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From Securities Regulation Daily, April 26, 2013

With Bow to SEC, FSOC Annual Report Urges Reform of Money Market Fund Regulation

By Jim Hamilton, J.D., LL.M.

With a shout-out to the SEC, the Financial Stability Oversight Council (FSOC) in its annual report to Congress urged the reform of the regulation of money market funds to prevent runs that could destabilize the U.S. financial system. For the same reason, reform of the tri-party repo market must be completed. More broadly, while FSOC found that the implementation of the Dodd-Frank Act has established a more resilient and stable financial system, significant risks to financial stability remain. The report was signed by all members of the Council, including SEC Chair Mary Jo White and CFTC Chair Gary Gensler.

Money market funds. FSOC is concerned about vulnerability to runs in wholesale funding markets that can lead to destabilizing fire sales. The report notes that the susceptibility of money market funds to runs could trigger fire sales of assets, impair the flow of short-term financing, and propagate strains throughout the financial system. In the past year, the Council took concrete steps in supporting the implementation of reforms to mitigate structural vulnerabilities of money market funds. In November 2012, the Council issued three alternative proposals for money market fund reform under Section 120 of the Dodd-Frank Act: (1) a floating net asset value (NAV) for money market funds; (2) the introduction of a NAV buffer and a minimum balance at risk for investors; or (3) a risk-based NAV buffer of 3 percent in addition to other measures.

The Council received approximately 150 comment letters on its proposed recommendations and is in the process of reviewing those comments. FSOC has believed and continues to believe that the SEC, by virtue of its institutional expertise and statutory authority, is best positioned to implement reforms to address the risk that money market funds present to the economy. If the SEC moves forward with meaningful structural reforms of money market funds before the Council completes its Section 120 process, the Council said, it would not issue a final Section 120 recommendation to the SEC.

The Council understands that the SEC is currently in the process of considering further regulatory action. To inform this examination, SEC staff produced a report, requested by certain SEC commissioners, on the causes of investor redemptions in prime money market funds during the 2008 financial crisis, on changes in certain characteristics of money market funds before and after the SEC’s 2010 modifications to money market fund regulation, and on the potential effect of further reform on investor demand for money market funds and alternative investments.

The Council urged the SEC to consider the views expressed by commenters on the Council’s proposed recommendations, and also by the comments of the Council itself, as the Commission considers any regulatory action to improve loss-absorption capacity and mitigate the susceptibility of money market funds to runs. The Council further asked its members to examine the nature and impact of any structural reform of money market funds that the SEC implements to determine whether the same or similar reforms are warranted for other cash-management vehicles, including non-Rule 2a-7 money market funds. In FSOC’s view, 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.

In a colloquy with then Treasury Secretary Tim Geithner (the Treasury secretary is the permanent Chair of FSOC) during his appearance before the Senate Banking Committee, Senator Robert Corker (R-Tenn) said that FSOC can act if the SEC fails to move forward with money market fund reforms beyond the 2010 reforms that the SEC has already effected. Like FSOC, Senator Corker is concerned that a run on money market funds could create systemic risk.

Tri-party repo market. There has been some progress in reforming the tri-party repo market, though vulnerabilities to fire sales remain, said the annual report. But the tri-party repo market remains vulnerable to runs by lenders in the event that concerns emerge regarding the financial condition of borrowers, such as securities broker-dealers, who depend heavily on this channel for short-term funding.

Additional risks stem from the continued heavy reliance on discretionary intraday credit in the settlement process and the limited capacity of lenders to manage the ramifications of a default by a major borrower. Some progress has been made in increasing the resiliency of the tri-party market. The reliance on intraday credit extended by the clearing banks has begun to decline and, as additional changes are made to the settlement process, should be largely eliminated by the end of 2014. Nonetheless, FSOC said that a default of a large broker-dealer or other large borrower would leave lenders with large volumes of collateral that they would likely seek to liquidate quickly.

Financial benchmarks. FSOC is also concerned about the reliance on reference interest rates, which recent investigations have demonstrated were manipulated, particularly in the case of the London Interbank Offered Rate (LIBOR). However, the Council feels that the international regulatory community is moving forcefully to reform the governance and integrity of LIBOR and to consider transitions towards alternative benchmarks.

In the United Kingdom, the Financial Services Authority has implemented reforms of LIBOR based on the recommendations of the Wheatley Review, which include a number of major revisions to the system of governance, calculation, and oversight. Committees across multiple international regulatory agencies are further engaged in developing improved governance and reporting frameworks for reference rates and considering alternative benchmarks.

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