationssetoutthemilestonesfortheindustryactionplandevelopedandagreedbytheTaskForcetoeliminatetothegreatestextentpossibleClearingBankextensionsofintradaycreditbyenhancingoperationalarrangementsinthetripartyrepomarket.Recommendationsareaddressedtoalltripartyrepomarketparticipantsunlessspecified.

1. ImplementoperationalenhancementstoachievethepracticaleliminationofintradaycreditbytheClearingBanks,wherepracticaleliminationisdefinedasapointbeyondwhichtheresidualamountsofintradaycreditextensionsarebothsmallandcanbegovernedbytransparentbilateralarrangements,knowninadvancetoparticipants5.

30Jun2011

1A.ClearingBankstoprovideprojectplansinrelationtotheirimplementationofrobustautomatedcollateralsubstitution(autosubstitution)capability.

15July2010

1B.EliminateremainingsourcesofambiguityorinaccuracyintripartyrepobookingproceduresandtradecommunicationstotheClearingBanks,includinginformationrelatedtothetermofthetransaction.

31Aug2010

1C.Agreetostandardizedintradaysettlementtime(s)formaturingrepotrades(e.g.,MorningSettlement,EndofDaySettlement),thatwillbeimplementedfollowingprerequisiteenhancements(e.g.,autosubstitution).

31Aug2010

1D.Agreesolution(s)forthreeway,realtime,pointoftradeconfirmationsfortripartyrepotransactions,inclusiveofdiscussionswiththirdpartyvendors.

15Oct2010

1E.ClearingBankstocompletedevelopmentofsoftwaretosupportautosubstitutioncapabilityandconfirmtimelinesforfullimplementation.

15Feb2011

1F.DealersandCashInvestorstoconfirmthatinternalprocessesrelatedtoallaspectsoftripartyrepoarepreparedfortheoperationalenhancementsrecommendedinthisReport.

15Feb2011

1G.Implementmarketwide,threeway,realtime,pointoftradeconfirmationsolution(s)whichmemorializeslegallybindingrepotransactionsenteredintobetweenCashInvestorsandDealers.

15Apr2011

2. DealersandCashInvestorstoundertakeregularduediligencereviewsofClearingBanksthatcover,ataminimum,operationalandcontractualconformity,adherencetocollateralallocationrules,andcollateralpricingmethodologies.

Ongoing

5Marketparticipantsshouldtargetthereductioninintradaycredittobelessthan10%ofaDealersnotionaltripartybook(representingtheestimatedportionofaDealer'sbookthatreachesfinalmaturityandisnotrolledonagivenday).

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DealerLiquidityRiskManagementTheTaskForceRecommendationssupportotherassessmentsofthefinancialcrisisinemphasizingtheimportanceofstrongerliquidityriskmanagement.

3. Dealersneedtoincorporatelessonsfromthefinancialcrisisexperiencerelatedtotripartyrepoinmakingappropriateimprovementstoliquidityriskmanagementandplanning.

Ongoing

4. Dealersshouldnotassumethatshorttermtripartyrepofinancingwithalloftheircounterpartiesthroughoutallmarketconditionsisinherentlystable.

Ongoing

5. DealersandClearingBankstoassessandclarifytermsforthepotentialavailabilityofsecuredintradaycreditfacilities(bothdiscretionaryandcommitted)tomitigatetheliquidityrisksassociatedwithmaturingrepotrades.

15Nov2010

MarginingPracticesTheTaskForceRecommendationssupportabroadstrengtheningofmarginingpractices,basedontheprinciplesthatmarginsshouldberiskbased,shouldnotbeprocyclical,andshouldbebasedonobjective/transparentcriteria.

6. CashInvestors,Dealers,andClearingBankstodetermineappropriatecollateralmarginsinlinewiththeprinciplessetoutinSection6ofthisReport,takingnoteofmonthlyTriPartyRepoStatisticstobepublishedontheFederalReserveBankofNewYorkwebsite.

Ongoing

7. ClearingBankstocontinuetoshareinformationonintradaymarginmethodologiesandprocesseswithrespectiveDealers.

Ongoing

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ContingencyPlanningTheTaskForceRecommendationssupportimprovingthepreparednessofCashInvestorsandthetripartyrepomarkettocopewithaDealerdefault.

8. CashInvestorstoundertakeregularstresstestsoftripartyrepocounterpartyexposuresthatconsideradefaultofthelargestrepocounterpartytogetherwithpotentialchangesinthemarketvalueoftheunderlyingcollateral.

Ongoing

9. CashInvestorstoputinplaceandregularlyreviewcontingencyplansforaDealerdefaultthatcover,ataminimum,aprocessforeffectivelymanagingcollateral,includingaplantomanageliquidityandriskexposureduringtheliquidationprocess.

15Jan2011

10. RelevantindustryassociationsinconjunctionwiththeirconstituentsareencouragedtopublishcomprehensiveBestPracticeguidanceforCashInvestors. 30Sep2010

11. DTCCanditsaffiliatestoworkwithothermarketparticipantstomaximizethepotentialforoffsettingofpositionsintheeventofaDealerdefault;DTCCand/orotherinterestedpartiescanprovideaviablecollateralliquidationmanagementserviceforthoseCashInvestorswishingtodelegatetheseactivities.

30Nov2010

12. Allmarketparticipantstocontinueexploringadditionalconceptsthathavethepotentialtoaddtothestabilityandresilienceoftripartyrepofinancingand/orreducethepotentialforcollateralfiresalesintheeventofaDealerdefault.

Ongoing

TransparencyTheTaskForceRecommendationsareintendedtoincreasetransparencywithrespecttothesize,composition,andconcentrationofthetripartyrepomarket,therangeofmarginsapplied,andthevaluationmethodologiesappliedtotheunderlyingrepocollateral.

13. Initiatemonthlypublication,viatheFederalReserve,ofaggregatestatisticsontripartyrepocollateralandCashInvestormarginlevels,withdisclosurebyassetclass,basedoninformationprovidedbytheClearingBanks.(SeeTable1forapilotversion.)

30Jul2010

14. TheTaskForcewillestablishaworkinggroupofvaluationspecialistsacrosstripartyrepomarketparticipantstoevaluatecollateralpricingmethodsandmakerecommendationsforimprovements,includingthefeasibilityofsamedaypricing.

15Oct2010

15. CashInvestorstoregularlyvalidatetripartycollateralforpricing,appropriateness,andclassification.DealerstoregularlycomparecollateralmarksontheirownbooksandrecordswithvendorpricesprovidedbytheClearingBanks.

Ongoing

16. DealerstoinformCashInvestorsandClearingBanksincaseswheretheDealersmarksaremateriallybelowthevendorpricesprovidedbytheClearingBank.

Ongoing

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Section3: BackgroundTheaccompanyingWhitePaperissuedbytheFederalReserveprovidesadditionaldetailonthehistoryandmechanicsofthetripartyrepomarket.Accordingly,theTaskForceisnotreplicatingthatmaterialhere.Inthissectionwesimplyreviewsomeofthemainpointsnecessaryasastartingpointforfurtheranalysis.TripartyrepogrewfromitsoriginasafundinginstrumentforU.S.TreasuriestoincludenearlyallsecuritiesheldbyDealers.ThegrowthofthetripartyrepomarketmirroredthegrowthofDealerbalancesheets.Themarketevolvedfromastrictlyovernightmarkettoincludesignificanttermtrading.Atpeaklevelsin2008,overUS$2.8trillioninsecuritieswerebeingfinancedthroughtripartyrepotransactions,manywithveryshortmaturities,andinvolvingthedailytransferofnearlythefullamountofassociatedcashandsecuritiesontheaccountsofoneortheotherofthetwotripartyClearingBanks:BankofNewYorkMellon(BNY)andJPMorganChase(JPM).IndividualDealers(reposellers/borrowers)routinelyfinancedmorethanUS$100bninsecuritiesviathetripartymechanism.ThelargestsinglefirmexposurepeakedatmorethanUS$400bn.Tripartyrepoarrangementswereatthecenteroftheliquiditypressuresfacedbysecuritiesfirmsattheheightofthefinancialcrisis,especiallyasthepricingtransparencyandliquidityofsomeformsoftripartycollateraldeterioratedatthesametimethatcounterpartycreditconcernswereescalating.CashInvestorsinthetripartymarketincludemoneymarketmutualfunds(2a7funds),securitieslendingagents(typicallymajorcustodianbanks),andotherinstitutionalinvestorsorfundmanagers(includingcommercialbanksandcorporatetreasurers)whoseektoinvestcashshortterm.Therepotradescanbeovernighttrades,termtradeswithsomefixedfuturematuritydate,oropentradeswhichremaininplaceuntiloneortheotherpartieselectsnottorenewthetrade.Atitsheart,thetripartyrepomarketmatchesalargedemandonthepartofCashInvestorsforsafe,flexible,shortterminvestmentswiththedesireforbanksandsecuritiesdealerstofinancetheirsecuritiesinventoriesonamoreefficientandreliablebasisthantheycanborrowonanunsecuredbasis.Thetreatmentofrepurchasetransactionsinbankruptcy,theuseofsecuritiesascollateral(includingdailymarginingandhaircuts),andthecustodianservicesoftheClearingBanksprovideprotectionstorepoCashInvestorsthatdonotexistforunsecuredcreditors.ThismechanismforfinancingDealersecuritiesinventoriesgrewduringthelastdecadetobecomeasubstantialportionoftotalDealerbalancesheetliabilities.Forreference,thedailyvolumeoftripartytransactionsisamultipleoftheentirefinancialcommercialpapermarket.Dealerscollectivelybelievedthatthismethodoffinancingwouldbemorestablethanunsecuredfinancingintheeventofmarketorfirmspecificstresseventsgiventheprotectionsdescribedabove,inparticularthefactthattherepoCashInvestoriscollateralized.Currently,thebulkoftheentiresecuredexposurepassesfromtheCashInvestorstotheClearingBanksintradaytoprovideoperationalefficiency.Thebulkoftripartyrepotransactionscurrentlyareunwoundvs.cashontheClearingBanksbookseachday(normallyaround8am),withnewallocationseffectedonthebooksoftheClearingBanksbeginningintheafternoon.Asaresult,theamountofsecuredcreditandmarketriskexposurebornebythetwoClearingBanksinthenormalcourseofbusinesstodayisextremeandthereisuniformsupportfromalltripartyrepomarketparticipantsontheimportanceofreducingthisintradayexposureasthetoppriorityfromasystemicriskperspective.

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Section4: OperationalArrangementsTheTaskForceworkstreamcoveringoperationalarrangementsfocusedfirstonidentifyingtheprocessesthatmustbeenhancedtoenablelargereductionsinintradaycreditextensionsbytheClearingBankswithouthinderingthetradingandfinancingfunctionalityassociatedwiththecurrentplatform.6Threecoreprocesseswereidentified.

TradeBookingProcess:SomemarketparticipantsdonotsubmitcompletetradeinformationtotheClearingBanksonatimelybasisaftertradeexecution.BookingandsubmissionflawsaretworeasonsClearingBanksreturncollateraltoDealersandcashtoCashInvestorseveryday,evenwhentherepohasamaturitydatebeyondoneday.

TradeConfirmation:Thereisnoindustrywideformalizedtwoway(DealersandCashInvestors)orthree

way(addingClearingBank)tradeconfirmationpracticeatthetimeoftradeexecution.CashInvestorsandDealersgenerallyconfirmtheirtradesbilaterally.ThetimelyreportingoftradeinformationtoClearingBanksgivesthemmoreinformationforbetterriskmanagement.

IntradayCollateralManagement:InmosttripartyrepotradestheClearingBankreturnscollateraltothe

DealerandcashtotheCashInvestoreveryday,evenfortermrepotransactions.Thispracticeiscalledtheunwind.ThepurposeoftheunwindisoperationalinthatitgivesDealersaccesstothecollateralfordailysettlementactivity.TheresultisthatmostofthesecuredexposureistransferredfromtheCashInvestorstotheClearingBanksuntilcollateralisreturnedtotheCashInvestorlaterinthebusinessday,resultinginexcessive,albeitsecured,intradayexposuresforthetwoClearingBanks.

TheTaskForceconcludedthatenhancementsintheseareas,inparticularthedevelopmentofrobustautomatedintradaycollateralsubstitution(autosubstitution)capability,togetherwithimplementationofnewstandardizedsettlementtimesformaturingrepotrades,shouldenableverysubstantialreductionsinintradayexposureswithoutlossoffunctionality.Accordingly,theTaskForcehasdevelopedandagreedonanambitiousindustryactionplantoachievethisobjective.Thisactionplanculminatesinthepracticaleliminationofintradayexposurebythemiddleofnextyear.Recommendation1.Implementoperationalenhancementstoachievethepracticaleliminationofintraday

creditbytheClearingBanks,wherepracticaleliminationisdefinedasapointbeyondwhichtheresidualamountsofintradaycreditextensionsarebothsmallandcanbegovernedbytransparentbilateralarrangements,knowninadvancetoparticipants7.(30Jun2011)

TheuseofthepracticaleliminationstandardasdefinedinthisRecommendationreflectsthedesiretomeasureprogresstangiblyandquantitatively,whilealsorecognizingthatzerointradaysecuredfinancingisnotarealistictargetinthistimeframe.

6ClearingBankshaveemployedtwotacticalsolutionstoreduceintradayexposuressinceDecember2009:

Byeliminatingtheunwindofselectedtermrepos,participatingDealerskeepspecifictermloansfullycollateralizedandperformaminimallevelofsubstitutionincoordinationwiththeClearingBanks,

Bydelayingthemorningunwindprocess,Dealersreducedeliveryobligationsandcanthenreallocatetradestoeliminateintradayexposure.

Participationhasbeenbroadbasedandhasachievedanapproximate$150billionreductioninthedailyunwindatthetwoClearingBanks.Marketparticipantsarecommittedtoimplementingtacticalsolutionsuntilthestrategicsolutionisimplemented.Termtradesrepresent10%40%oftheentiremarket.Goingforward,marketparticipantscanreduceintradayexposurebyreplacingovernightmaturingtradeswithtermmaturingtradesandbysegregatingovernightmaturingtradesfromopenmaturities.7Marketparticipantsshouldtargetthereductioninintradaycredittobelessthan10%ofaDealersnotionaltripartybook(representingtheestimatedportionofaDealer'sbookthatreachesfinalmaturityandisnotrolledonagivenday).

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TheactionplanconsistsofadditionalintermediatemilestonesthattheTaskForcebelievesarenecessarytoachievesuccesswithrespecttotheoverallobjective.Theseareasfollows.TradeBookingProcessAnimportantprerequisiteformoreambitiouschangesistofirstensureashighalevelofaccuracyaspossibleintherecordingandcommunicationofallrelevanttradedetails.Recommendation1B.Eliminateremainingsourcesofambiguityorinaccuracyintripartyrepobooking

proceduresandtradecommunicationstotheClearingBanks,includinginformationrelatedtothetermofthetransaction.(31Aug2010)

TradeConfirmationAthreewayconfirmationprocesswillimprovethequalityandtimelinessoftradeinformationreceivedbytheClearingBanks.Errorswillbecaughtandresolvedearlierintheday.Sincemosttradesareexecutedearlyinthemorning,ClearingBankswillhavetheessentialfundinginformationnecessarytomakeaninformeddecisionaboutextensionofintradaycredittoindividualDealers.TheTaskForcesupportstheuseofopenarchitectureandstandardmessagingprotocolsinregardtopossibletradeconfirmationsolution(s).Recommendation1D.Recommendation1G.

Agreesolution(s)forthreeway,realtime,pointoftradeconfirmationsfortripartyrepotransactions,inclusiveofdiscussionswiththirdpartyvendors.(15Oct2010)Implementmarketwide,threeway,realtime,pointoftradeconfirmationsolution(s)whichmemorializeslegallybindingrepotransactionsenteredintobetweenCashInvestorsandDealers.(15April2011)

Itisessentialthatallrepoparticipantsagreethattripartyrepotradesarelegallybindingagreementswhicharememorializedatthepointofconfirmation.SeeAnnex1fortheMinimumParametersRequiredforTradeMatchingdevelopedbytheTaskForce.IntradayCollateralManagementTherearetwoprimaryelementstotheoperationalimprovementsneededinintradaycollateralmanagement.First,theClearingBankswillneedtodevelopandproviderobustautosubstitutioncapabilitythatallowsDealerstoaccessandsettletradesinvolvingcollateralbeingfinancedwithtripartyrepowithoutunwindingtheunderlyingtripartyrepotransaction.Thesecondchangeinintradaycollateralmanagementneededistoestablishagreed24hoursettlementcyclesthatkeepinvestorscollateralizedandborrowersfundedthroughoutthatperiod,sincethiswillbydefinitionreducetheneedforroutineintradaycreditextensionsbytheClearingBanks.Insum,themodelthatthiswillsupporthasthefollowingaspectsforeachmajorparticipant.Dealers

Preservesliquiditybyallowingreadyaccesstoencumberedcollateral ReducescreditdependencyontheClearingBanksascreditexposureiskeptwithCashInvestors Minimalimpacttocurrenttradingpracticesasprocessbecomesfullyautomatedandhighlyefficient

CashInvestors

GreatlyreducesunsecureddepositorrisktotheClearingBanks Ensuresappropriatemarginedcollateralizationwitheligiblesecuritiesandcashthroughouttheday

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ClearingBanks GreatlyreducestheoutsizedintradaycreditextensiontoDealersresultingfromthedailyunwind AllowsforgreaterclarityincreditlinesandcreditrelationshipswithDealers

KeymilestonesinrelationtotheClearingBankimplementationofautosubstitutionareasfollows.Recommendation1A.Recommendation1E.

ClearingBankstoprovideprojectplansinrelationtotheirimplementationofrobustautomatedcollateralsubstitution(autosubstitution)capability.(15Jul2010)ClearingBankstocompletedevelopmentofsoftwaretosupportautosubstitutioncapabilityandconfirmtimelinesforfullimplementation.(15Feb2011)

ThesecondchangeinintradaycollateralmanagementthatisneededistoestablishagreedsettlementtimesthatkeepCashInvestorscollateralizedandborrowersfundedthroughouttheperiod,sincethiswillbydefinitionreducetheneedforroutineintradaycreditextensionsbytheClearingBanks.Recommendation1C.

Agreetostandardizedintradaysettlementtime(s)formaturingrepotrades(e.g.,MorningSettlement,EndofDaySettlement),thatwillbeimplementedfollowingprerequisiteenhancements(e.g.,autosubstitution).(31Aug2010)

Althoughthenewstandardizedsettlementtimeswillnotbeimplementedrightaway,itisimportanttoreachagreementonthemwithinthenextfewmonthsinordertoplanotherelementsaroundthem.Inthiscontext,itisalsocriticaltorecognizetheagreementbytheLegalSubcommitteeregardingconfirmation(viathethreeway,pointoftradeconfirmation)ofthelegallybindingrepotransactionsenteredintobetweenDealersandCashInvestorsatthepointoftrade,asthiswillcreateamoresolidfoundationwithinwhichtheindustrywilloperate.Marketparticipantsshouldensurethatlegaldocumentationisappropriatelysupportiveofthisobligation.Thefollowingpointssummarizethecurrentthinkinginregardtopotentialstandardizedsettlementtimes,takingintoaccounttheworkdonebytheTaskForceslegalworkstream,assummarizedinAnnex2oftheReport.TheseconceptswillbediscussedfurtherandvettedacrosstheindustrypriortofinaldecisionsbytheTaskForce. Marketparticipantsshouldweighthemeritsofdevelopingastandardsettlementformaturingtransactions

duringtheafternoon,unlessthetwocounterpartiesotherwiseagreetoamorningsettlement.o Thebenefitsofatwicedailysettlementperiodforfinalmaturityoftransactionsaresignificant;itwould

provideadditionalopportunitiestoreduceintradaycreditextensionsbytheClearingBanks,itwouldallowadditionaltimeforCashInvestorstoprovidefinalallocationaccountinformationtotheDealersandClearingBanks,anditwouldkeepCashInvestorsfullysecuredthroughthe24hourcycle.

o Thesebenefitsneedtobebalancedwiththechallengesofintroducingasecondsettlementperiod,includingoperationalcomplexityduringacompressedendofdaytimeframe,aswellastheinabilityofCashInvestorstotakepossessionand/orliquidatecollaterallateintheday.

AsagreedbytheLegalSubcommittee,alltradesenteredintobetweenaCashInvestorandaDealer,including

blocktrades,representlegallybindingcommitmentstoprovidefinancingfromCashInvestortoDealerwhichismemorializedviathethreewayconfirmation.Otherwise,thissolutionwillnoteffectivelymitigateintradayexposure.(SeeAnnex2).

ItisincumbentuponCashInvestorstodeliversubaccounttradeinformationasearlyaspossibleduringthe

daytotransfertheriskofDealerdefaulttotheappropriatespecificentity(s)providingfinancingtotheDealer.

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CashInvestorsandDealersshouldseektoexecuteandconfirmrepospriorto10a.m.Notethatlaterdaytradesshouldstillbeabletobesettled;howeverifbothpartiesagreetoatransactioninthemorningitshouldbecommunicatedthroughtheconfirmationprocessimmediatelysotheClearingBankhasanappropriateassessmentofdailyfinancingactivity.

ReadinessforChangeTheoperationalchangesdiscussedherewillrequirealargeamountofcoordinationandcooperationtoachieve,especiallyintherapidtimeframeenvisioned.ClearingBankshaveamajorroletoplayinlayingouttheirplansandworkingcloselywiththeircustomers.CashInvestorsandDealersalsoneedtoworkconstructivelyandaggressivelytobesuretheyarereadyforthesechanges.Recommendation1F.

DealersandCashInvestorstoconfirmthatinternalprocessesrelatedtoallaspectsoftripartyrepoarepreparedfortheoperationalenhancementsrecommendedinthisReport.(15Feb2011)

TheTaskForcehasidentifiedthefollowingareasformarketparticipantstoconsiderastheyprepareforthesechangesinoperationalarrangements.

Extensiveoperationalandtechnologychangesarerequiredofallpartiestosupportasignificantincreaseinthelockupofcollateralfromthecurrentmodel.

Substitutions,accounting(includingthecalculationandpaymentofinterest),collateralvaluationmethodologies,andrelatedprocessesneedtobeadaptedtothenewmodel.

CashInvestorsandDealersrequirerealtimeinformationofthecompositionofcollateralsecuringatermtradeatanypointduringtheday.

DefiningcollateralsubstitutionprocessforinterbankGCFRepocollateralpledgedtotermtrades. EfficientlytargetingintradaysecuritiesandcashsubstitutionstominimizeCashInvestors'unsecured

depositorexposuretotheClearingBanks Atransparentprocessformanagingfailswillneedtobedevelopedpendingagreementonnew

standardizedsettlementtimes.ImpactWhencollectivelyimplemented,thenewoperationalarrangementswilldrasticallyreducetheneedforintradaycreditfromtheClearingBanks.EstimatesfromClearingBanksareanimmediate1040%reductioninintradaycredittoDealersfromtacticalsolutionsalreadyunderway,withreductionstargetedat90%ormorewhenthestrategicsolutionsareinplace.OngoingDueDiligenceInadditiontotheactionplandevelopedtosupportimprovementsinoperationalarrangements,theTaskForcesupportsbothDealersandCashInvestorsreviewingtheoperationalpracticesoftheClearingBanksonaregularbasis.Thisshouldincludemonitoringcollateralallocationstoensurethatcollateralhasbeenproperlyallocatedandcheckingthepriceoftheallocatedcollateral.Recommendation2.

DealersandCashInvestorstoundertakeregularduediligencereviewsofClearingBanksthatcover,ataminimum,operationalandcontractualconformity,adherencetocollateralallocationrules,andcollateralpricingmethodologies.(Ongoing)

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Section5: DealerLiquidityRiskManagementDealerliquiditycontingencyplansandliquidityriskmanagementpracticesprecrisishadevolvedpredominantlyduringstableenvironmentsandinmanycaseswerepredicatedonshorttermsecuredfundingbeingmorestableduringtimesofstressthanunsecuredfunding.TheseapproachestoliquidityriskmanagementdidnotsufficientlyappreciatethesensitivityofmanyCashInvestorstocounterpartyconcernseveninthepresenceofhighqualitycollateral,thepotentialforabroadpullbackintripartyrepofinancing,andthelossofpricetransparencyandliquidityforcertaincollateraltypes.Dealershavetakentheselessonstoheartandhavebeenapplyingthemtotheirliquidityriskmanagementpractices.Thesupervisoryandregulatorycommunityhasalsomadeliquidityriskapriorityissueandhavebeendrivingfurtherimprovementsthroughproposedregulatorychangesandheightenedsupervisoryreview.AmongtheareasofemphasisthathavebeenhighlightedinTaskForcediscussionsarethefollowing.

Improvingliquidityriskmeasurementandreportingcapabilities,withrespecttobothgranularityandfrequencyandthecaptureofinstrumentswithcontingentliquidityimplications.

Undertakingmoresystematicanddetailedliquidityriskstresstestsandusingtheresultstohelpsizemorerobustliquiditybuffers.

Makinggreateruseoftermfundingwhereavailable.Staggeringmaturitiesandcombiningshorttermandlongtermfundingwiththesamecounterpartytomodifyincentivestowithdrawshorttermfunding.

Morerobustgovernanceandincreasedseniormanagementfocus.LiquidityriskmanagementwasnotintendedtobeaprimaryfocusoftheTaskForce,butisacrucialaspectfortheanalysisofhowfuturestressscenarioscouldevolveandthereforefortheassessmentofsystemicriskinrelationtotripartyrepoactivity.IntermsofRecommendations,theTaskForcesupportsthebroademphasisonstrengtheningliquidityriskmanagementpracticesandwishestohighlighttheneedforDealerstoensurethattheliquidityriskmanagementaspectsoftripartyrepoactivitiesreceivepriorityattention.Recommendation3.

Dealersneedtoincorporatelessonsfromthefinancialcrisisexperiencerelatedtotripartyrepoinmakingappropriateimprovementstoliquidityriskmanagementandplanning.(Ongoing)

Inthecontextofthetripartyrepomarket,thelessonlearnedthatstandsoutthemostistheoverrelianceonshorttermsecuredfundinganditspresumedstability.DiscussionsintheTaskForceemphasizedrepeatedlythatmanyCashInvestorsfocusprimarilyifnotalmostexclusivelyoncounterpartyconcernsandthattheywillwithdrawsecuredfundingonthesameorverysimilartimeframesastheywouldwithdrawunsecuredfunding.Recommendation4.

Dealersshouldnotassumethatshorttermtripartyrepofinancingwithalloftheircounterpartiesthroughoutallmarketconditionsisinherentlystable.(Ongoing)

IntradayCreditAparticularaspectofliquidityriskinthetripartymarketgoingforwardwillbethetreatmentofmaturingrepos.IfaDealerisunabletorolloverrepofinancingorotherwisefinancethematuringassets,theClearingBankmaychoosenottoallowtherepotomature,meaningtheCashInvestorwillretaintherisk.Dealerswillnaturallybeeagertopreventeventsfromreachingthispoint,especiallyifitisnotreflectiveofabroaderdeteriorationintheDealerscondition.

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DealersthereforehaveastronginterestinclarifyingthetermsunderwhichClearingBankswouldbewillingtoprovideintradaysecuredfinancing,eitheronadiscretionarybasisorpossiblyonacommittedbasis.ClearingBankshaveaninterestinunderstandingtheassumptionsDealersaremakingwithrespecttopotentialrequestsforClearingBankcreditinastressevent.Bilateraldiscussionstoexplorethesetopicsandaddresstherangeoftermsinvolved(e.g.,amount,drawdownconditions,maturity,fees,expiration,collateraleligibility,marginlevels)willbebeneficialinprovidingclaritytobothDealersandClearingBanksaheadoffuturestressevents.Recommendation5.

DealersandClearingBankstoassessandclarifytermsforthepotentialavailabilityofsecuredintradaycreditfacilities(bothdiscretionaryandcommitted)tomitigatetheliquidityrisksassociatedwithmaturingrepotrades.(15Nov2010)

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Section6: MarginingPracticesRecentmarketeventshavehighlightedseveralissuesrelatedtomarginingpractices.Theseissuesinclude:

MarginLevels:Marginlevelsincertainassetclasseswereinsufficienttocoverthecloseout/liquidationriskofthesecuritiesheldascollateral.

Valuations:Marketparticipantsdidnotsufficientlyanticipatethepotentialforsometypesofrepo

collateraltolosepricetransparencyandliquidityforextendedperiodsoftime. MarginingProcessbetweenDealerandClearingBank:TheClearingBankunwindandmarginingprocess

wasnotwellunderstoodbyallDealersandCashInvestorsDuetotheissueshighlightedabove,someCashInvestorswerebecomingmoreexposedtocounterpartycreditriskatthesametimethatcounterpartycreditconcernswereescalating.Asaresult,behaviorstartedtotrendclosertothebehaviorofunsecuredcreditinvestors,resultinginCashInvestorsexitingtherepomarketordrasticallychangingtheircollateralrequirements.Giventheheavyrelianceontherepomarketforfinancing,thispullbackinfundingandthemeaningfulincreasesinmarginrequirementsinadeterioratingmarketcontributedtosystemicriskconcerns.Toaddresstheseissues,theTaskForceinitiatedaworkstreamonmarginingpractices,whichhasdevelopedasetofprinciplesforfirmstouseinsettingmargins.TheTaskForcebelievesthatifCashInvestorsandClearingBanksfullyincorporatetheseprinciplesintotheirmarginprocesses,theresultwillbemorerobust,lessprocyclical,andmoretransparentandpredictablemargins.Inturn,thiswillcontributetothestabilityoftherepomarketinfuturetimesofmarketstress.ItisimportanttonotethattheTaskForceisnotendorsingstandardizationofmarginingmethodologiesorofmarginlevelsacrossthemarket.TheTaskForcebelievesthemarginingprocessisariskmanagementtool,andeachinstitutionshouldbeaffordedtheflexibilitytomanagetheirriskinaccordancewiththeirownriskmanagementpolicies,principles,andprocesses.PrinciplestoConsiderForMarginRequirementsRiskBasedAsvolatilityincreasedthroughout2008,marketparticipantsrecognizedthattheliquidationvalueofthecollateralreceivedmightnotbesufficienttorecover100%oftherepofinancingintheeventofaDealerdefault.TheTaskForcebelievesthatthisuncertaintycanleadtoinstabilityasCashInvestorsaremorelikelytoexittherepomarketorexcludebroadassettypesinordertoavoidunsecuredexposureinadeterioratingmarket.InhindsightwebelievethatthisuncertaintywaslargelydrivenbyanunderestimationofhowquicklyahealthymarketcantransitionintoastressedmarketinwhichaDealerscreditqualityandassetliquiditybecomesaconcern.ThereisbroadagreementwithintheTaskForcethatClearingBanksandCashInvestorsshouldsetmarginrequirementsconsideringthepotentialpricedeclineofthesecuritiesheldascollateralduringaperiodofmarketstressandvolatilitywhileassumingastrongcorrelationwithaDealersfailuretoperform.Thisriskbasedanalysisshouldalsoconsider:

Portfolioconcentrationrisks:Aportfolioofdiverseassetsmayperformbetterthanahighlyconcentratedportfolio.Inotherwords,anincreaseinportfolioconcentrationswillcorrespondtoanincreaseinsecurityspecific,idiosyncraticgaprisk.

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Liquidationhorizon:Aconservativeliquidationtimehorizonshouldbeassumedtosupportanorderlyliquidationofcollateralandtoaccountforpotentialdelaysinliquidatingaportfolio.Thesedelayscanbedrivenbypotentialstayperiods(e.g.SIPCStay)orbyassetconcentrations(e.g.asecurityholdingmayexceedthedailytradedvolume,andthereforemultipledaysmayberequiredforthemarkettoabsorbtheposition),orpossiblyotherfactors.

Implied&historicalassetvolatility:Whencalculatingcounterpartyriskexposure,marketparticipantsshouldcomplementahistoricalvolatilityanalysiswiththeimpliedvolatilityinthemarkets.Thisisimportantsincehistoryisnotalwaysagoodproxyforthefuture.

Stresstesting:Incasesofstablemarketswhereimpliedvolatilityislowandhistoricalvolatilityassumptionshavedecayed,anoverlayofmarketstresstestingtodeterminemarginlevelsiscriticaltoensurethatalowvolatilityenvironmentdoesnotleadtoprocyclicalbehavior.

ItisimportanttonotethatalthoughtheTaskForceencouragesallmarketparticipantstofullyanalyzeallrisksinherentinthetripartyrepomarket,itisnotintendedtobeariskfreemarket.Marketparticipantsshouldhaveflexibilitytoscaletheirmargininglevelsupordowninexchangeforincrementalyieldbasedupontheirindividualriskappetite.Thekeyisformarketparticipantstosizetheirappetiteforunsecuredcreditriskandthensetassumptionsandmarginsaccordingly8.GranularityInordertoproperlyquantifytheliquidationrisk,themarginanalysisshouldbeconductedatleastatalevelgranularenoughtodistinguishtheriskbetweenthevariousassetclasses,creditratings,durations,etc.Asanexample,itmaynotbesufficienttolookatthehistoricalpricevolatilityofCorporateBonds.TheCorporateBondassetclassisverybroadandincludessubassetclassesthatmayhavedifferentriskandliquidityprofiles.ByenablingmarginlevelstobesetatamoregranularlevelClearingBanks/CashInvestorswillbeinabetterpositiontounderstand/assesstheriskofcollateralthattheyhold,aswellasensurethatthemarginproperlycoverstheirliquidationrisk.PeriodicReviewItisimportanttoreviewthemethodologiesandassumptionsthatareusedinthecalculationonaperiodicbasisinordertorecalibratethehaircuts.Althoughtheinitialhaircutshavealreadyassumedastressedscenario,therecalibrationwillberequiredifchangesinmarketconditionsprovethatvariousassumptionsweretooaggressiveortooconservative.Reliable3rdPartyValuationsCollateralizingtripartyrepotradeswithassetsthathavereliable3rdpartyvaluationsisanintegralpartofanyriskbasedmarginingprocess.ThisisdiscussedfurtherinSection8below.PracticalityAsacounterbalancetotheprinciplesabove,anymarginingproposalshouldconsiderthepracticalityofthecalculation/implementation.Simplyput,arobustriskbasedalgorithmthatanalyzesstresslevelsandvolatilityatthecusiplevelmaybeidealfromariskmanagementapproach,butthepracticalrequirementsofbuildingthisinfrastructureandrollingoutthisapproachtoallmarketparticipantsisbeyondwhatmarketwideinfrastructurecancurrentlymanage.FormostCashInvestors,theTaskForcebelievesthatsettingmarginlevelsbyassetclassprovidesanappropriatebalance,allowingcreditratingsandmaturitiestobetakenintoaccount,withsufficientgranularitytoensuresufficientriskdifferentiationbutalsoensuringthatthenumberofcollateraltypesassociatedwithmarginlevelsismanageable.Inaddition,therepomarketwillneedtobalanceanynewriskbasedapproacheswiththepotentialcostofimplementationaswellastheoperationaldifficultiesassociatedwithdayto8AsdiscussedinSection5,someCashInvestorsassignmoreweighttotheDealercreditquality,independentlyofthecollateralpledged,soriskbasedmarginingmaynotpreventCashInvestorsfromexitingtripartyreposwithadeterioratingDealer. 22of43


daymanagement.However,theprinciplesoutlinedhereshouldbefollowedbyallmarketparticipants,regardlessoftheriskmanagementtoolsandthespecificapproachtheyusetoimplementthem.ThismaymeanthatsomesecuritiesarenotappropriateforcertainCashInvestors.Thiswillbedriven,atleastinpart,bytheCashInvestorsabilitytoanalyzetheriskofthespecificassetclassgiventheirinternalrisksystems.AvoidProCyclicalBehaviorAsriskwasperceivedtobelowerandspreadstightenedthroughoutthelastcreditcycleacommontrendwastoseereductionsintheamountofcollateralthatwasprovidedintherepomarket.Atthetime,themarketacceptedthispracticebasedupontheprevailingstablemarket.Asthemarketsdeterioratedin2008and2009marketparticipantschangedmarginrulesetsbyexcludingcertainassettypesandincreasingmarginlevelsinordertooffsettheperceivedhighercollateralliquidationriskduetotheincreaseinpricevolatility.Attheextreme,someparticipantspulledoutoftherepomarketbecausetheybecameuncomfortablewiththeunsecuredcreditriskresultingfrominsufficientmargin.Thisprocyclicalbehaviorincentedrisktakinginperiodsofstabilityanditconstrainedliquidityattheworstpossibletime.Insomecases,thisalsoresultedinparticularconcernassomeDealersreliedonClearingBankstofinancecollateralnolongeracceptedbyCashInvestorswhilealternativefinancingwassought.Ingeneral,theTaskForcebelievesthemarginingprocessshouldavoidprocyclicalbehaviorwherebyClearingBanksandCashInvestorschangetheirrulesetsinasuddenandcapriciouswayintimesofstress,leavingDealerswithlittlefinancingoptionsforilliquidcollateral.Asamoreriskfocusedandstressbasedhaircutapproachisincorporatedwebelievethisprocyclicalbehaviorwillbereducedbecauseofthehighermarginlevelsthatwillbeappliedexanteandregularlyadjustedthroughoutthemarketcycle.Thisshouldreducedramaticorunexpectedcallsforadditionalcollateral.Furthermore,thisthroughthecyclemarginwillprovidesufficientprotectionsuchthatincreasesinvolatilityorreductionsinliquidityandpricetransparencywillnothavethesamesignificantimpactonrepofundingormarginarrangements.Objective&TransparentMethodologyMisunderstandingsrelatedtothetripartymarginingprocessbetweenDealersandClearingBankswasanotherdriverofinstabilityintherecentmarketcrisis.WhilebothClearingBanksandCashInvestorshaddiscretiontoincreasetheirmargin,therewasnoframeworktodiscloseorexplainthemarginmethodologyorunderlyingdriversandassumptions.Incontrast,theTaskForcebelievesthatanobjective,welldefined,andtransparentmethodologythatreducesunexpectedincreasesordecreasesinmarginrequirementsshouldcontributetotheeliminationofthisuncertainty.Furthermore,webelieveamoretransparentapproachwillreducetheneedforunanticipatedandpoorlyunderstoodmargincalls.Akeyfeatureofthisapproachwillbedisclosurethatexplainsthedriversandrationaleofthecalculation,aswellasitsunderlyingassumptionsandmechanics(e.g.,howarecreditrisk,interestraterisk,liquidity,concentrationrisks,etc.accountedfor?).Additionally,anychangestothemethodologyshouldbecommunicatedtoallparties,andshouldbephasedintothemarginingprocesswithreasonablenoticetime.Althoughtheabilitytoincreasehaircutsisakeycomponenttoriskmanagement,thephasinginofchangestothemarginingprocessshouldnotmateriallyimpactthevariouspartiescreditexposureanalysisastheagreeduponthroughthecyclehaircutshavealreadyassumedastressbasedcushion.Additionally,thisphasedinapproachwillgiveDealerssufficienttimetoprepareforincreasedhaircutsortootherwisemanagetheirinventoryifpostingtheincrementalmarginisuneconomic.Asaresult,webelievethisprocesswillreducethepossibilitythatchangesinrepomarginingwillhaveadestabilizingimpactonthemarket.DeterminingAppropriateMarginsBecauseofthecomplexitiesofthemarginingprocess,theTaskForceisnotmakingdetailedtechnicalRecommendationsonmarginapproaches.Instead,theTaskForcehasarticulatedtheprinciplesjustdescribedand

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recommendsthatmarketparticipantsadopttheseprincipleswithintheirownriskmanagementapproaches.Inaddition,theTaskForcerecommendsthatmarketparticipantsreviewtheregularpublicationoftripartyrepomarginlevelsthatwillbecomeavailableastheresultoftheTaskForcesRecommendationsinSection8oftheReport.Theseshouldserveasabenchmarkforassessingmarginlevelsbutarenotasubstituteforundertakingonesownanalysis.InformationontherelativeconcentrationofDealersindifferentassetcategoriesmaybeinformativewithrespecttothepotentialforlargerliquidityeffectsonpricingintheeventofaliquidationandthereforemightbeparticularlyusefulinthemargincontext.Recommendation6.

CashInvestors,Dealers,andClearingBankstodetermineappropriatecollateralmarginsinlinewiththeprinciplessetoutinSection6ofthisReport,takingnoteofmonthlyTriPartyRepoStatisticstobepublishedontheFederalReserveBankofNewYorkwebsite.(Ongoing)

AlthoughthisRecommendationisaddressedtobothClearingBanksandCashInvestors,itisimportanttonotethattheimplementationconsiderationsaredifferent.Therefore,itshouldnotbeexpectedthatthespecificmarginingmethodologies/processeswouldbethesamebetweenClearingBanksandCashInvestors.MarginingProcessbetweenDealerandClearingBankTheClearingBankunwindandmarginingprocesswasnotwellunderstoodbyallDealers.Ashighlightedabove,theTaskForcedoesnotproposeaprecisemarginingmethodologytobeusedbyallClearingBanks.InsteadwerecommendthatClearingBanks/Dealersworktogethertoimprovetransparencyandreducesubjectivityinthedailymarginingprocess.Recommendation7.

ClearingBankstocontinuetoshareinformationonintradaymarginmethodologiesandprocesseswithrespectiveDealers.(Ongoing)

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Section7: ContingencyPlanningThefocusofthispartoftheTaskForceseffortshasbeenonimprovingpreparednesstocopeeffectivelywiththedefaultofaDealerfirm.GiventheRecommendationsonoperationalarrangementsandtheenvisionedreductionsinClearingBankprovisionofintradaycredit,itfollowsthatCashInvestorsshouldhaveevenstrongerincentivestoengageineffectivecontingencyplanningforsuchevents.Acriticalstartingpointforsuchcontingencyplanningistheassessmentofpotentialimpactsfromsuchadefaultevent.ThistypeofstressanalysisshouldconsiderthedefaultoftheCashInvestorssinglelargestrepocounterparty(asmeasuredbyexposure),astandardthathaslongbeenappliedtoparticipantsinsystemicallyimportantpaymentandsettlementarrangements.Inaddition,itshouldconsidertheimpactofthatDealersdefaultonthepriceofthecollateralthatwouldneedtobeliquidated,thelengthoftimetheCashInvestorbelieveswouldbeavailableforsuchliquidation,andanyotherfactorsthatmightimpacttheproceedsfromcollateralliquidation.TheresultsofthestressanalysisshouldfactorintotheriskassessmentandriskappetiteofCashInvestorsaswellastheircollateralconcentrationlimitsandmarginsettingprocesses.Theseresultsshouldbediscussedwithseniormanagementandboardsasappropriatedependingonthenatureoftheorganization.Recommendation8.

CashInvestorstoundertakeregularstresstestsoftripartyrepocounterpartyexposuresthatconsideradefaultofthelargestrepocounterpartytogetherwithpotentialchangesinthemarketvalueoftheunderlyingcollateral.(Ongoing)

AfteraDealerdefault,CashInvestorshavetherighttoseizeandliquidatethecollateralandshouldhaveappropriateprocessesandprocedurestohandlecollateralmanagementandliquidation.IntheeventthatthecollateralliquidationproceedsareinsufficienttooffsettheentireamountoftheCashInvestorsclaim,theCashInvestorretainsanunsecuredclaimagainsttheDealerfortheamountnotsatisfied.ThoughtfulmanagementofthecollateralcanminimizetheimpacttoanindividualCashInvestorandtothemarketasawhole.CashInvestorsshouldbepreparedforaborrowerdefaultbyhavingpolicies,procedures,andsystemsinplacetobeabletofacilitatethedeliveryofcollateral.ThisplancouldincludeinstructingtheClearingBankthatholdsthecollateralonbehalfoftheCashInvestorpriortothedefaulttotransferthecollateraltoasegregatedcollateralaccountattheClearingBank.TheCashInvestor,eitherdirectlyorwiththeassistanceofanagent,mustbeabletopricethecollateralinordertoassignapricetotheirdefaultedrepopositionheldbytheCashInvestor(e.g.,marketvalueofdefaultedrepopositionisdependentuponthemarketvalueofthecollateralitexpectstoreceiveuponliquidation).CashInvestorsshouldhaveacohesivestrategyandresourcestosupporttheorderlyliquidationofadefaultedDealerstripartyrepocollateral.Dependinguponmarketconditions,immediateliquidationmaynotbethebestoptionforsomeCashInvestors.ThedefaultedrepopositioncouldbeanilliquidholdingandtheCashInvestormayneedliquiditybeforetherepocollateralisliquidated.EachCashInvestorshouldhaveanoverallliquidityplanwhichtakesintoaccountthepossibilityofaDealerdefault.SomeCashInvestorsmaychoosetomanagethesaleofcollateraldirectlywhileothersmayelecttouseadelegatedliquidationagent.Cashinvestorsshouldestablish,monitor,andtesttheseprocedurestoensurethatagentsareabletoacceptthedeliveryofcollateralatanytime.Recommendation9.

CashInvestorstoputinplaceandregularlyreviewcontingencyplansforaDealerdefaultthatcover,ataminimum,aprocessforeffectivelymanagingcollateral,includingaplantomanageliquidityandriskexposureduringtheliquidationprocess.(15Jan2011)

BuildingontheworkofTaskForce,towhichithascontributedsubstantially,theInvestmentCompanyInstituteisdevelopingamorecomprehensivesetofBestPracticeguidancefortheCashInvestorcommunity,withaparticularfocusonmoneymarketmutualfunds.TheTaskForcestronglysupportsthisinitiative. 25of43


Recommendation10.

RelevantindustryassociationsinconjunctionwiththeirconstituentsareencouragedtopublishcomprehensiveBestPracticeguidanceforCashInvestors.(30Sep2010)

MitigatingliquidityimpactofDealerdefaultThereareseveralpossiblewaystoreducetheliquidityimpactofafailingDealeronCashInvestors,inadditiontotheobviousapproachofreducingthesizeofrepoexposuresinthefirstplace.PrearrangingsecuredliquidityfacilitiesCashInvestorsmaychoosetoenterintoacommittedliquidityfacilitythatwouldallowthemtoobtaintemporaryliquiditysecuredbyhighqualityunencumberedsecuritiesthattheyown.ManyCashInvestorsownsufficienthighquality,shortdatedsecuritiesthatcouldcollateralizethefundingundersuchafacility.Thefacilitywouldreducetheneedtoengageinafiresaleofcollateralthatcoulddepresssecuritiesprices.Cashinvestorswouldneedtogaugehowlargeacreditfacilitymightbeneededtocovertheirliquidityneeds.Thismustbereassessedregularly.ThepotentialuseofsuchfacilitiesbyregulatedCashInvestorsshouldbediscussedwiththoseregulators.Netting/offsetofDealerpositionsthroughDTCC(TheDepositoryTrust&ClearingCorporation)OffsetingpositionsthatCashInvestorsholdrelativetoadefaultedDealerandthosethattheDealerheldwithitsotherclientsreducesthenumberofpositionsthatneedtobeliquidated.Themorepotentialoffsetsthatcanbeidentified,thelesspotentialliquidationneedstooccurIntheeventofaDealerdefault,ClearingBanksandDTCCshouldreviewallFICC(FixedIncomeClearingCorporation),NSCC(NationalSecuritiesClearingCorporation),andDTC(TheDepositoryTrustCompany)sellpositionsinordertoidentifytripartyrepocollateralthatcanbeusedtosatisfythedefaultedDealersshortpositionsthroughanetting/setoffprocess,whichcouldresultinlesscollateraltobeliquidatedintheopenmarket.Proceduresneedtobeinplacetocontrolthisflow.DTCChasexistinginfrastructureinplacewithClearingBanksthatcouldpotentiallybeleveragedtoaccommodatethisprocess.DTCCdidapreliminarysampleanalysisofthreelargetripartyrepoportfoliosbasedondatareceivedfromeachoftheClearingBanks.TheanalysisfocusedonU.S.TreasuryandU.S.Agencydebtcollateral.Nettingopportunitiesrangedfrom9%to18%.Recommendation11.

DTCCanditsaffiliatestoworkwithothermarketparticipantstomaximizethepotentialforoffsettingofpositionsintheeventofaDealerdefault;DTCCand/orotherinterestedpartiescanprovideaviablecollateralliquidationmanagementserviceforthoseCashInvestorswishingtodelegatetheseactivities.(30Nov2010)

AdditionalConceptsLiquidityStabilizationUtilityThisisamorefarreachingconceptasmentionedinSection1oftheReport.Theideawouldbetoestablishanongoingbankentity,theLiquidityStabilizationUtility(LSU),whichwouldexistfortheprimarypurposeofprovidingliquiditytoCashInvestors.TheLSUcouldprovideCashInvestorsacollateralizedloantransactionsecuredbyhighqualityshorttermassetsownedbytheCashInvestors.CashInvestorscouldthendisposeoftherepocollateralreceivedfromthedefaultedDealerinanorderlymanner.Asabank,theLSUcouldinprincipleraisecashtofundtheloanstotheCashInvestorsbypledgingthehighqualityassetstotheFederalReservediscountwindow.TheobjectivewouldbetoeliminateasfaraspossibletheriskoflosstotheLSUortheFederalReservebyhavingtherelevantCashInvestorscontractuallyobligatedtobearthe 26of43


firstlossofanyshortfallsduetothepricesobtainedintheultimateliquidation.CapitalwouldbebuiltupintheLSUovertimethroughfees,allowingittoplayagreaterroleinprovidingliquidityasitgrows.AsnotedinSection1,theLSUraisesanumberofissues,includingitsultimaterelianceonFederalReserveliquidity,andthereforetheTaskForceisnotincludingarecommendationregardingtheLSU.CentralCounterpartyAnotherfarreachingconceptisthenotionofacentralcounterpartyorCCPfortripartyrepotransactions.AttheheartoftheCCPideaistheconceptofmutualizationofanylossesabovethemarginschargedbytheCCP.Theseareexpectedtobehigherthanthosechargedinbilateraltransactions.ThemutualizationcouldoccuracrosstheDealercommunity,oracrosssomecombinationofDealersandCashInvestors,andwouldnotnecessarilyimplyanychangeininfrastructurerelativetothatmaintainedbythetwoClearingBanks.BecausetheCCPstandsinasthecounterpartyfacingCashInvestorsinitstripartytransactions,inprincipleitcouldfinancetheliquidationofcollateralassociatedwithadefaultedDealersimplybyundertakingnewtripartytransactions.AslongasthecreditqualityoftheCCPitselfwasnotinquestion,thisapproachwouldthereforehavepotentialtoaddressconcernsbothwithrespecttothefiresaleliquidationofcollateralandwithrespecttothestabilityoftripartyfinancing.Thecostsandcomplexityoftheissuesinvolved,however,especiallypriortotheoperationalenhancementsneededtoeliminatetheneedforintradaycredit,leadtheTaskForcetoavoidmakingaspecificrecommendationregardingacentralcounterparty.Recommendation12.

Allmarketparticipantstocontinueexploringadditionalconceptsthathavethepotentialtoaddtothestabilityandresilienceoftripartyrepofinancingand/orreducethepotentialforcollateralfiresalesintheeventofaDealerdefault.(Ongoing)

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Section8: TransparencyThetripartyrepomarkethashistoricallyseenonlylimiteddisclosuresregardingtheaggregatesizeofthemarket,collateraltypes,andmarginlevels.Thislackoftransparencycontributestomarketuncertaintyduringtimesofstressandalsomayhavecontributedtounderestimatesoftheextentofprocyclicalityinherentinprecrisismarginlevelsandinthesystemicriskpotentialofthetripartyrepomarketoverall.Recommendation13.

Initiatemonthlypublication,viatheFederalReserve,ofaggregatestatisticsontripartyrepocollateralandCashInvestormarginlevels,withdisclosurebyassetclass,basedoninformationprovidedbytheClearingBanks.(SeeTable1forapilotversion.)(30Jul2010)

Thepilotversionofthereportdoesnotyetincludeterminformation,howevertheplanistoprovidethisonceitisavailableandreviewedbytheTaskForce.CollateralValuationAshighlightedinthediscussionofmarginingpractices,marginswillonlybeeffectivetotheextenttheyarebeingappliedinconjunctionwithanaccuratepriceforthesecuritiesheldascollateral.IfinaccuratepricesarebeingsuppliedbythirdpartyvendorstheClearingBank/CashInvestormaybeexposedtoasituationwherethemarketvalueofcollateralisinsufficienttocoverthereponotional.Thiscouldpotentiallyresultinunsecuredcounterpartycreditexposureresultingfromcollateralvaluationrisk.InordertominimizethecollateralvaluationrisktheTaskForcebelievesthevaluationprocessrequiresrobust,reliableandindependentpricingsources.Managingcollateralvaluationriskrequiresthatparticipantsunderstandthenatureandtypeofsourcesthatarebeingusedtogetherwithassociatedmethodologies,inparticularwheremodelbasedpricesarebeingused,aswellastheassumptionsandinputsourcesassociatedwiththosemodels.TheremayalsobesomecollateraltypeswherecollectiveeffortsbyDealerscouldfurtherenhancethetransparencyofvaluation.Forexample,insomemarkets,thirdpartyserviceshaveenabledanonymouscompilationofmarksappliedandtherebyprovidedadditionalusefulinformationontherangeandcentraltendencyofsuchmarks.Giventhelossofliquidityandtheincreaseinvaluationuncertaintythatsomecollateraltypesexperiencedduringthecrisis,theremayalsobebenefitinexploringwhetheradditionalinformationontherangeandnatureofvaluationscouldbeusefulinmeasuringtheextentofvaluationuncertainty.CashInvestorswouldalsobenefitfromunderstandingasrapidlyaspossiblewhenandwherevaluationuncertaintyisincreasing.Lastly,inthecurrentenvironment,therearemanyassetclassesforwhichthevendorsprovidepricingasofthepreviousdayscloseofbusiness.Inavolatilemarket,thisstalepricingcanmisstatethecurrentvalueoftheassets.Asaresult,thereisaneedtoevaluatethepossibilityofprovidingsamedaypricingvaluationsacrossawiderrangeofassetsincludedwithinthetripartyrepomarket.Forallthesereasons,theTaskForcebelievesthatitisdesirabletoestablishafocusedworkinggroupofvaluationspecialiststolookattheseandotherissuesandtomakerecommendations.Recommendation14.

TheTaskForcewillestablishaworkinggroupofvaluationspecialistsacrosstripartyrepomarketparticipantstoevaluatecollateralpricingmethodsandmakerecommendationsforimprovements,includingthefeasibilityofsamedaypricing.(15Oct2010)

Onaregularbasis,bothDealersandCashInvestorsshouldbecomparingortestingvaluationsprovidedbyClearingBanks.CashInvestorsshouldtestthevendorpricesprovidedbytheClearingBanktodetermineifthelevelofovercollateralizationisappropriate.RunningindependentpricinganalysiscanhelpCashInvestorsidentify 28of43


potentialissuesandcorrectthem.CashInvestorsshouldbeabletopricethecollateraltheyreceiveandshouldvalidatetheirpriceswithClearingBanksandDealers.ThissupportsvalidatingthepricesusedbyClearingBanksandincreasespricetransparencyacrossthetripartyrepomarket.DealersshouldlikewiseincludeacomparisonofvaluationsaspartoftheirregularinteractionswithClearingBanks.ThiscouldincludeestablishingbilateraltolerancelevelsthattriggergreaterreviewordiscussionbetweentheDealerandtheClearingBank.Recommendation15.

CashInvestorstoregularlyvalidatetripartycollateralforpricing,appropriateness,andclassification.DealerstoregularlycomparecollateralmarksontheirownbooksandrecordswithvendorpricesprovidedbytheClearingBanks.(Ongoing)

AspecialcaseariseswhentheDealersmarksforagivensecurityaremateriallybelowthepricesprovidedbytheClearingBanks,whichobtainthemfromthirdpartyvendors.Insuchcases,DealersshouldhighlightthevariationstoCashInvestorsandClearingBankstoensurethatrepotransactionsarenotfinancingsecuritiesatlevelsthatwouldimplyamaterialshortfallofmargin,assumingtheDealersvaluationisthecorrectone.Recommendation16.

DealerstoinformCashInvestorsandClearingBanksincaseswheretheDealersmarksaremateriallybelowthevendorpricesprovidedbytheClearingBank.(Ongoing)

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Section9: AssessmentAsdiscussedinSection1ofthisReport,therecentcreditcrisishighlightedmaterialweaknessesintheU.S.tripartyrepomarketthatexposedtheglobalfinancialmarketstosystemicrisk.Theseweaknessescanbegroupedintothefollowingcategories:

OperationalArrangements:ThedailyunwindprocessresultedinthetwoClearingBanksextendingupto$2.8trilliondollarsinintradayfunding.Thisalsoresultedinuncertaintyastowherethecreditexposureresidedthroughouttheday.

DealerLiquidityRiskManagement:ExamplesincludeDealersrelianceonveryshortdatedrepofinancing,aswellasDealersrelianceonuncommittedfundingtosupportthedailyunwindprocess.

MarginingPractices:ProcyclicalmarginingpracticesresultedinalossofliquidityforDealersinastressedmarket.

ContingencyPlanning:InsufficientpreparationformarketparticipantstocopewithaDealerdefault.

Transparency:Themarketgenerallylackedtransparencyintermsofmarketdepthandrisk.Inaggregate,theproposalsthataredetailedinthisReportwilldrasticallyreduce,althoughnoteliminate,manyoftheserisks.Thefollowingparagraphswillsummarize,throughspecificexamples,wherethisriskisreduced.ThepracticaleliminationofthedailyunwindsfornonmaturingtradeswillreducetheintradaycreditbytheClearingBankstolessthan10%9.Atitspeak,thiswouldhaveresultedina$2.5trillionreductioninClearingBankscreditrisk.Furthermore,bypotentiallyresettingthemarketstandardforunwindingmaturingtradesuntillaterintheday,theClearingBanksremainingcreditriskwillbefurtherreducedtoanafternoonwindowperiodinagivendaywithregardstotheunwindprocessformaturingtrades10.InordertoimproveCashInvestorscapacitytomanageaDealerdefault,theRecommendationsinthisReport(1)encourageamoreriskbased,nonprocyclicalmarginingprocessthatwillimprovetheexpectedrecoveryrateinadefaultscenario,and(2)provideanindustrynettingmechanismandsupportanoptionalliquidationagent.Theseenhancementswillimprovetheresiliencyoftheproductasparticipantswillhavegreateraccesstoafullyfunctionaloperationalprocessforcollateralliquidation.FromaDealersperspective,althoughtheamountofintradayfundingrequiredfromtheClearingBanksislimited,atransitionfromuncommittedfundingfacilitiestocommittedfundingfacilitieswouldgreatlyreduceaDealersliquidityrisk.Additionally,bythemarketmovingtoariskbased,nonprocyclicalmarginingprocesstheDealerswillbelesslikelytoseeamassivewithdrawaloffundingastheyenterastressedenvironment.Lastly,theindustryisundertakinganefforttoimprovemarkettransparency.Thistransparencywillcomeinvariousforms:(1)theindustrysfirstmonthlypublicationwhichdetailstheoverallsizeanddepthoftheU.S.tripartyrepomarket,(2)TriPartyRepoBestPracticesguidanceforCashInvestorswhichwilleducateallmarketparticipantsastotherisksoftheproductandthebestpracticestomanagetheserisks,(3)athreeway,realtimetradeconfirmationprocess,and(4)practicaleliminationofthedailyunwindprocesswhichwillensureclarityonintradayexposures.Thiswillsubstantiallyenhancetheabilityforsupervisorsandmarketparticipantstoassesstrendsandcallattentiontoemergingissuesbeforetheybecomesystemicinnature.

9The10%representstheestimatedportionofaDealer'sbookthatmaturesorreceivesinitialfundingonagivenday.10ClearingBanksmayadditionallyprovidesomeintradaycreditrelatedtocashsubstitutionspriortotradematurity.Wedonotexpecttheseamountstobematerial. 30of43


ItisimportanttonotethattheTaskForcewasnotmandatedtoopineontheliquidityriskmanagementpracticesofthevariousDealers.AlthoughtheReporthastouchedbrieflyonsomegeneralbestpracticesonthistopic,italsoseemsclearthatupcomingregulatorychanges(e.g.BaselIII,etc)willfurtherreduce,althoughnoteliminate,theprobabilityofaDealerdefaultbyincreasingcapitalandliquiditystandardsgenerally.Thestandardsproposedinrelationtoliquidityareparticularlyrelevantastheyarelikelytomeanthatlowerqualitycollateralfundedviashortdatedrepomustbematchedbyliquidassetswithinthefirmsliquiditybuffer.Thebenefitsofthesemodificationsareillustratedbythefollowingsimplifiedtransactionexamplesthatcompare(1)thecurrenttripartyframework,and(2)theframeworkafterimplementationofallproposals:Example#1:BusinessAsUsualScenarioRepoTradeIsExtended11

Assumptionso Dealerhasasingle,$1.0bnrepomaturingtodayo DealerandCashInvestoragreetoenterintoanew$1.0bnrepopriortothemorningdeadlineo Thecollateralallocationisstatic(e.g.nocollateralsubstitutionsarerequired)

CurrentMarketProcesso TheClearingBankisnotnotifiedofthenewtradedetailso TheClearingBankextendsa$1.0bnintradayloantotheDealeraspartofthedailyunwind

processo TheClearingBankcreditsa$1.0bndepositintotheCashInvestorsaccounto TheDealerisreliantonadiscretionarylineofcreditfromtheClearingBanktomanagethe

operationalflowsonthistradeo Attheendoftheday:theClearingBankreallocatesthecollateraltotheCashInvestor;

withdrawsthecashdepositfromtheCashInvestorsaccount,andclosesouttheintradayloantotheDealer

o CashInvestorscreditriskistransferredbetweensecuredDealerriskandunsecuredClearingBankdepositrisk.ThetimingofthisrisktransferisunknowntoCashInvestorthroughouttheday

PostTaskForceImplementation

o TheDealer,CashInvestor,andClearingBankconfirmthedetailsofthenewtradeviathethreeway,realtimeconfirmationprocess

o Thetradeisnolongersubjecttothedailyunwindo TheClearingBankwillnotneedtoextendanycredittotheDealerinthecontextofthisexampleo TheCashInvestorhasrepoexposuretotheDealerallday

Example#2:BusinessAsUsualScenarioRepoTradeMatures Assumptions

o Dealerhasasingle,$1.0bnrepomaturingtodayo TheDealerandCashInvestorareunabletoagreeonanewrepotradeo Thecollateralallocationisstatic(e.g.nocollateralsubstitutionsarerequired)o InthePostImplementationTaskForcescenario,theoriginaltradewillbesubjecttotheEndof

DaySettlementtimediscussedinSection4oftheReport.

CurrentMarketProcesso Inthemorning,theClearingBankextendsa$1.0bnintradayloantotheDealeraspartofthe

dailyunwindprocesso TheClearingBankcreditsa$1.0bndepositintotheCashInvestorsaccount

11Withtheexceptionoftheconfirmationprocess,anonmaturingtermtradewillhavesimilarmechanics 31of43


o TheDealerisreliantonadiscretionarylineofcreditfromtheClearingBanktomanagetheoperationflowsonthistrade

o CashInvestorwithdrawsthiscashinthemorningleavingtheClearingBankwithsoleexposuretotheDealer

o Attheendoftheday,theDealerrepaysthe$1.0bntotheClearingBanktocloseouttheintradayloan

PostTaskForceImplementation

o AttheendofthebusinessdayandsubjecttothetermsofthecommittedfundinglineinplacebetweentheDealerandtheClearingBank12,theClearingBankextendsa$1.0bnloantotheDealer,andcredits$1.0bnofcashintotheCashInvestorsaccount

o FromtheDealersperspective,theintradayloaniscommittedsubjecttothetermsoftheagreement

o TheCashInvestorwithdrawsitscashattheendofthedayo TheDealerwillrepaytheintradayloanpriortotheendoftheday

Example#3:DealerStressScenario($1.0bnrepotradedoesnotmatureduetoDealerdefault) Assumptions

o Dealerhasasingle,$1.0bnrepomaturingtodayo InthePostImplementationTaskForcescenario,Dealerisunabletomeetthetermsofits

committedintradayfundingfacilityfromtheClearingBank(e.g.unabletopostthenecessarycollateral),andtheDealerisunabletorepaytheprincipalamountdue

CurrentMarketProcess

o Duetothestressinthemarket,thereisgeneraluncertaintyastohowtheunwindprocesswillwork: TheClearingBankmayormaynotunwindthistrade TheDealerdoesnothaveanyclarityastowhetherthetradewillunwind TheCashInvestordoesnotknowif/howthematuringtradewillbeunwound IfthetradeisnotunwoundandtheDealerdefaults,thereisuncertaintyregardingthe

liquidationprocess

PostTaskForceImplementationo Attheendoftheday,theClearingBankmakesamargincalltotheDealer;Dealerisunableto

meetthecallo PerthetermsofthecommittedfundingfacilitytheClearingBankwillnotunwindthematuring

trade(i.e.nocreditwillbeextendedtotheDealer,collateralwillremainintheCashInvestorsaccount).Asaresult,theCashInvestorwillretainitsrisktotheDealer

o Attheendoftheday,iftheDealerhasnotrepaidtheprincipaldue,thecollateralliquidationprocesswillbegin Theindustrynettingprocesswouldpairofftradestoreducetheinventorythatwillbe

deliveredtotheCashInvestors Ifelected,theremainingcollateralafternettingwillbetransferredtothethirdparty

liquidationagentwhowillactonbehalfoftheCashInvestor Ingeneral,theCashInvestorwillbebetterpreparedtomanagethisscenarioduetotheir

improvedcontingencyplanning

12Termsmayincludemaximumfundingcapacity,collateraleligibility,definedhaircuts,etc 32of43


Section10: NextStepsUponthepublicationofthisReporttheTaskForcesoriginalmandatewillbecompleted.However,inordertomaintainthecurrentmomentumthroughtoexecution,theTaskForceproposestotakeownershipoftheimplementationphasefromacollectiveindustryperspective.ThisproposalisintendedtocombinethebenefitsofcontinuitywiththeflexibilitytoevolvetheTaskForceandtheindividualsthatareparticipating.TheTaskForcealsorecognizesthatothergroupingsmayintimebeseenasmorenaturalpointsofgovernanceforcertainissuesdiscussedinthisReport.Nevertheless,theTaskForcebelievesthegreaterconcernintheshortrunmustbetomaintainmomentumanddrivetheoperationalimprovementsneededinthetripartyrepoinfrastructure.Accordingly,thefocusoftheTaskForcesnextphasewillconsistof:(1)theexecutionofitsRecommendations,inparticulartheindustryactionplantoimprovetripartyrepooperationalarrangements,and(2)analyzingandadaptingtheseRecommendationsbaseduponpotentialregulatorydevelopmentsandresponsestotheFederalReservesWhitePaper.TheTaskForcewillmaintainaworkinggroupfocusedprimarilyonoperationalinfrastructureimprovementsandwillestablishasecondworkinggrouponvaluationissuesasoutlinedintheRecommendations.TheTaskForcewillalsocontinuetoseekinputfrommarketparticipantsnotdirectlyrepresentedontheTaskForce.TheTaskForcewishestothankallmarketparticipantsandstaffatofficialagencieswhoprovidedinputorotherwisecontributedtothisReport.AfulllistingoftheTaskForcemembersandthosewhocontributedtoitsworkstreamsisincludedasAnnex4oftheReport.

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Section11: AnnexesAnnex1MinimumParametersRequiredforTradeMatchingAminimumnumberofparametersmustagreeinorderforabookedtradetobematched.Theseparametershavebeenlistedanddefinedbelow.Therearecertaineconomictermsofarepotrade,suchastheactualbenchmarkused,whichmaynothavebeendefinedintheinitialbooking,butwhicharenotrequiredforasuccessfulmatch.Allfieldslistedbelowmustbepopulated,atleastwithdefaultvalues.Nofieldscanbeblankunlessotherwisenotedbelow.1. Buyerlegalentity.TheBuyerslegalname.Fortheinitialmorningtrades,priortobeneficialownersub

accountallocationsbeingready,theBuyerslegalnamemaybelongtothetopaccountowner,theinvestmentadvisor,oranotheraffiliatedentityrepresentingtheeventualbeneficialowner(s).Intheafternoon,onceallocationsareavailable,thisfieldwouldbepopulatedwithbeneficialownerslegalname.

2. Sellerlegalentity.TheSellerslegalentityname.3. Transactiontype.(Repo,B/P,[other])ThedefaultwouldbeRepo.4. Tradedate.(MM/DD/YYYY)Thedatethetradestermsareagreed.5. Settlement/startdate.(MM/DD/YYYY)ThedateonwhichtheBuyerscashbeginsfundingtheSellers

inventory.6. Currency.(CCY)ThiswilldefaulttoUSD.7. Principal.Thesizeoftherepofinancing,listedintheunitsofCCY.8. Ratetype.(fixedorfloating)9. Rate.(NNNNbps)IfRatetypeisfixed,thefixedrateisentered.IftheRatetypeisfloating,theapplicable

spreadtothebenchmarkwouldbeincluded.Thebenchmarkwouldbeincludedinasubsequentcommunication.

10. Maturitydate.(MM/DD/YYYY)Thedatewhenatradematures,whetheritisanovernighttradeoratermtradelongerthanovernight.OpentradeswillhaveastandardrepresentationTBDinthisfield.

11. Collateraltypeidentification.TheSellerandBuyerwillinputthesameidentifiertorepresentthecollateralagreedtounderthetrade.TheClearingBankwillneedtobeabletorecognize,attheveryleastatahighlevel,whatthiscollateralbasketis(e.g.,Treasuries,commonequities,etc.)inordertodoallocations.Note:thismayrequireastandardcollateralclassificationacrossallmarketparticipants,aswellasmorestandardcollateralschedules.

12. Blocktradeidentification.ThisfieldisnecessarytobepopulatedbytheMatchingServiceinorderforsubsequentallocationstobeneficialownersubaccountscancancelandreplacetheoriginalearlymorningtopaccounttrades.Thiswillonlybeusedfortradesthathaveafternoonallocations.

13. Initial/RevisedBreakdown.(Willbecomefinalbreakdownifnosubsequentsubmissionreceivedat"endofday"tobedefined)

14. Morning/Afternoonsettlement.(Ifconventionisadoptedbyindustry)15. RolledTrade.(Y/N)

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Annex2SummaryofWorkoftheLegalSubcommitteeoftheTaskForceonTriPartyRepoInfrastructureOverviewUndertheleadershipoftheFederalReserveBankofNewYork,theLegalSubcommitteeoftheTriPartyRepoTaskForceincludedlegalrepresentativesfromCashInvestors(assetmanagers/repoBuyers,Dealers(repoSellers),andClearingBanks.TheworkoftheLegalSubcommitteefocusedontryingtoprovidelegalsolutionstothefollowingtwochallengesinthetripartyrepomarket:

1. Confirmingthelegalcertaintyregardingrepocommitmentsmadeearlyinthedaybetweenvariousfundsand/orjointaccount(s)andtheirDealercounterparties(onaprincipaltoprincipalbasis)whilemaintainingflexibilitytochangeallocationstospecificprincipalsaftertheoverallcommitmentisestablished;and

2. EliminatingthedailyunwindofcashandcollateralcurrentlyperformedbytheClearingBanksinrespectoftermrepurchasetransactionsand,tothegreatestextentpossible,eliminatingthedailyunwindofcashandcollateralperformedbytheClearingBanksinrespectofallotherrepurchasetransactions.

TheproposaloftheLegalSubcommitteeisdescribedbelow,inbroadterms.Thisproposalisintendedtocoveralltypesofrepurchasetransactions,includingtransactionswhichinvolvejointtradingaccountsaswellastransactionsinvolvinggovernmentandnongovernmentsecurities,withtheunderstandingthattherewillnolongerbedailyunwindsfortermrepurchasetransactions.Inaddition,theLegalSubcommitteethoughtitwasimportanttonotethateachtimeaCashInvestorandaDealerenterintoanewrepur

FRB Report_100517-Clearing Banks as Loan Funders-BONY

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