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[Senate Hearing 112-746]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 112-746

            THE TRI-PARTY REPO MARKET: REMAINING CHALLENGES

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             SECOND SESSION

                                   ON

                  EXAMINING THE TRI-PARTY REPO MARKET

                               __________

                             AUGUST 2, 2012

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

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                 Available at: http: //www.fdsys.gov /

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80-130 PDF                WASHINGTON : 2013
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                     Riker Vermilye, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

              MIKE CRAPO, Idaho, Ranking Republican Member

CHARLES E. SCHUMER, New York         PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey          MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
HERB KOHL, Wisconsin                 JIM DeMINT, South Carolina
MARK R. WARNER, Virginia             DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota

                Kara Stein, Subcommittee Staff Director

         Gregg Richard, Republican Subcommittee Staff Director

                    Catherine Topping, FDIC Detailee

                                  (ii)

                            C O N T E N T S

                              ----------                              

                        THURSDAY, AUGUST 2, 2012

                                                                   Page

Opening statement of Chairman Reed...............................     1
    Prepared statement...........................................    23

                               WITNESSES

Matthew J. Eichner, Deputy Director, Division of Research and 
  Statistics, Board of Governors of the Federal Reserve System...     3
    Prepared statement...........................................    24
    Responses to written questions of:
        Chairman Reed............................................    35
Karen B. Peetz, Vice Chairman, The Bank of New York Mellon.......     5
    Prepared statement...........................................    28
Steven R. Meier, Executive Vice President, Chief Investment 
  Officer, State Street Global Advisors..........................     7
    Prepared statement...........................................    30
Thomas G. Wipf, Managing Director and Global Head of Bank 
  Resource Management, Morgan Stanley............................     9
    Prepared statement...........................................    32

              Additional Material Supplied for the Record

Statement submitted by the Investment Company Institute..........    38

                                 (iii)

 
            THE TRI-PARTY REPO MARKET: REMAINING CHALLENGES

                              ----------                              

                        THURSDAY, AUGUST 2, 2012

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 9:01 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Jack Reed, Chairman of the 
Subcommittee, presiding.

             OPENING STATEMENT OF SENATOR JACK REED

    Chairman Reed. Let me call the hearing to order. I first 
want to thank my colleague the Ranking Member, Senator Crapo, 
and his staff for participating, and particularly at this early 
hour. I have another hearing on Appropriations later, so we had 
to move it up.
    I want to thank the panel for being here, for your 
excellent testimony, and also for cooperating with our time 
shift.
    Today our hearing is entitled ``The Tri-Party Repo Market: 
Remaining Challenges''. Last week, Secretary Geithner presented 
the Financial Stability Oversight Council's second annual 
report to Congress. The Council is responsible for providing us 
with a comprehensive, coherent overview of the health of our 
financial system, a direct result of the Dodd-Frank Act in 
terms of trying to alert Congress and the Nation to potential 
systemic problems, giving us time to respond, not at the last 
moment when we are in crisis mode.
    The Council report identified structural vulnerabilities in 
the short-term funding markets, particularly the tri-party 
repurchase, or repo, market, as a continuing area of concern. 
The report states that ``limited progress has been made in 
substantially reducing the reliance of this market on intraday 
credits or improving risk-management and collateral practices 
to avoid fire sales in the event of a large dealer default.''
    The Council also stated that the industry's suggestion that 
it will take several more years to eliminate the intraday 
credit associated with tri-party settlements was, in their 
words, unacceptable and called for greater Government 
involvement. And that is one of the reasons why we are 
convening this hearing and asking experts to comment upon where 
do we go from here.
    In general, a repo or repurchase agreement is the sale of a 
portfolio of securities with an agreement to repurchase that 
portfolio at a later date; the economics of repos are similar 
to that of short-term loans collateralized by long-term assets. 
Tri-party repos are typically used by large securities firms 
and bank holding companies with broker-dealer operations to 
raise short-term financing from cash investors, such as money 
market mutual funds. The dealer and the investor typically use 
one of two clearing banks to settle their transactions.
    This market is very large. Tri-party repos peaked at $2.8 
trillion at the height of the crisis in 2008 and today are 
roughly $1.8 trillion.
    Three major weaknesses of the tri-party market were 
highlighted by the 2008 financial crisis: the market's reliance 
on intraday credit from the clearing banks, the procyclicality 
of risk management practices, and the lack of effective plans 
to support the orderly liquidation of a defaulted dealer's 
collateral.
    Motivated by these risks, in 2009 the Federal Reserve Bank 
of New York formed an industry-led task force to address the 
problems highlighted by the financial crisis. Although this 
task force disbanded in early 2012, its work led to a number of 
important changes, including: moving the daily unwind of some 
tri-party repo transactions from 8:30 a.m. to 3:30 p.m. which 
shortens the period of intraday credit exposure; implementing a 
mandatory three-way trade confirmation between dealers, cash 
investors, and the clearing banks, marking the first time this 
$1.8 trillion market has had an established confirmation 
process; publishing of a monthly report regarding activity in 
the tri-party repo market, which includes the size of the 
market, collateral breakdowns, dealer concentrations, and 
margin levels. This report enhances the ability of supervisors 
and market participants to assess trends and call attention to 
emerging issues before they become systemic.
    However, as I indicated before, in its 2012 report, the 
FSOC found that limited progress has been made in substantially 
reducing the reliance of this market on intraday credits or 
improving risk management and collateral practices to avoid 
fire sales in the event of a large dealer default. The Council 
also stated that that the industry's suggestion that it will 
take several more years to eliminate the intraday credit 
associated with tri-party settlements was unacceptable.
    Because FSOC has sounded an alarm about the tri-party repo 
market and stated the need to move quickly in implementing 
further reforms, we have convened this morning's hearing to 
discuss the report, better understand the changes to this 
market already in place, and explore what more needs to be 
done.
    Improving the tri-party repo market will make it safer, to 
the benefit of all market participants. And I also want to 
indicate, too, since mutual funds are a large part of this 
market, to the extent that we can improve the quality of this 
market, I think we will help in other areas as we all know 
those serious discussions from SEC and others about further 
changes to the money market fund market. But these are 
interrelated issues, and a strong repo market will, in fact, I 
think, help immensely with respect to the profitability and to 
the stability of money market funds.
    With that, let me introduce my Ranking Member for his 
comments. Thank you.
    Senator Crapo. Thank you very much, Senator Reed. I 
appreciate your holding this oversight hearing, and I have a 
prepared opening statement, but you just made all the points 
that I had in my opening statement, so rather than repeat 
them----
    Chairman Reed. Not as well, but----
    [Laughter.]
    Senator Crapo. Rather than repeat them, maybe I will submit 
my statement for the record and we can proceed.
    Chairman Reed. Without objection.
    Senator Crapo. I note that we have an outstanding panel 
today, and I expect that we will be able to make some serious 
and helpful progress on this issue, so I look forward to the 
witnesses' testimony.
    Thank you.
    Chairman Reed. Thank you very much, Senator Crapo.
    Let me introduce the panel and then recognize them. Our 
first panelist is Mr. Matthew Eichner. Mr. Eichner is currently 
Deputy Director of the Division of Research and Statistics at 
the Federal Reserve Board, where he focuses on issues related 
to securities markets and dealers in securities and 
derivatives. Prior to joining the Board staff, Mr. Eichner was 
an Assistant Director in the Division of Trading and Markets at 
the Securities and Exchange Commission. Thank you.
    Ms. Karen Peetz is the vice chairman with responsibility 
for the Financial Markets and Treasury Services Group within 
BNY Mellon. Ms. Peetz is a member of BNY Mellon's Executive 
Committee, the organization's most senior management body which 
oversees day-to-day operations. Before joining BNY Mellon, you 
spent 16 years with JPMorgan Chase. Thank you.
    Mr. Steven Meier is an executive vice president of State 
Street Global Advisors and is the global cash chief investment 
officer. He has more than 28 years of experience in the global 
cash and fixed-income markets. He held senior positions in 
trading and investment banking while working for Merrill Lynch 
and Credit Suisse First Boston for nearly 12 years. Thank you, 
Mr. Meier.
    Mr. Tom Wipf is managing director and global head of bank 
resource management for Morgan Stanley. He is responsible for 
the firm's secured funding, securities lending, collateral 
management, and counterparty portfolio management activities. 
Tom has been with Morgan Stanley since 1986. He served as a 
member of the Tri-Party Repo Infrastructure Reform Task Force 
Committee, the private sector body sponsored by the Federal 
Reserve Bank of New York to address reforms in the tri-party 
repo market.
    Thank you all. Your testimony will be made part of the 
record. Not only feel free but please limit your comments to 
roughly 5 minutes so we can proceed to questions.
    Mr. Eichner, please.

 STATEMENT OF MATTHEW J. EICHNER, DEPUTY DIRECTOR, DIVISION OF 
  RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL 
                         RESERVE SYSTEM

    Mr. Eichner. Thank you. Chairman Reed, Ranking Member 
Crapo, and Members of the Subcommittee, thank you very much for 
inviting me to appear before you today to discuss the tri-party 
repo market. The Federal Reserve has a strong interest in the 
smooth functioning and resiliency of this market for several 
reasons:
    First, the market serves as a tool for cash and liquidity 
management as well as short-term borrowing for a wide range of 
financial intermediaries, including money market funds, 
insurance companies, banks, and securities dealers, all of 
which play an important role in supporting the savings and 
investment programs of households, small businesses, and 
nonfinancial corporations.
    Second, a number of entities subject to direct prudential 
supervision by the Federal Reserve are significant 
participants, including the holding companies of the two 
clearing banks--JPMorgan Chase and BNY Mellon--as well as many 
other bank holding companies.
    Finally, tri-party funding materially supports the depth 
and liquidity of a number of critical markets, including those 
for U.S. Government securities in which U.S. monetary policy is 
executed.
    In light of the critical importance of the tri-party repo 
market, the Federal Reserve has been and is committed to 
working with market participants and other supervisory and 
regulatory organizations to enhance the market's resiliency. 
During the crisis, it became apparent that the design of the 
market's infrastructure to settle transactions had fundamental 
flaws that could lead to serious instability during periods of 
market stress.
    A particular weakness was the reliance on large amounts of 
discretionary intraday credit extended by the clearing banks 
which could create incentives for both clearing banks and 
lenders, such as money market funds, to rapidly withdraw from 
the market. In fact, such run dynamics were visible around the 
time of the near failure of Bear Stearns in March 2008 and 
again during the worsening of the crisis in mid-September of 
that year after the bankruptcy of Lehman Brothers.
    Some significant progress has been made subsequently to 
address this vulnerability, but not as much--or as quickly--as 
we believe that the seriousness of the situation warrants. 
Clear vulnerabilities remain, even now that the tri-party 
market is smaller than at its precrisis peak and, in general, 
funds higher-quality collateral than was the case prior to the 
crisis.
    The Federal Reserve, therefore, continues to be fully 
engaged on a number of fronts to promote further measures that 
will more completely mitigate the risks. We are also working 
with the Securities and Exchange Commission, which plays a key 
role as the primary regulator of major participants in the tri-
party repo market, including broker-dealers and many cash 
lenders, notably money market funds.
    Following the financial crisis, an industry-led Tri-Party 
Repo Infrastructure Reform Task Force was formed in 2009 as an 
initiative of the Payments Risk Committee, a private sector 
body convened by the Federal Reserve Bank of New York. The task 
force included representatives of market participants, such as 
cash lenders, dealers, clearing banks, and other service 
providers, as well as industry groups representing both dealers 
and investors.
    In its May 2010 interim report, the task force dealt 
directly with the issue of reliance on intraday credit 
extension, creating a detailed plan for its practical 
elimination by mid-2011. In fact, participants achieved some 
important prerequisites to this goal last year. However, it 
became clear last year that more fundamental changes to systems 
at both clearing banks and on the part of other market 
participants as well as associated adjustments to market 
practices would take significantly longer to implement.
    The Federal Reserve responded on several fronts to 
meaningfully address the tri-party market's continued heavy 
reliance on discretionary credit in 2011. Notably, the Federal 
Reserve has used supervisory tools to encourage market 
participants, over which it has direct authority, a group which 
includes but is not limited to the clearing banks, to implement 
the task force recommendations in a timely fashion.
    While eliminating the daily unwind and reducing reliance on 
intraday credit will materially reduce the potential for a 
recurrence of many of the problems evident during the financial 
crisis, other vulnerabilities will remain. A particular concern 
of the Federal Reserve and also reflected in the Financial 
Stability Oversight Council's most recent annual report 
involves the challenge of managing the collateral of a 
defaulting securities dealer in an orderly manner. A solution 
to this so-called fire sale problem likely requires a market-
wide collateral liquidation mechanism, but the challenges in 
designing and creating a robust mechanism are appreciable and 
most surely need to be the focus of much additional study.
    Given the importance of the tri-party repo market and the 
potential consequences of its vulnerabilities, enhancing the 
market's resiliency and its settlement system remains an 
important regulatory and financial stability priority. Building 
on the work of the task force, we believe that supervisory 
efforts will yield substantial progress in eliminating the 
reliance of the tri-party market on intraday credit, although 
not perhaps as quickly as many of us had hoped, and in 
improving risk management practices across a range of market 
participants.
    A significant remaining challenge, however, is the 
development of a process to liquidate in an orderly fashion the 
collateral of a defaulting dealer that would operate reliably 
in the context of the settlement system organized around 
clearing banks.
    Thank you once again for the invitation to appear before 
you today to share the perspectives of the Federal Reserve on 
these important issues. I would be pleased to answer any 
questions you may have.
    Chairman Reed. Thank you very much.
    Ms. Peetz, please.

  STATEMENT OF KAREN B. PEETZ, VICE CHAIRMAN, THE BANK OF NEW 
                          YORK MELLON

    Ms. Peetz. Chairman Reed, Ranking Member Crapo, and Members 
of the Subcommittee, my name is Karen Peetz, and I am vice 
chairman of The Bank of New York Mellon and CEO of the 
company's Financial Markets and Treasury Services businesses. I 
appreciate the opportunity to appear before you today to 
discuss the tri-party repurchase, or repo, market in the United 
States.
    I would like to begin by briefly describing the history and 
operations of BNY Mellon as our business model is very distinct 
from traditional retail or investment banks.
    In contrast to most global banking organizations, our 
business model does not focus on the broad retail market: We do 
not offer credit cards, traditional mortgages, auto loans, or 
similar products to retail consumers. Rather, we are a provider 
of services that help major financial institutions access 
funding and support the operational infrastructure of the 
global capital markets.
    Before I address the topic of today's meeting, let me begin 
by stressing BNY Mellon's support for recent U.S. and 
international regulatory reforms that have strengthened our 
financial system, including the Dodd-Frank Act. We have 
heartily endorsed meaningful reforms that will strengthen the 
banking sector, guard against future systemic shocks, and 
encourage economic expansion.
    For the purposes of my testimony today, I will focus on 
three issues: first, how the tri-party repo market operates; 
second, BNY Mellon's role supporting the tri-party repo market; 
and, third, ongoing reform efforts aimed at reducing risk.
    Tri-party repo transactions are a type of repurchase 
agreement involving a third party, the tri-party agent--the 
function plaintiff BNY Mellon. The tri-party agent facilitates 
settlement between dealers--or cash borrowers--and investors--
or cash lenders. The tri-party agent maintains custody of the 
collateral securities, processes payment and delivery between 
the dealer and the investor, and provides other services, 
including settlement of cash and securities, valuation of 
collateral, and optimization tools to allocate collateral.
    According to the Financial Stability Oversight Council's 
2012 Annual Report the current value of the tri-party repo 
market is $1.8 trillion. BNY Mellon is a substantial tri-party 
agent, with an approximately 80-percent market share. Our 
involvement in a transaction commences after a broker-dealer 
and a cash investor agree to a tri-party repo trade and send 
instructions to BNY Mellon. These instructions represent the 
parties' agreement concerning the tenor of the transaction, the 
amount of cash lent, the value and type of collateral returned, 
and the repo rate.
    To facilitate the tri-party repo market, we extend secured 
intraday credit to dealers to repay their investors from the 
prior day's trades. If a dealer becomes distressed, we could 
refuse to extend such credit and investors could withdraw from 
the market. Both of these actions could lead to destabilization 
in the economy. Once a tri-party trade settles, BNY Mellon is 
no longer exposed to direct risk of the dealer or the 
underlying securities. Thereafter, the ultimate risks 
associated with a defaulting dealer who has pledged collateral 
are with its cash investors.
    After the financial crisis, the Federal Reserve asked 
clearing banks, primary dealers, and investors to consider 
policy options to address problems with tri-party repo 
infrastructure that were revealed during the financial crisis, 
which led to the creation of the Tri-Party Repo Infrastructure 
Reform Task Force--in which BNY Mellon participated. The task 
force published its final report in February of 2012 
summarizing the current state of reform efforts.
    With respect to reducing intraday credit provided by BNY 
Mellon to facilitate the tri-party repo market, we are 
implementing recommendations made by the task force. We have 
moved to a later day unwind for most maturing tri-party repos, 
reducing the intraday risk exposure window from 10 to 
approximately 3 hours. We have instituted an ``auto 
substitution'' process to allow dealers to replace needed, 
pledged collateral by first overcollateralizing with cash. 
Additionally, BNY Mellon introduced a three-way trade 
confirmation process known as automated deal matching for 
dealers, agents, and investors. The trade matching enhancements 
allow BNY Mellon, as the clearing bank, to receive both the 
dealer and cash investor's trade instructions separately and 
match the required information fields systematically. These 
measures have already significantly reduced intraday credit 
exposure.
    BNY Mellon is identifying asset classes eligible for 
intraday credit associated with tri-party repo transactions, 
and we are working with our clients to eliminate intraday 
credit associated with less liquid forms of collateral. We 
expect these measures to reduce intraday exposures by $230 
billion by early next year. Moreover, we are developing the 
technology for a systematic approach for reforming the entire 
unwind process that will practically eliminate exposures by the 
end of 2014. As we develop and implement these measures, we are 
working closely with our clients and the Federal Reserve to 
ensure that these changes are adopted in a manner and on a 
timetable that does not unduly disrupt the market.
    Specific to the pace of reforms, I would note that the 
measures we have already implemented have materially reduced 
intraday credit exposures.
    Again, I thank you for the opportunity to testify before 
you today and look forward to any questions you may have.
    Chairman Reed. Thank you very much.
    Mr. Meier, please.

 STATEMENT OF STEVEN R. MEIER, EXECUTIVE VICE PRESIDENT, CHIEF 
        INVESTMENT OFFICER, STATE STREET GLOBAL ADVISORS

    Mr. Meier. Chairman Reed and Senator Crapo, thank you for 
the opportunity to appear before you today. My name is Steven 
Meier, and I am the chief investment officer of global cash 
management at State Street Global Advisors, the investment 
management business of State Street Corporation. The Committee 
has asked me to provide an investor's perspective on the tri-
party repurchase market settlement mechanism, with a specific 
focus on the systemic risk reducing initiatives recommended by 
the Federal Reserve Bank of New York's Tri-Party Repo 
Infrastructure Reform Task Force.
    State Street had the privilege of participating in this 
task force and agrees with the initiatives put forward. We are 
prepared to further adjust our operating model in order to 
address the remaining systemic risk concerns. I hope my 
testimony today will assist the Committee in its important 
work.
    Let me begin with a brief description of my background and 
experience. I have over 28 years' experience in financial 
services, with a focus on money markets, bonds, global cash, 
and financing. Today I am an executive vice president of State 
Street and chief investment officer of the cash asset class. I 
am a member of SSgA's Senior Management Group and Investment 
Committee and manage a team of 40 investment professionals 
dedicated to cash and short-term asset strategies around the 
world. Our clients include State and local governments, private 
pension funds, corporations, endowments, and charitable trusts, 
among others.
    State Street is one of the world's leading providers of 
financial services to institutional investors with nearly $22 
trillion in assets under custody and administration and almost 
$2 trillion of assets under management. SSgA manages global 
cash and short-term assets of approximately $400 billion, of 
which over $300 billion is denominated in U.S. dollars. Our 
investment activities in the U.S. span a range of asset types, 
including U.S. Treasury and Government agency debt, municipal 
debt, unsecured bank and corporate obligations, asset-backed 
securities, and other similar instruments including repurchase 
agreements, which are a key focus and core competency at our 
firm.
    On behalf of our clients, SSgA is an investor and provider 
of funding in these repurchase agreement transactions. Our 
average total U.S. dollar repurchase transaction volume 
outstanding consistently exceeds $100 billion, most of which 
settle and are collateralized through the tri-party mechanism. 
Collateralization provides diversification away from unsecured 
credit exposure and a generally favorable risk/return dynamic. 
The tri-party mechanism provides significant operational 
efficiencies, settlement risk reduction, and collateral 
diversification, delivering transaction scale and investment 
capacity. Without these benefits, our repurchase agreement 
investment activities would be a fraction of what they are 
today.
    Tri-party repurchase transactions provide asset managers an 
excellent alternative for maintaining core portfolio liquidity 
as well as an instrument to enhance returns through 
transactions involving a broader range of collateral. Core 
portfolio liquidity is typically maintained through repurchase 
transactions collateralized with traditional forms of 
collateral, including U.S. Treasury bills, bonds, and notes, 
Government agency obligations, and Government agency mortgage-
backed securities. Core liquidity trades are executed for 
tenors of 1 to 7 days.
    In comparison, portfolio yield enhancement is often 
achieved through repurchase transactions collateralized with 
nontraditional or alternative forms of collateral, including 
investment grade corporate bonds, money market instruments, 
municipal obligations, asset-backed securities, high-yield 
bonds, and equities. Yield enhancement trades are typically 
executed for periods ranging from 1 week to 1 year.
    SSgA has considerable resources committed to the ongoing 
support of these transactions and managing the risks associated 
with them, including dedicated senior portfolio managers, 
specialized technology infrastructure, collateral analysts, 
legal expertise, and senior management oversight. We actively 
review, assess, and manage repurchase agreement collateral 
daily.
    Implementation of the task force recommendations has 
resulted in considerable progress toward reducing the system 
risk associated with these transactions. Through altering trade 
processing timelines and protocols, the industry has achieved 
real progress. However, there is still work to be done to 
eliminate these risks. Additional systems enhancements and 
trade processing efficiencies are required to reach this 
objective and are in process.
    It should be noted, however, the industry has made 
significant progress in transaction risk mitigation through 
ongoing task force discussions and findings. Specifically, 
participants are now more aware of the need for counterparty 
default contingency planning, the requirement of knowing both 
your counterparty and your collateral, the benefits of maturity 
extension, the required analysis and judgment concerning 
collateral suitability, and the benefits of dynamic margining.
    SSgA has a strong interest in ensuring that these important 
money market investment arrangements and supporting settlement 
mechanism continue to be viable aspects of the U.S. market.
    Thank you for the opportunity to be here today to speak on 
this subject. I would be pleased to answer the Committee's 
questions.
    Chairman Reed. Thank you very much.
    Mr. Wipf, please.

STATEMENT OF THOMAS G. WIPF, MANAGING DIRECTOR AND GLOBAL HEAD 
          OF BANK RESOURCE MANAGEMENT, MORGAN STANLEY

    Mr. Wipf. Thank you. Chairman Reed, Ranking Member Crapo, 
and Members of the Subcommittee, thank you for inviting me to 
appear before you today. My name is Thomas Wipf, and I am a 
managing director at Morgan Stanley, responsible for the firm's 
bank resource management. Thank you again for the opportunity 
to discuss this very important issue in the markets for secured 
funding.
    As an active member participant in the work of the Tri-
Party Reform Committee, Morgan Stanley remains fully committed 
to accomplishing the goals laid out by the committee within a 
timeline that is ambitious and acceptable to all stakeholders. 
Our firm views this work as a top priority and a critical path 
in our own funding and liquidity strategy. As the committee's 
recommendations continue to be processed, we have seen 
meaningful benefits and risk reduction on a market-wide basis. 
Morgan Stanley agrees with the Financial Stability Oversight 
Council that more needs to be done and the delay in soundly 
eliminating intraday credit risks is unacceptable.
    Secured funding is an important funding source and a 
foundational component of our centralized liability management 
strategy. We are committed to and have taken significant steps 
to put all the recommendations into practice at our firm. We 
have heard clearly from the secured funding investor community 
that the collateral management services provided by the 
clearing banks are an important element of their collateral 
valuation and risk management process.
    The significant stability issues that appeared in 2008 
provided the committee, our regulators, and all tri-party 
market participants--bank dealers, cash investors, and the two 
clearing banks--with a road map for reform. Many long-held 
assumptions around durability, settlement, credit exposure, 
agent versus principal relationships, and contingency planning 
were proven wrong or overly optimistic during a period of 
significant stress in the broad funding markets. The major 
factors for the instability were the short tenor of funding, 
particularly for less liquid assets; lack of transparency 
regarding collateral for investors; insufficient 
overcollateralization on less liquid assets; and uncertainty 
regarding credit counterparties during the period between trade 
maturity and settlement. Additionally, a heightened market-wide 
aversion to counterparty risk contributed to the instability of 
the platform.
    We believe that the Tri-Party Reform Committee identified 
all of these weaknesses and defined the issues requiring 
remediation. In implementing these recommendations, we see the 
remaining strategic issues falling into three categories: 
complete clarity on the terms and limits for credit extension 
between the clearing banks and the bank dealers by asset class; 
full implementation of a transparent settlement process with a 
clear timeline that enables all market participants to 
understand and manage their settlement risk; and, third, 
further building investor confidence and reducing intraday 
credit risk by a meaningful and systematic reduction of 
collateral turnover between trade execution and maturity.
    Many of the challenges faced by the committee were a result 
of mixing these issues. Credit extension, collateral 
management, and settlements are separate and distinct issues 
that all impact the tri-party funding market. The extension of 
intraday credit is a major focus issue for the bank dealers and 
the two clearing banks. While our investors are focused on the 
collateral management services provided by the clearing banks, 
the operational issues are relevant to all three parties to the 
transaction.
    Part of the challenge faced by the committee was to 
separate these issues, and although there are certain 
codependencies among them, we believe that the work ahead will 
only be successful if the issues are treated individually going 
forward.
    At Morgan Stanley, we have taken a number of steps to 
meaningfully reduce our daily settlement exposures ahead of the 
committee's deadlines, most notably in the area of prudent 
liability and collateral management. Our firm has taken 
proactive steps to extend the maturity of our secured funding 
liabilities in a rules-based governance process that requires 
minimum term of maturities consistent with the fundability 
characteristics of our assets. We additionally have imposed 
investor diversification and maturity limits to reduce our 
maturities with any given investor in a period and an overall 
limit on maturities during any given period.
    Our investors have focused on transparency of collateral, a 
reduction in collateral turnover during the period of the 
transaction, and clarity on their credit exposure through 
execution, settlement, and maturity. We have seen through these 
changes a firsthand and marked increase in pretrade collateral 
due diligence by secured funding investors.
    We fully acknowledge that there is considerable work 
remaining for the industry that requires senior leadership 
focus, commitment, and investment by all participants in the 
market. We are committed to continuing to collaborate with 
investors, the two clearing banks, and our regulators to 
complete the remaining work streams and to advocate for a 
timeline that is acceptable to all stakeholders.
    Morgan Stanley's overarching goal in tri-party repo reform 
is investor confidence. The meaningful reduction in intraday 
credit extension, transparency in collateral and advance rates, 
combined with a more sound and durable operational platform are 
all positive steps toward this goal. We have prioritized our 
resource commitments in the context of the tri-party reform 
committee's agenda on initiatives designed to retain the 
confidence of our secured funding investors, the cash 
providers.
    With lessons learned following the crisis, Morgan Stanley 
has worked over the past several years to add significant risk 
management enhancements to our secured funding program. As 
mentioned above, we have added significant term to the 
maturities in our secured funding liabilities, and since a 
large portion of those liabilities come from investors who 
utilize the tri-party repo platform, our pro forma and actual 
intraday credit from our clearing banks has been meaningfully 
reduced.
    We have extended the weighted average maturity of our 
secured funding book from less than 30 days to now well in 
excess of 120 days. This is now a disclosure metric in our 
public filings. Extending the maturity and limiting rollover 
risk are the most powerful tactical steps that can be taken by 
bank dealers immediately to reduce the intraday extension of 
credit. Since the credit extension takes place at the maturity 
of the trade, creating a longer and staggered maturity profile 
can yield significant risk reduction.
    The Tri-Party Reform Committee has worked to identify the 
issues and put forth recommendations for the remediation of the 
gaps that became apparent in 2008. Many of those 
recommendations are now in practice or in scope on a clear 
timeline. Many of the enhancements to the settlement and 
confirmation processes have created increased stability and 
added clarity. It is clear, however, that the main and most 
important goal of reducing intraday credit extension has not 
yet been achieved. It is also clear, however, that the 
responsibility for this cannot be solely assigned to the two 
clearing banks. We in the bank dealer community have to take 
the immediate and incremental steps available through our 
liability management practices to become a much bigger part of 
the solution. There is no single operational solution or 
systems development that can solve this issue completely. What 
is required is collaboration between the bank dealers and the 
two clearing banks to provide a set of strategic steps to begin 
a tactical but meaningful reduction of intraday credit 
extension in parallel to building operational and system 
enhancements. We believe that the status quo is unacceptable, 
and by beginning this reduction through prudent liability 
management, we can reduce risk during the proposed buildout by 
the clearing banks.
    At Morgan Stanley, we have seen considerable results 
achieved by working directly with our clearing banks to take 
these tactical steps. Morgan Stanley is committed to taking the 
steps necessary to build investor confidence in this important 
funding channel. The markets' liquidity is provided by 
investors who seek to have transparency to their collateral, a 
clear understanding of the settlement process, and the 
information they need in real time to make appropriate risk 
decisions and to effectively manage their collateral and 
counterparty exposures.
    We have worked with the Tri-Party Committee and other 
industry groups to move this reform forward. Morgan Stanley is 
committed to achieving the entirety of goals laid out in the 
committee's report and has invested and executed on changes to 
our processes well in advance of the scheduled timelines with 
the goal of meeting the needs of our investors. This work is a 
top priority of our firm, and we will continue to work at both 
an industry and a firm level along with our regulators to add 
stability and durability to this funding platform.
    Again, we are appreciative of the opportunity to discuss 
these important issues and look forward to providing this 
Committee with any level of detail and information that will be 
helpful as you deliberate on the path forward.
    Chairman Reed. Well, thank you very much for your excellent 
testimony, and we will do 7-minute rounds, and I will yield at 
the end of my time to Senator Crapo, and I suspect we have the 
luxury of going back and forth a bit after that, too.
    First, again, thank you, and let me recognize that there 
has been progress made by the clearing banks, by the broker-
dealers, by the investors in terms of prudent steps to improve 
the process. But the FSOC's--and it echoes something that Mr. 
Wipf said, that the continued intraday trading activities is 
still a severe problem; and, second, FSOC talked about the need 
for increased Government involvement. This task force, as I 
understood it, was the principal private actor with the 
technical assistance of the Federal Reserve Bank of New York, 
and that leads me to a question, and this is sort of echoing 
from our discussion about the LIBOR, which is a question of who 
was really in charge.
    So with respect to this issue, does the New York Fed Bank 
have the responsibility or authority to step in and be the 
involved Government party? Or is it the Board of Governors or 
is it the SEC or is it lots of people, and leading to the 
conclusion everybody has a role but no one is in charge? Mr. 
Eichner.
    Mr. Eichner. Thank you, Senator Reed. Let me begin by 
emphasizing I am here today speaking for the Federal Reserve 
Board, but obviously the Federal Reserve Bank of New York and 
the Federal Reserve Board have worked closely and 
collaboratively on this tri-party issue.
    In the wake of the most acute phase of the crisis, there 
was a broad agreement that some steps needed to be taken and 
that the risks that had become evidence during the crisis 
needed to be addressed.
    At that time we were not entirely clear as to what exactly 
the right way would be to address those vulnerabilities.
    One thing that was clear was that the tri-party market is 
unusually large and unusually complex. It does not just have 
broker-dealers, cash lenders, clearing banks, but all of the 
above involved fundamentally in a daily settlement process that 
is fairly complicated and has to be accomplished in a 
reasonably tight timeframe.
    We started out hoping that we could find an industry 
solution, and as you suggested that involved bringing people 
together in 2009.
    As all of us in various ways have reflected in our 
testimony, substantial progress was made through that process. 
People have mentioned some of the specifics, but everybody also 
has fundamentally recognized what I would like to emphasize 
today, which is that we did not get to the end of that road. 
This task force process did not get to the end of the road. 
Despite the fact, for example, that the daily unwind now occurs 
later in the day than it did several years ago, essentially all 
of the $1.8 trillion tri-party market is still unwound every 
day.
    What we want to emphasize is that we began with an industry 
process. We thought that the industry was best positioned to 
think about what the right solution would be, but that we were 
absolutely committed to progress being achieved here. And to 
that point, when it became clear in the middle part of 2011 
that the Tri-Party Task Force was not going to meet its public 
commitment from 2010, despite significant progress having been 
made, to practically eliminate intraday credit by the end of 
2011, the Federal Reserve increased our involvement in the 
process, and in particular brought supervisory tools to bear in 
a very direct way. The details of that are described, for 
example, in our July 18th press release.
    Chairman Reed. I think this is an important point. Who is 
in charge? If the FSOC is calling for greater Government 
involvement to try to shepherd this private sector initiative, 
which has been very productive to date, to a timely conclusion, 
which several of the panelists have said must be done, who is 
in charge? Who is the person who has got the mission to do 
this, to get this done? Is it Mr. Dudley or is it Chairman 
Bernanke or is it Chairman Schapiro? Or is it--who knows? Do 
you have an answer?
    Mr. Eichner. Yes, I think there are two answers. One is 
sort of all of the above, right? There are authorities that 
each of those individuals has that bring to bear on specific 
participants in the market. That having been said, the 2010 
Dodd-Frank Act did also create a Financial Stability Oversight 
Council which does have a clear statutory responsibility to 
deal with situations where things threaten, as you suggest 
might be the case here----
    Chairman Reed. I appreciate your comments, but I think this 
is something that, as a result of this hearing, we need a 
specific answer, because we do not want to be in a situation 
again where everybody is involved but no one is responsible, 
if, in fact, the FSOC, as you point out, has called for greater 
Government involvement.
    Let me move quickly, and I appreciate your response, but, 
Ms. Peetz, what has been the stumbling block to prevent dealing 
with the intraday trading issue? Mr. Wipf has been quite 
specific. That is still a huge problem. Second, Mr. Eichner 
just pointed out that even though the settlement date has been 
moved back to 3:30, there is still--basically it is every day 
you are rolling the dice in some respects. Can you elaborate?
    Ms. Peetz. Yes, and I would absolutely reiterate what Mr. 
Eichner said about the fact that we all need to work in 
concert, and I believe actually that the Fed has provided great 
leadership for this.
    Our part of it that has provided a stumbling block is we 
really are responsible to get a technology platform to enable 
simultaneous settlement between new and expiring trades, and we 
are working on that right now. So we can provide a platform so 
that this all happens much more efficiently.
    Chairman Reed. Would it be helpful if you were--well, 
helpful at least to justify the funding, if you were sort of 
required at a time certain to do it? Is that an issue?
    Ms. Peetz. We have actually reduced the time already. We 
were originally projecting to finish this at the end of 2016. 
We have reduced that time, through a lot of extra investment in 
technology, to 2014.
    Chairman Reed. The tenor of some of the comments from the 
panel but also from FSOC is even that 2014 deadline still 
exposes the system to risks that should be mitigated.
    Just a final point because my time has expired, and I will 
recognize Senator Crapo. One of the aspects of the progress you 
have made is the automatic substitution of collateral. 
Previously I understood that individual broker-dealers could 
come in and sort of rearrange their collateral at the end of 
the day or during the day, causing delays and confusion, et 
cetera. Is that still possible and is that still prevalent?
    Ms. Peetz. No, actually, the addition of automated deal 
matching plus that cash substitution for automatic substitution 
has actually improved that significantly.
    Chairman Reed. Thank you. And, again, that is a testament 
and a tribute to what you all have done. I appreciate it.
    Ms. Peetz. Thank you.
    Chairman Reed. Thank you.
    Senator Crapo. Thank you very much, Mr. Chairman.
    I would like to understand the objective we are trying to 
achieve here a little better. As I understand it, the entire 
tri-party repo market is unwound every day still, if I 
understand you correctly, Mr. Eichner. And, Ms. Peetz, you 
indicated that simultaneous settlement is the ultimate 
objective, if I understand it correctly. Explain to me, if you 
would, Ms. Peetz--and others, I would welcome your putting your 
input in here, too--how would it ideally work? How would the 
market ideally work if we can achieve the objectives that the 
task force is seeking to achieve?
    Ms. Peetz. There would be several changes. This technology 
would enable just the trades that are actually maturing to be 
rolled, if you will, and so you would not have the intraday 
required for the whole book. It would be just for that activity 
that is changing. So that would reduce the amount of intraday 
significantly.
    You also would have higher-quality collateral, is another 
aspect that we are working on, and asking dealers to prefund 
that collateral that is not as high quality. And, also, 
increasing the duration of tri-party transactions, so what we 
call ``terming the book'' will be another concrete move toward 
getting the risk out of the equation.
    Senator Crapo. Thank you.
    Anybody else? Mr. Eichner, did you want to----
    Mr. Eichner. Yes, I would just say taking a more 10,000-
foot approach here that the critical problem in the market that 
became evident during the crisis was that the locus of certain 
risks was not fully understood in a consistent way by all 
market participants. So when you say what is the key goal here, 
the key goal here is to make sure that it is very clear who 
bears risk at every single moment and that those risks then can 
be priced into people's decisions.
    Senator Crapo. Mr. Meier.
    Mr. Meier. Senator, I would say from an investor's 
perspective, we certainly support the elimination of the 
process of unwinding trades every day, particularly term 
trades. It certainly helps us to have more of a static pool of 
assets, and as I said, we actively manage and stress-test those 
assets daily. The fact that they do not change over and are 
recollateralized after the close of the market certainly is a 
benefit for investors.
    Senator Crapo. Thank you.
    Mr. Wipf.
    Mr. Wipf. Yes, we would agree with that, and we think that 
where some of these interests are very much aligned is bank 
dealers funding their less liquid assets for the longer term 
obviously makes sense, combined with the fact that reducing 
this optimization that occurs every day on trades that are much 
longer to maturity allows our investors to have a more stable 
pool of collateral that they can risk manage on a much more 
real-time basis. So by changing that collateral more 
frequently, that presents a lot more revaluation and the like.
    So to the extent that the intraday credit is drawn at the 
point either at maturity or at these substitution points, 
reducing that, stabilizing the pool is actually beneficial to 
both investors and to the reduction of intraday credit risk.
    Senator Crapo. Explain that a little better to me. One of 
the points you made in your testimony was that the issue or the 
risk related to collateral management or the turnover of 
collateral is one of the big problems that we are trying to 
deal with here. I do not quite understand how the collateral 
turnover issue plays out. Could you explain that?
    Mr. Wipf. Yes, it plays out in two forms. First, just at 
the maturity of a trade, there is a credit extension, so it was 
a trade that has been put on, it is now come due, it is due and 
payable, at that point the collateral is coming back through 
the clearing bank to the bank dealer who now has to take 
intraday credit.
    To the extent that those books have been moved out 
considerably and that those maturities are staggered, the 
amount of actual credit that is going to be extended can be 
reduced. So, simply stated, if the entire book rolls over every 
day and the liabilities are 1 day in nature, the amount of 
credit is considerably higher than if the book has been put out 
for 6 months or a year, additionally with the less liquid 
assets, which present more risk, and we have seen, in working 
with our clearing banks, the meaningful outcome of pushing 
those maturities out has really benefited significantly in the 
reduction of intraday credit.
    Secondarily to that is this optimization or the 
substitution of collateral at dealers need collateral back and 
want to re-optimize that book. The frequency of that also 
creates some intraday credit exposure as well. So when we think 
about investor confidence, having a more stable pool of 
collateral with our investors, giving up some of that ability 
to optimize plays out both from an investor confidence 
perspective and from a creditor perspective.
    Senator Crapo. All right. Thank you.
    The Basel III framework, as I understand it, includes two 
new minimum standards for funding liquidity: one, the liquidity 
coverage ratio, or LCR, which is intended to promote short-term 
resilience to potential liquidity disruptions; and the other, 
the net stable funding ratio, or NSFR, which is intended to 
address liquidity mismatches and provide incentives for banks 
to use stable sources to fund their activities.
    To what extent will the new Basel liquidity standards 
affect the tri-party repo market? I guess that question is for 
any of you. Mr. Eichner.
    Mr. Eichner. I will be happy to start. I think that gets to 
really a very important point. We have talked here about sort 
of three basic vulnerabilities. Senator Reed began by 
reiterating those. One involves the funding profile of dealers. 
Mr. Wipf has talked about that extensively as well.
    The Basel III LCR and net stable funding ratio requirements 
are surely going to provide additional impetus to dealers to 
more effectively manage that risk. So it certainly directly 
addresses that one vulnerability.
    The second vulnerability is the one that we spent most of 
the time talking about, namely, the settlement process and its 
reliance on intraday credit, which remains, as we have 
emphasized, still quite a concern.
    The third vulnerability involves the liquidation of 
collateral of a deal that faces distress or default.
    The LCR and the NSFR are really focused on the first 
question: dealer liquidity risk management and providing 
additional incentives for that to be improved and strengthened.
    Senator Crapo. All right. Thank you, Mr. Chairman.
    Chairman Reed. Thank you very much.
    Senator Merkley, questions, please.
    Senator Merkley. Thank you very much, Mr. Chair, and thank 
you all for testifying on this. The piece of this that I am 
trying to get my hands around is the domino effect--that is, 
when one firm is in trouble and has to sell a lot of assets 
quickly, it creates a fire-sale price that drives down the 
securities that have been used in other repo sections or deals, 
immediately causing trouble in other institutions. And do we 
feel like we are in any better position in regards to this 
right now than we were, say, in 2008?
    Ms. Peetz. Do you want to say anything?
    Mr. Eichner. Sure. As emphasized in the FSOC report, and as 
we have emphasized in various other fora as well, this remains 
a very real concern. So we would certainly recognize the 
tremendous progress that has been made and will continue to be 
made on the intraday settlement issue. The collateral 
liquidation issue, Senator Merkley, which you referred to, that 
remains a task ahead of everybody sitting on this panel. We are 
hopeful at the Federal Reserve that, like the intraday credit 
issue, this will be something for which over time the industry 
develops a consensus and then that consensus can be a route to 
a solution, possibly with regulators urging along the way. But 
in reality, this is something that remains yet to be done.
    Ms. Peetz. I was just going to add that we are getting 
increased transparency also among the players so that we will 
be able to monitor and, in fact, the Fed is interested in 
monitoring not only dealer-specific activity and investors, but 
then collectively the market, and we are getting better and 
better information for that.
    Senator Merkley. As we get that better information, I 
assume that the reason that repo plays such a large role is it 
is some of the cheapest ways to borrow, and you obviously want 
to borrow at the cheapest available cost. But at some point, 
how much of kind of the source of credit can that be before it 
becomes a huge systemic risk to significant institutions?
    Ms. Peetz. I would say that that is another aspect that all 
of us are looking at, which is should dealers have limits on 
the amount that they can actually extend during the day. And 
that is another thing that we are working in concert with the 
industry as well as with the Fed to develop plans for that.
    Senator Merkley. In terms of the limits on the dealers or 
actually the limits on the amount of funds that a particular 
institution can raise through repo transactions?
    Ms. Peetz. It is a bit of both because you would analyze 
the name and what they could withstand. And, of course, that 
changes as the market changes, so we are building tools to do 
that.
    Senator Merkley. OK. Other insights on that?
    Mr. Wipf. Yes, we would see this--again, getting back to 
this liability, the topic of liability management, to the 
extent that less liquid assets are funded for short periods, 
that does present risk both to dealers and systemically.
    To the extent that those are funded for longer periods of 
time, we have seen several developments from the work of the 
Committee. First, investor due diligence has gone up 
considerably with the transparency that has come out. The 
overcollateralization levels are significantly higher. But the 
real risk happens to the extent that these books are maturing 
too quickly, particularly in less liquid assets.
    So as dealers are funding for longer periods of time 
because the reduction of intraday credit is taking place, it 
does require that the books are termed and staggered, with a 
focus on less liquid assets. That provides a valuable commodity 
of time that these adjustments can take place, not in a short 
period of time but over periods of time that move to 3, 6, 9, 
12 months as opposed to 7 days. And I think that is a very big 
change, and I think the discussions about the liquidity 
coverage ratio and the reduction of intraday credit extension 
will force those issues. And, again, the benefit that we see to 
investors is at that point the collateral becomes more stable, 
the ability to value and to make choices and to do the due 
diligence that Mr. Meier has laid out becomes a much easier 
task over time.
    Senator Merkley. Let me ask a little bit of a different 
track question, and that is because your bank has been involved 
in the arrangements made on the spot market to supply crude to 
certain refineries and to buy refined products. And that has 
struck me as some form of systemic risk given the volatility 
that can occur in natural resource markets.
    Does that play an interplay at all in terms of the 
financing through repo?
    Mr. Wipf. That is not an active asset in the repo market.
    Senator Merkley. All right. Thank you.
    Chairman Reed. Thank you very much.
    Mr. Wipf, one of the points that Mr. Eichner made in his 
prepared testimony--and I believe it is true--is that it is 
still discretionary with the bank to extend credit on an 
intraday arrangement. Is that correct?
    Mr. Wipf. Yes, and I think at this point we have gone 
through several work streams with our clearing bank to begin to 
reduce the credit extended, particularly with a focus on less 
liquid assets. So I think that there is a major work stream 
underway at BNY Mellon with all the dealers. We can only speak 
from our perspective on this, but there are some pretty clear 
deadlines out there in terms of what that extension will be, 
which will certainly move to a very direct asset-based model 
very shortly.
    Chairman Reed. But the clearing bank, for reasons--any 
reason, hopefully a prudent research, could essentially say we 
are not extending credit to the broker-dealer, which would 
force you, for a broker-dealer like Morgan to somehow--how 
would you deal with that?
    Mr. Wipf. Reducing the amount of intraday credit extension 
certainly can--as we mentioned, there is no operational 
solution that will eliminate all of that. Ultimately there are 
a few ways to pay for that. One is, if the books are funded too 
short, you have to post up liquidity at maturity. So to the 
extent that the bank will not extend it, the dealer would have 
to replace that liquidity, or to reduce the activity that 
matures; and, again, getting back to this terming and 
staggering and reducing the amount that comes due on any given 
day, particularly with a focus on less liquid assets. So those 
two things--so terming out the book, there is a cost to that, 
of course, because you are paying for a longer-duration 
liability, and/or posting cash liquidity during the period of 
that unwind between that, and I think that is the--that is how 
it would be replaced, and we think that by taking the actions 
that we have laid out, that can be reduced very dramatically as 
well.
    Chairman Reed. We are still in a position of sort of the 
cascade effect that Senator Merkley referred to, whereas, if a 
bank for their own prudent reasons decides not to extend the 
credit, the dealer is now forced to take some--basically come 
up with cash. If they do not have the cash, they are in a very 
awkward position. That leads typically to a downward spiral 
with respect to the whole system.
    Mr. Wipf. Yes, and----
    Chairman Reed. There is still that potential, but less so 
today.
    Mr. Wipf. We think it has been somewhat mitigated, but at 
the point that that actually occurs, the bank, as we see it, 
with a lot of the confirmation and the transparency around the 
collateral and the term, will have a much clearer view of that 
will have lots more early warning signals well in advance of an 
event.
    Chairman Reed. Ms. Peetz, with respect to this issue, 
Morgan has taken these steps. Do you have the contractual 
authority to require every one of your broker-dealers to sort 
of step up to what you think is the appropriate standard in 
terms of the way they operate, the way they--the tenor of their 
arrangements, all these different aspects?
    Ms. Peetz. Yes. How we facilitate that is through different 
agreements, and the near-term activity that we are pushing on 
at the moment is prefunding of DTCC collateral, and so there is 
a separate agreement that each of the broker-dealers will now 
sign with us to acknowledge that they understand how that has 
changed. And so as this kind of continues to change, we will 
amend those agreements, giving us that power.
    Chairman Reed. Mr. Meier, you represent the investors side, 
basically the people putting the cash up. And there has been a 
report by Fitch Ratings that there is a higher amount of 
structured finance paper pledged in these repo transactions, 
which is not--let me assume not as liquid as some of the other 
forms of paper that you have. And particularly in the case of 
money market funds with the new rules, the 2a-7 rule about what 
they can hold and what they cannot hold, is there a potential 
problem here where they get the collateral back but it is 
collateral that they cannot hold or they have to dispose of 
immediately so it is basically we have to give it away almost 
because--is that a dilemma that you face?
    Mr. Meier. I think it is a real risk, Senator. I also read 
the Fitch report yesterday, and I was disturbed, and I 
mentioned it to Mr. Wipf, who had read it as well, that there 
still is a lack of, I would say, proper diligence on the part 
of investors really to really look at the types of collateral, 
the suitability.
    So, for example, in a money market fund, you know, our 
position is the traditional collateral, treasuries, agencies, 
mortgage-backed securities, are appropriate and suitable forms 
of collateral. We do not go down in credit quality. We do not 
take credit spread bonds, et cetera, into the money funds. And 
I do think--I was actually encouraged. We had a meeting last 
week with someone from the Federal Reserve Bank of New York and 
the SEC asking all the right questions about, you know, our 
activities as an investor, do we have default contingency plans 
in place and what our thoughts are around suitability of 
collateral, particularly from money market funds. Those 
questions were asked by the SEC. So I think the right questions 
are being asked.
    What I would like to see is the Federal Reserve start to 
audit default contingency plans and actually make sure that 
people have a thoughtful process in terms of what they are 
accepting as collateral and are they actually looking at it. We 
can rely on the tri-party custodian banks to do that for us. We 
do not. We do not feel that is appropriate. And we are very 
thoughtful in terms of the process we go through when we 
determine what are acceptable forms of collateral, even down to 
CUSIP-specific levels with various counterparties.
    Chairman Reed. But there still exists the possibility that, 
either wittingly or unwittingly, a money market fund could have 
the collateral in that transaction that the dealer put up is 
something that would be very difficult for them to liquidate if 
that became their only mechanism to pay back?
    Mr. Meier. That is a real risk, Senator, yes.
    Chairman Reed. Let me ask a final question before I 
recognize Senator Crapo. There is an alternate, at least one 
other alternate mode to this market, that is, to designate--
rather than having clearing banks, to have what would be known 
technically as a financial market utility. Briefly, could you 
all comment upon whether that has been looked at, the efficacy 
of that, et cetera? And very briefly. Mr. Eichner.
    Mr. Eichner. Sure. I would start right where Mr. Meier left 
off in saying that we remain very concerned about this 
collateral liquidation problem that you are discussing. 
Obviously the largest concern is with respect to less liquid 
collateral, but it is a concern even with more liquid 
collateral in a market that is as large as the tri-party market 
is.
    We feel that even once the intraday credit issue has been 
addressed by reaching the target state, as Ms. Peetz and others 
have described, there is still more work to be done around 
collateral liquidation. There are a number of models that might 
work there. We think it can be done in the context of a 
clearing bank system, although there are certain challenges 
there because collateral liquidation systems in general rely on 
a membership structure, in general rely on the ability to 
mutualize risk, in general rely on the ability to assess 
capital contributions. But we think that could work in the 
context, nonetheless, of a clearing bank system.
    We also think, though, that a utility is another 
possibility and is going to be something that will have to be 
looked at seriously and considered, as we move to this next 
phase, once the target state with regard to the settlement 
process has been reached.
    Chairman Reed. Ms. Peetz, you have to have a chance to 
answer this one.
    Ms. Peetz. Thank you. No, I would agree with everything 
that was said, that we have been discussing the topic, that 
there are some significant obstacles regarding capitalization 
and the sharing of risk. And we think that as we move toward 
our 2014 state that we will not necessarily need a utility, 
which is, I think, what you are getting at.
    Chairman Reed. Mr. Meier, from your perspective, and then 
Mr. Wipf.
    Mr. Meier. Sure. Thank you, Senator. From my perspective, I 
do not really support a utility, and I do believe in terms of 
liquidating collateral, that is the job of the investment 
manager. I do think you run the risk of rewarding those that 
are less diligent and less thoughtful around the collateral 
process.
    From our firm's specific interest, we are both long and 
short collateral, and that gives us a competitive advantage in 
the marketplace in order to be able to provide funding against 
credit product out the curve, and that we lend securities to, 
say, Morgan Stanley and we take in securities from Morgan 
Stanley in repurchase agreements. If there is a problem in the 
marketplace, we go through a liquidation process. We net down 
those exposures, and we actually feed or optimize those buy-ins 
and liquidations into the marketplace. So we do think that is 
one of the key risk drivers, risk mitigants that we have as an 
organization that benefits our clients.
    Chairman Reed. Mr. Wipf, just quickly.
    Mr. Wipf. From a dealer perspective, our view on this is 
that we are--our overarching goal is investor confidence, and 
what we have heard from our investors clearly is that the 
collateral management services provide by the clearing banks 
are an extremely important part of their risk management.
    As we view this, what we want is a safe and sound platform 
that accomplishes that, but, you know, the overriding vote we 
are going to get here is what do our investors need to see in 
terms of collateral management, and whoever can provide that, 
we obviously need to be agnostic to that. And then in terms of 
how we think of this, you know, we have to work on the intraday 
credit work with our clearing banks. So we see these, again, as 
two issues with the overarching goal being heightened investor 
confidence.
    Chairman Reed. Thank you.
    Senator Crapo.
    Senator Crapo. Thank you, Mr. Chairman. I do not have any 
further questions. I do want to thank the panel for not only 
their oral presentations here but their written testimony. I 
found it very helpful, and I am encouraged by what I hear about 
the fact that we may be able to make some good progress in 
resolving this.
    You and I may need to sit down and talk about the first 
question you asked about who is in charge and what the Federal 
response is.
    Chairman Reed. I think that is a very critical question, 
particularly given the last several months of our experience 
here.
    Let me just, if I may for just a moment, you know, we are 
looking at sort of the potential triggering event for market 
behavior, which is dysfunctional, that a dealer fails, et 
cetera. We have got huge issues in Europe with respect to the 
stability of their banks, et cetera. And it raises a question, 
frankly: Is 2014 too long? We have given ourselves apparently 
sort of this timetable. I know you have pulled it back from 
2016. But if there was a financial crisis even greater than the 
present one in Europe, putting pressure on, would it result in 
undue pressure so that you would have to in certain cases, you 
know, not--you know, it is discretionary not sort of to extend 
credit, forcing dealers to come up with the credit in a market 
that is just chaotic? All of this goes to the point of do we 
have until 2014. I do not know if you have a comment or anyone 
has a comment.
    Mr. Eichner. As Chairman Bernanke and other policy makers 
at the Federal Reserve have pointed out, this remains a real 
concern here. That having been said, we also recognize the 
importance here of moving in a deliberate fashion, recognizing 
that this is a really complicated market that has real 
implications across the economy. We want to move in a way and 
see the industry move in a way that gets to the target state 
but does not do so in an unnecessarily or even a necessarily 
disruptive way.
    We would be uncomfortable with 2014 if this were just 2014, 
and, you know, we will tell you when we are there. One of the 
things that the Federal Reserve has done since the task force 
process bogged down a bit in 2011 and by bringing some 
supervisory tools to bear is we have asked the market 
participants, including the clearing banks but others as well 
over which the Federal Reserve has direct supervisory 
authority, for very detailed timelines with milestones along 
the way.
    We do not want to be told, yes, we will get this done in 
2014, trust us. What we want to see is a very clear path to 
getting all of this done by 2014, but with many intermediate 
steps and pieces of risk reduction that occur along the way, 
and that is the way that we get comfortable with 2014 in light 
of the environment that we are now operating in.
    Chairman Reed. Anyone else, any other comments?
    Mr. Wipf. What we would say from our perspective at Morgan 
Stanley is that, to the extent that this flows through where 
investors have real clarity on what they have and we have real 
clarity as bank dealers with our clearing banks on what our 
clearing bank will do during normal and stressed market 
environments in terms of whatever the intraday lending is and 
against what assets they are at a very specific level, the 
accountability then, again, falls back to the bank dealer about 
prudent liability management.
    So, you know, as it works through to the due diligence 
around the collateral from an investor perspective, clarity 
between the clearing bank and the bank dealers in terms of what 
everyone can expect during times of stress in normal operating 
environments and then prudent liability management resting 
clearly with the dealers we think is the best outcome. And on 
the way to that, that is how we think that we can get to 2014.
    Chairman Reed. Well, I want to thank you all. Again, just 
echoing the comment Senator Crapo made, I do think we need to 
get a much more definitive, clarifying sort of notion of who is 
in charge here from the Federal perspective. That is one of the 
lessons we have learned over the last couple of years. When 
everyone is in charge, no one is in charge. So we would like to 
see--we will follow up, but I thank you for excellent 
testimony, both your written testimony and your oral testimony, 
and I thank Senator Crapo and my colleagues.
    If there are no further questions, we will, in fact, keep 
the record open because there could be some of my colleagues 
who have additional questions. We would ask my colleagues to 
submit those questions no later than next Thursday, August 9th, 
and then we would ask you to respond as quickly as possible to 
the questions if you are given some.
    Thank you very much. With that, the hearing is adjourned.
    [Whereupon, at 10:09 a.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]
                PREPARED STATEMENT OF CHAIRMAN JACK REED
    I want to welcome everyone to our hearing this morning entitled 
``The Tri-Party Repo Market: Remaining Challenges''.
    Last week, Secretary Geithner presented the Financial Stability 
Oversight Council's second annual report to Congress. The Council is 
responsible for providing us with a comprehensive, coherent overview of 
the health of our financial system.
    The Council's report identified structural vulnerabilities in the 
short-term funding markets, particularly the tri-party repurchase 
(repo) market, as a continuing area of concern. The report states that: 
``limited progress has been made in substantially reducing the reliance 
of this market on intraday credits or improving risk-management and 
collateral practices to avoid fire sales in the event of a large dealer 
default.'' The Council also stated that the industry's suggestion that 
it will take several more years to eliminate the intraday credit 
associated with tri-party settlements was ``unacceptable'' and called 
for greater Government involvement.
    In general, a repo or repurchase agreement is the sale of a 
portfolio of securities with an agreement to repurchase that portfolio 
at a later date: the economics of repos are similar to that of short-
term loans collateralized by long-term assets. Tri-party repos are 
typically used by large securities firms and bank holding companies 
with broker-dealer operations to raise short-term financing from cash 
investors, such as money market mutual funds. The dealer and the 
investor typically use one of two clearing banks to settle the 
transaction.
    This market is very large. Tri-party repos peaked at $2.8 trillion 
at the height of the crisis in 2008 and are $1.7 trillion today.
    Three major weaknesses of the tri-party market were highlighted by 
the 2008 financial crisis:

    the market's reliance on intraday credit from the clearing 
        banks,

    the procyclicality of risk management practices, and

    the lack of effective plans to support the orderly 
        liquidation of a defaulted dealer's collateral.

    Motivated by these risks, in 2009 the Federal Reserve Bank of New 
York formed an industry-led Task Force to address the problems 
highlighted by the financial crisis. Although this Task Force disbanded 
in early 2012, its work led to a number of important changes, 
including:

    moving the daily unwind of some tri-party repo transactions 
        from 8:30 a.m. to 3:30 p.m., which shortens the period of 
        intraday credit exposure;

    implementing a mandatory three-way trade confirmation 
        between dealers, cash investors and the clearing banks, marking 
        the first time this $1.7 trillion market has had an established 
        confirmation process;

    publishing of a monthly report regarding activity in the 
        tri-party repo market, which includes the size of the market, 
        collateral breakdowns, dealer concentrations, and margin 
        levels. This report enhances the ability of supervisors and 
        market participants to assess trends and call attention to 
        emerging issues before they become systemic.

    However, in its 2012 Report, the FSOC found that ``limited progress 
has been made in substantially reducing the reliance of this market on 
intraday credits or improving risk-management and collateral practices 
to avoid fire sales in the event of a large dealer default.'' The 
Council also stated that that the industry's suggestion that it will 
take several more years to eliminate the intraday credit associated 
with tri-party settlements was ``unacceptable.''
    Because FSOC has sounded an alarm about the tri-party repo market 
and stated the need to more quickly implement additional reforms, we 
have convened this morning's hearing to discuss the report, better 
understand the changes to this market already in place, and explore 
what more needs to be done.
    Improving the tri-party repo market will make it safer, to the 
benefit of all market participants. I look forward to hearing from all 
our witnesses on this important part of our financial markets.
                                 ______
                                 
                PREPARED STATEMENT OF MATTHEW J. EICHNER
    Deputy Director, Division of Research and Statistics, Board of 
                Governors of the Federal Reserve System
                             August 2, 2012
    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, thank you for inviting me to appear before you today to 
discuss the tri-party repurchase agreement (repo) market.
    The Federal Reserve has a strong interest in the smooth functioning 
and resiliency of this market for several reasons. First, the market 
serves as a tool for cash and liquidity management as well as for 
short-term borrowing for a wide range of financial intermediaries, 
including money market funds, insurance companies, banks, and 
securities dealers, all of which play an important role in supporting 
the savings and investment programs of households, small businesses, 
and nonfinancial corporations. Second, a number of entities subject to 
direct prudential supervision by the Federal Reserve are significant 
participants, including the holding companies of the two clearing 
banks, JPMorgan Chase and BNY Mellon, as well as many other bank 
holding companies. Finally, tri-party funding materially supports the 
depth and liquidity of a number of critical markets, including those 
for U.S. Government securities in which U.S. monetary policy is 
executed.
    In light of the importance of the tri-party repo market, the 
Federal Reserve has been and is committed to working with market 
participants and other supervisory and regulatory organizations to 
enhance the market's resiliency. During the crisis, it became apparent 
that the design of the market's infrastructure to settle transactions, 
in particular, had fundamental flaws that could lead to serious 
instability during periods of market stress. Some significant progress 
has been made subsequently by market participants to address these 
shortcomings. The tri-party repo market is now smaller than its peak 
and in general funds higher-quality collateral than it did prior to the 
crisis. However, not as much progress has been made--or made as 
quickly--as we believe is warranted given the seriousness of the 
situation, and certain clear vulnerabilities remain. The Federal 
Reserve continues to be fully engaged on a number of fronts to promote 
measures that will further mitigate these risks.
    I would now like to describe in greater detail the underlying 
vulnerabilities in the tri-party repo market, the risk mitigation 
accomplished since the financial crisis, and the significant work that 
still remains. In offering this perspective, I think it will become 
clear that the very importance of the tri-party repo market--which is 
currently the locus of funding for some $1.8 trillion in securities 
held by securities dealers, down from $2.7 trillion in 2007--
complicates the task of enhancing its resiliency. As in the case of a 
busy highway that must be rebuilt while traffic continues to flow, 
fundamental changes to the tri-party infrastructure must be 
accomplished in a manner that allows the market to continue to function 
without introducing new risks as market participants adjust. Further 
complexities are introduced by the diversity of participants in this 
market, which connects institutional investors of many types that have 
surplus cash with dealers who need funding for their securities 
portfolios. These different classes of entities, although tied together 
through the tri-party infrastructure, have very distinct institutional 
priorities, operational needs, and regulatory requirements.
Tri-Party Repos and the Financial Crisis
    A tri-party repo, like other repurchase agreements, is a form of 
secured borrowing in which one party effectively lends cash against the 
securities collateral of the other party. As the name suggests, a tri-
party repo is distinguished by the involvement of a third party, a 
clearing bank that provides custody and settlement services related to 
the transaction. Of particular importance, the triparty repo settlement 
process in the United States evolved over time to rely on the extension 
of very substantial amounts of intraday credit by the clearing banks. 
While securities are funded each evening with cash provided by the 
lenders in the tri-party repo market, each day almost all trades are 
``unwound,'' with cash being returned to the accounts held by lenders 
at their clearing bank. The clearing bank, protected by a lien on the 
securities, provides funding for the collateral during part of the day. 
This unwind, which is reversed at the end of each trading day with a 
``rewind,'' permits borrowers in the tri-party repo market--generally 
securities dealers--to have full and unimpeded access to their 
securities inventory for routine operational purposes, notably 
delivering and receiving securities, while ensuring that tri-party 
lenders at all times hold either cash in their accounts at the clearing 
bank or a perfected security interest in specific collateral. Under 
this settlement process, almost all trades are unwound each day whether 
the trades are maturing or have remaining terms. Thus, almost the 
entire value of this market is funded each day through the extension of 
intraday credit by a clearing bank. Further, these extensions of 
intraday credit by the clearing banks are not contractually committed, 
but rather wholly discretionary. In short, a clearing bank can decide 
at any time to stop providing intraday credit to a securities dealer.
    The reliance on discretionary intraday credit in the tri-party 
settlement process poses difficult dilemmas for cash lenders, 
borrowers, and clearing banks during periods of market stress. As a 
result, securities dealers may experience a sudden and acute loss of 
funding. A clearing bank may be reluctant to unwind the tri-party 
trades of a securities dealer and extend credit if the bank perceives a 
material risk to the financial viability of the dealer, or even if 
market sentiment regarding the dealer is merely deteriorating in a way 
that could deter cash lenders from providing sufficient new funding to 
support a rewind at the end of the day. On the one hand, such a 
decision by a clearing bank not to unwind would likely push the 
securities dealer into immediate default and would certainly impair its 
ability to operate normally. On the other hand, the clearing bank 
unwinding the tri-party trades of an apparently weakened securities 
dealer has potentially serious implications as well. If the securities 
dealer subsequently fails to attract sufficient new cash from lenders 
to fully finance its securities inventory, the clearing bank faces a 
material, albeit secured, credit exposure to that dealer. This 
situation could call the clearing bank's own viability into question, 
impair its ability to settle transactions for other dealers, and 
potentially spread distress across broader markets.
    In essence, a clearing bank is inclined to provide intraday credit 
to a dealer only when it is confident that sufficient incremental 
funding from cash lenders will materialize to make the rewind possible. 
And cash lenders will only enter new trades that provide incremental 
funding to a dealer if they are confident that their transactions will 
be unwound at maturity by the clearing bank. So, if concerns rise 
markedly about the financial condition of one or more securities 
dealers, the instantaneous transfer of the risk of a default that 
occurs twice each trading day--the first time through the unwind to the 
clearing bank and the second time through the rewind to the cash 
lenders--creates incentives for both the clearing bank and cash lenders 
to ``get out first,'' leaving the tri-party repo market highly 
vulnerable to runs.
    The fundamental susceptibility to runs stemming from this 
settlement process was exacerbated during the financial crisis by other 
compounding factors, which included weaknesses in the risk-management 
practices of many market participants. Some dealers were heavily 
reliant on triparty financing with very short tenor--which entailed 
significant potential rollover risk--on the assumption that this 
funding would be durable during a stress event. And some cash lenders 
were apparently not fully aware of the discretionary nature of intraday 
credit or of the consequences of a decision by a clearing bank to 
decline to provide such funding. In particular, in the event that a 
clearing bank declined to provide intraday credit to support the unwind 
of a securities dealer's tri-party trades, no mechanism existed then or 
now to orchestrate an orderly liquidation of the collateral to repay 
the lender. The absence of such a process raised the specter of a 
``fire sale'' of securities by cash lenders who could find themselves 
taking possession of collateral they had limited operational capacity 
to manage or that might place them in violation of their portfolio 
composition guidelines. Concerned that other firms similarly situated 
would quickly liquidate large volumes of collateral and cause market 
dislocations, each cash investor would, quite rationally, try to sell 
first with predictable, but possibly dire, consequences. These 
compounding factors--the weaknesses in risk management and the absence 
of a mechanism to assist with the orderly liquidation of tri-party 
collateral--further increased the vulnerability of the tri-party repo 
market to runs.
    In fact, runs did occur, and they played out with surprising speed 
around the time of the near failure of Bear Stearns in March 2008 and 
again during the worsening of the crisis in mid-September of that year 
after the bankruptcy of Lehman Brothers. Indeed, the Federal Reserve 
implemented the Primary Dealer Credit Facility in March 2008, and 
expanded its scope in September 2008, in part to stabilize the tri-
party repo market in the face of rapid erosion of investor and clearing 
bank confidence. While this facility proved to be a critical crisis-
management tool, the fact that it was necessary underscored the need 
for fundamental changes to market conventions and practices.
The Task Force
    Following broad recognition of the vulnerabilities associated with 
discretionary intraday credit, an industry-led Tri-party Repo 
Infrastructure Reform Task Force was formed in 2009 as an initiative of 
the Payments Risk Committee, a private-sector body convened by the 
Federal Reserve Bank of New York. \1\ The task force included 
representatives of market participants, such as cash lenders, dealers, 
clearing banks, and other service providers, as well as industry groups 
representing both dealers and investors. The Federal Reserve and 
agencies with regulatory authority over other market participants 
served in an advisory capacity. Not surprisingly, a key focus of the 
task force's efforts was the reduction in reliance on intraday credit 
in the settlement process. But the group also considered some related 
vulnerabilities, including the risk-management practices of both 
securities dealers and cash lenders.
---------------------------------------------------------------------------
     \1\ Information on the Tri-Party Repo Infrastructure Reform Task 
Force is available on the Federal Reserve Bank of New York's Web site 
at www.newyorkfed.org/tri-partyrepo.
---------------------------------------------------------------------------
    In its May 2010 interim report, the task force dealt directly with 
the issue of reliance on intraday credit extension, creating a detailed 
plan for its ``practical elimination'' by mid-2011. \2\ In fact, 
participants achieved some important prerequisites to this goal last 
year. Clearing banks developed tools that will allow automated 
substitution of collateral, and hence access to securities for routine 
operational purposes without requiring a daily unwind of a dealer's 
entire tri-party book. A process was implemented to support the three-
way confirmation of trades, ensuring that nonmaturing trades could be 
readily identified as such by the clearing bank, and eventually not 
unwound on a daily basis. Further, the unwind, while still very much a 
part of the settlement process, was moved from early morning to mid-
afternoon, allowing clearing banks more time to make an informed 
decision regarding the extension of intraday credit. While not directly 
related to the reduction of reliance on intraday credit, the task force 
also played an important role in improving the transparency of the tri-
party repo market for market participants and the public, working with 
staff at the Federal Reserve Bank of New York in a process that 
culminated in the publication, beginning in June 2010, of key monthly 
statistics on the types of collateral funded and applicable terms. \3\
---------------------------------------------------------------------------
     \2\ See, Federal Reserve Bank of New York (2010), ``Tri-Party Repo 
Infrastructure Reform'', white paper (New York: FRBNY, May), 
www.newyorkfed.org/banking/nyfrb_tri-party_whitepaper.pdf.
     \3\ Information on the Tri-Party Repo Margin and GCF Repo 
Statistics is available on the Federal Reserve Bank of New York's Web 
site at www.newyorkfed.org/tri-partyrepo/margin_data.html.
---------------------------------------------------------------------------
    These significant achievements notwithstanding, it became clear 
last year that more-fundamental changes to systems at both clearing 
banks and on the part of other market participants, as well as 
associated adjustments to market practices, would take significantly 
longer to implement. The task force, in its final report issued in 
early 2012, acknowledged that the work had entered a new phase and 
described in greater detail the ``target state,'' a safer and more 
robust settlement process for the tri-party repo market that would not 
rely on significant discretionary intraday credit. \4\
---------------------------------------------------------------------------
     \4\ See, Tri-Party Repo Infrastructure Reform Task Force (2012), 
``Tri-Party Repo Infrastructure Reform Task Force Releases Final 
Report'', press release, February 15, www.newyorkfed.org/tri-partyrepo/
pdf/PR_l20215.pdf; the report is also available directly at 
www.newyorkfed.org/tri-partyrepo/pdf/report_120215.pdf.
---------------------------------------------------------------------------
Federal Reserve Use of Supervisory Authorities
    The Federal Reserve, while acknowledging the contributions and 
achievements of the task force, responded on several fronts to the 
inability of the industry to meet its commitment to meaningfully 
address the tri-party repo market's heavy reliance on discretionary 
intraday credit in 2011. Notably, the Federal Reserve has used 
supervisory tools to encourage market participants over which it has 
direct authority to implement the task force recommendations in a 
timely fashion. If adopted uniformly across the market, these 
recommendations should materially reduce reliance on discretionary 
intraday credit. While a great deal of focus is appropriately on the 
clearing banks, given their pivotal role in the settlement process, the 
active engagement of all market participants is critical to reaching 
the goal of material risk reduction. To this end, the largest 
securities dealers affiliated with bank holding companies have recently 
been asked to submit to the Federal Reserve detailed execution plans 
and timelines for the necessary changes to systems and processes. At 
the same time, the Federal Reserve is pressing them to work with 
lenders to achieve more-timely and more-accurate trade confirmations, 
which are critical to ensuring that the coming process changes are 
effective in reducing the use of intraday credit, and thus risk. \5\
---------------------------------------------------------------------------
     \5\ See, Federal Reserve Bank of New York (2012), ``Update on Tri-
Party Repo Infrastructure Reform'', statement, July 18, 
www.newyorkfed.org/newsevents/statements/2012/0718_2012.html.
---------------------------------------------------------------------------
    On another front, the Federal Reserve is working with regulators of 
other important market participants. As I described earlier, there are 
a wide range of participants in the tri-party repo market, only some of 
whom are subject to direct Federal Reserve oversight. A particular 
strength of the task force process was the involvement of essentially 
all important classes of market participants and their regulators. With 
that process now concluded, the Federal Reserve is committed to finding 
other ways to continue and expand these interactions. Such an inclusive 
approach is essential if key changes to the settlement process that 
require adjustments in the behavior of all market participants are to 
be effectively implemented. Not only securities dealers affiliated with 
bank holding companies but also other broker-dealers as well as cash 
lenders, such as money market funds, must modify systems and protocols 
consistent with the requirements of the target state. To this end, 
engagement with the Securities and Exchange Commission has been and 
will continue to be particularly important given its role as the 
primary regulator of broker-dealers and many cash lenders, notably 
money market funds.
    Given the broad interest in the tri-party repo market and the 
complexities involved in reaching the target-state settlement system, 
the Federal Reserve considers it critical that the general public have 
the opportunity to follow progress, including by tracking relevant 
metrics of risk reduction associated with the gradual decline in 
reliance on intraday credit. In addition, the Federal Reserve is 
committed to providing information on its initiatives related to the 
tri-party repo market. With these aims in mind, the Federal Reserve 
Bank of New York recently launched a Web site that will serve as a 
portal for a range of information related to the tri-party repo market. 
\6\
---------------------------------------------------------------------------
     \6\ Information on Tri-Party Repo Infrastructure Reform is 
available on the Federal Reserve Bank of New York's Web site at 
www.newyorkfed.org/banking/tpr_infr_reform.html.
---------------------------------------------------------------------------
The Problem of Fire Sales
    While eliminating the daily unwind and reducing reliance on 
intraday credit will materially reduce the potential for a recurrence 
of many of the problems evident during the financial crisis, other 
vulnerabilities will remain. A particular concern of the Federal 
Reserve, and also reflected in the Financial Stability Oversight 
Council's most recent annual report, involves the challenge of managing 
the collateral of a defaulting securities dealer in an orderly manner. 
\7\ Larger dealers finance portfolios of securities that can easily 
exceed $100 billion and would be difficult to liquidate even under 
favorable market conditions without causing dislocations. As I noted 
earlier, the situation could be further complicated by the fact that 
many cash lenders are highly risk averse, subject by regulation or 
prospectus to stringent limitations on their portfolio holdings, and 
may have limited operational capacity to manage collateral. As a 
result, they would likely be inclined to quickly liquidate securities 
that they had obtained from a failed dealer, creating the potential for 
a fire sale that could destabilize markets and propagate shocks across 
the financial system.
---------------------------------------------------------------------------
     \7\ See, Financial Stability Oversight Council (2012), 2012 Annual 
Report (Washington: FSOC), www.treasury.gov/initiatives/fsoc/Pages/
annual-report.aspx.
---------------------------------------------------------------------------
    A solution to this fire sale problem likely requires a marketwide 
collateral liquidation mechanism. The challenges in designing and 
creating a robust mechanism--which would almost certainly need the 
capacity to fund a significant volume of collateral for some period of 
time--are appreciable, and include assuring adequate liquidity 
resources even under adverse market conditions and developing rules for 
the allocation of any eventual losses across market participants. Such 
capabilities typically exist today in the context of clearing 
organizations that have a formal membership structure, which allows for 
capital assessments and the sharing, or ``mutualization,'' of potential 
losses. How this model might be adapted to a market more loosely 
organized around clearing banks, particularly in which certain less-
liquid collateral types continue to be funded, remains unclear and will 
surely need to be the focus of much additional study.
Conclusion
    Given the importance of the tri-party repo market and the 
vulnerabilities that were so evident during the financial crisis, 
enhancing the market's resiliency and its settlement system is an 
important regulatory and financial stability priority. Building on the 
work of the task force, we believe that supervisory efforts will yield 
substantial progress in eliminating the reliance of the tri-party repo 
market on intraday credit, although perhaps not as quickly as many of 
us had hoped, and in improving risk-management practices across a range 
of market participants. A significant remaining challenge, however, is 
the development of a process to liquidate in an orderly fashion the 
collateral of a defaulting dealer that would operate reliably in the 
context of a settlement system organized around clearing banks.
    Thank you once again for the invitation to appear before you today 
to share the perspectives of the Federal Reserve on these important 
issues. I would be pleased to answer any questions you may have.
                                 ______
                                 
                  PREPARED STATEMENT OF KAREN B. PEETZ
               Vice Chairman, The Bank of New York Mellon
                             August 2, 2012
    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, my name is Karen Peetz, and I am Vice Chairman of The 
Bank of New York Mellon and CEO of the company's Financial Markets and 
Treasury Services businesses. I appreciate the opportunity to appear 
before you today to discuss the tri-party repurchase--or ``repo''--
market in the United States.
    I would like to begin by briefly describing the history and 
operations of BNY Mellon, as our business model is very distinct from 
traditional retail or investment banks. BNY Mellon was formed in 2007 
as a result of the merger between The Bank of New York and Mellon 
Financial Corporation. The company has a rich and distinguished history 
that is inextricably woven into the broader history of the United 
States. The Bank of New York was founded in 1784 by Alexander Hamilton, 
and with its predecessors, BNY Mellon has been in business for 228 
years, making it one of the oldest continuously operating financial 
institutions in the world.
    In contrast to most global banking organizations, our business 
model does not focus on the broad retail market--we do not offer credit 
cards, traditional mortgages, auto loans or similar products to retail 
consumers. Rather, we are a provider of services that help major 
financial institutions access funding and support the operational 
infrastructure of the global capital markets. BNY Mellon operates two 
primary businesses: investment servicing and traditional asset 
management. Through our various clearance, advisory, global markets, 
treasury services and asset management platforms, we facilitate the 
trading, settlement and distribution of client assets around the world.
    Before I address the topic of today's hearing, let me begin by 
stressing BNY Mellon's support for recent U.S. and international 
regulatory reforms that have strengthened our financial system, 
including the Dodd-Frank Wall Street Reform and Consumer Protection 
Act. BNY Mellon has a long history of working with the Government to 
help steady financial markets, often providing the benefit of the 
expertise we have developed from our unique role in the markets to the 
Government regarding the structure of support facilities.
    In addition, the nature of our business allowed us to see first-
hand how insufficient capital and liquidity at some institutions 
contributed to the financial crisis. Since the Dodd-Frank Act was 
enacted, we have worked with our global and domestic prudential 
supervisors to provide meaningful feedback on regulatory proposals and 
explain how proposed rules may affect critical aspects of the financial 
system. We have heartily endorsed meaningful reforms--including 
enhancing the quality and quantity of bank capital--that will 
strengthen the banking sector, guard against future systemic shocks, 
and encourage economic expansion.
    For the purposes of my testimony today, I will focus on three 
issues:

    How the tri-party repo market operates;

    BNY Mellon's role supporting the tri-party repo market; and

    The performance of the tri-party repo market during the 
        financial crisis and ongoing reform efforts.

    Before addressing the intricacies of the tri-party repo market, I 
would like to start with a general explanation of the repurchase market 
and why it exists. A ``repo'' is a sale of securities by a dealer to an 
investor, accompanied by a contract to repurchase the securities for an 
agreed upon price at a later date. These arrangements are entered into 
by dealers who have liquidity needs and investors looking to put cash 
holdings to good use (often investment managers for endowments, pension 
funds, and municipalities, money market mutual funds, custodial banks 
investing cash collateral on behalf of their securities lending 
clients, and other asset managers). The repo market is a major source 
of funding for the financial institutions that drive business and 
finance globally and is an integral part of ensuring that the financial 
system is able to work for downstream customers.
    Functionally and economically, repos operate like secured loans. On 
any given day, a cash investor (the lender) extends funds to a dealer 
(the borrower) at an agreed rate--the ``repo rate''--and the dealer 
provides the investor with securities as collateral. As the Federal 
Reserve Bank of New York (the ``FRBNY'') has explained, ``[t]he 
proceeds of the initial securities sale can be thought of as the 
principal amount of the loan, and the excess paid by the cash borrower 
to repurchase the securities corresponds to the interest paid on the 
loan, also known as the repo rate.'' \1\
---------------------------------------------------------------------------
     \1\ ``Tri-Party Repo Infrastructure Reform'', The Federal Reserve 
Bank of New York, p. 5 (2010).
---------------------------------------------------------------------------
Tri-Party Repo and BNY Mellon Operations
    Tri-party repo transactions are a type of repurchase agreement 
involving a third party, the tri-party agent--the function BNY Mellon 
serves--who facilitates settlement between dealers (cash borrowers) and 
investors (cash lenders). The tri-party agent maintains custody of the 
collateral securities, processes payment and delivery between the 
dealer and the investor and provides other services, including 
settlement of cash and securities, valuation of collateral, and 
optimization tools to allocate collateral.
    The tri-party repo market has grown and evolved over the years, in 
response to market and economic factors that made the structure a more 
attractive mechanism for meeting the market's funding needs. The use of 
a tri-party agent has enabled the market to operate more efficiently by 
reducing settlement risk and related costs, allowing for collateral 
recall, providing independent collateral verification and monitoring 
and standardizing transaction agreements. According to the Financial 
Stability Oversight Council's (the ``FSOC'') 2012 Annual Report the 
current value of the tri-party repo market is $1.8 trillion.
    BNY Mellon is a substantial tri-party agent, with an approximately 
80 percent market share. Our involvement in a transaction commences 
after a broker-dealer and a cash investor agree to a tri-party repo 
trade and send instructions to BNY Mellon. These instructions represent 
the parties' agreement concerning the tenor of the transaction, the 
amount of cash lent, the value and type of collateral returned, and the 
repo rate.
    To facilitate the tri-party repo market we extend secured intraday 
credit to dealers to repay their investors from the prior day's trades. 
If a dealer becomes distressed we could refuse to extend such credit 
and investors could withdraw from the market. Both of these actions 
could lead to destabilizations in the economy. Once a tri-party trade 
settles, BNY Mellon is no longer exposed to direct risk of the dealer 
or the underlying securities. Thereafter, the ultimate risks associated 
with a defaulting dealer who has pledged collateral are with its cash 
investors.
Tri-Party Repo Reform and the Financial Crisis
    Few parts of the United States financial system were untouched by 
the global financial meltdown from 2007-2009; therefore, it is 
unsurprising that the tri-party repo market experienced strain. The 
crisis revealed that the market could experience systemic problems: 
dealer defaults could leave investor counterparties or the tri-party 
agent holding collateral that was increasingly illiquid, leading to a 
seizing up of the financial markets.
    In light of our role as tri-party agent, we are uniquely positioned 
to work with the Federal Reserve to identify ways to take risk out of 
the way this market operates. We have been in continual discussions 
with supervisors and clients regarding measures to reduce and 
eventually eliminate our exposure to intraday credit risk, as well as 
to help address broader structural concerns with the tri-party repo 
market.
    After the financial crisis, the Federal Reserve asked clearing 
banks, primary dealers, and investors to consider policy options to 
address problems with tri-party repo infrastructure that were revealed 
during the financial crisis, which led to the creation of the Tri-Party 
Repo Infrastructure Reform Task Force \2\--in which BNY Mellon 
participated. The Task Force published its final report in February 
2012 summarizing the current state of reform efforts. In addition to 
identifying the measures I describe below as important steps, the Task 
Force noted other achievements that increased transparency, enhanced 
data reporting and strengthened cash investor stress testing practices. 
The report recognized that additional measures to further reduce 
intraday credit to broker-dealers would be necessary.
---------------------------------------------------------------------------
     \2\ The Task Force on Tri-Party Repo Infrastructure Reform was 
formed by the Payments Risk Committee, a private sector body sponsored 
by the FRBNY. The Task Force included representatives from a diverse 
group of market participants. Federal Reserve and SEC staff 
participated in meetings of the Task Force as observers and technical 
advisors. Task Force on Tri-Party Repo Infrastructure, Payments Risk 
Committee, p. 1 (2010).
---------------------------------------------------------------------------
    In addition to our work on the Task Force, BNY Mellon has been 
working with our regulators and our clients to address practices within 
the market that require strengthening. We have focused our own internal 
reform efforts on reducing the provision of intraday credit and 
influencing collateral standards.
    With respect to reducing intraday credit provided by BNY Mellon to 
facilitate the tri-party repo market, we are implementing 
recommendations made by the Task Force. We have moved to a later day 
unwind for most maturing tri-party repos, reducing the intraday risk 
exposure window from 10 to approximately 3 hours. We have instituted an 
``auto substitution'' process to allow dealers to replace needed, 
pledged collateral by first over-collateralizing with cash. 
Additionally, BNY Mellon introduced a three-way trade confirmation 
process known as automated deal matching for dealers, agents and 
investors. The trade matching enhancements allow BNY Mellon, as the 
clearing bank, to receive both the dealer and cash investor's trade 
instructions separately and match the required information fields 
systematically. This automated matching process provides dealers and 
investors with an efficient and consolidated view of trade 
instructions, terms and modifications to ensure accuracy and 
transparency.
    BNY Mellon is also identifying asset classes eligible for intraday 
credit associated with tri-party repo transactions and we are working 
with our clients to eliminate intraday credit associated with less 
liquid forms of collateral. We expect these measures to reduce intraday 
exposures by $230 billion by early next year. Moreover, we are 
developing the technology for a systematic approach to reforming the 
entire unwind process that will practically eliminate exposures by the 
end of 2014. As we develop and implement these measures, we are working 
closely with our clients and the Federal Reserve to ensure that these 
changes are adopted in a manner and on a timetable that does not unduly 
disrupt the market.
    Last, I would note that on July 18, The Federal Reserve Bank of New 
York released a statement acknowledging its efforts to use the 
supervisory process to effect reductions in intraday credit and 
implement other risk management reforms detailed in the Task Force's 
recommendations. A day earlier, the FSOC issued its annual report, 
which sounded similar themes. The report raised the intraday credit 
concern I have described and stated that reforms should proceed 
expeditiously. I can assure you that we are partnering with the Federal 
Reserve on these efforts and are committed to enhancing tri-party 
operations to reduce systemic risk. Specific to the pace of reforms, I 
would note that the measures we have already implemented are materially 
reducing intraday credit exposures.
Conclusion
    BNY Mellon strongly believes that the tri-party repo market is a 
crucial component of the global financial system's infrastructure. We 
are committed to continuing to develop meaningful reforms that limit 
systemic risk and enable market participants to efficiently and 
effectively fund their operations.
    Again, I thank you for the opportunity to testify before you today 
and look forward to any questions you may have.
                                 ______
                                 
                 PREPARED STATEMENT OF STEVEN R. MEIER
Executive Vice President, Chief Investment Officer, State Street Global 
                                Advisors
                             August 2, 2012
    Chairman Reed and Members of the Subcommittee on Securities, 
Insurance, and Investment: Thank you for the opportunity to appear 
before you today. My name is Steven Meier and I am the Chief Investment 
Officer, Global Cash Management, for State Street Global Advisors 
(SSgA), the investment management business of State Street Corporation 
(State Street).
    The Committee has asked me to provide an investor's perspective on 
the tri-party repurchase market settlement mechanism, with a specific 
focus on the systemic risk reducing initiatives recommended by the 
Federal Reserve Bank of New York's Tri-Party Repo Infrastructure Reform 
Task Force. I hope my testimony will assist the Committee with its 
important work.
    State Street had the privilege of participating in this Task Force 
to provide investor insight into the functioning of these arrangements 
and the benefits of such transactions for our clients. State Street 
agrees with the risk reducing initiatives put forward by the Task Force 
and is prepared to adjust our operating model in order to address the 
concerns raised by the Federal Reserve Bank of New York and others, 
including the Financial Stability Oversight Council in its most recent 
report.
Background and Experience
    Let me begin with a brief description of my background and 
experience. I have more than 28 years' experience in financial 
services, with a focus on traditional money markets, fixed income, 
global cash, and financing. Today, I am an Executive Vice President of 
State Street and Chief Investment Officer of the cash asset. I am a 
member of SSgA's Senior Management Group and Investment Committee. I 
have the responsibility of managing a team of nearly 40 investment 
professionals dedicated to cash and short-term asset strategies across 
seven currencies located in six investment sites around the world. Our 
clients include State and local governments, private pension funds, 
corporations, endowments, charitable trusts, foreign central banks, and 
sovereign wealth funds.
    State Street is one of the world's leading providers of financial 
services to institutional investors with nearly $22 trillion in assets 
under custody and administration, and almost $2 trillion of assets 
under management. As of the end of June 2012, SSgA managed global cash 
and short-term assets and strategies of approximately $400 billion, of 
which over $300 billion is denominated in U.S. dollars. Our cash and 
short-term investment activities in the U.S. span a range of asset 
types, including U.S. Treasury and Government agency debt, municipal 
debt, unsecured bank and corporate obligations, asset-backed 
securities, and other similar instruments including repurchase 
agreements. In accordance with our client risk tolerance and return 
objectives, repurchase agreements are a key area of focus and a core 
competency at our firm.
Repurchase Agreement Transactions
    In a typical repurchase transaction, an investor transacts directly 
with a bank or broker-dealer that is looking to borrow short-term 
funding collateralized with assets to secure the trade. In a tri-party 
repurchase transaction, a third party acts as an agent to facilitate 
trade settlement and collateralization. On behalf of the client assets 
that it manages, SSgA is an investor and provider of funding in a 
repurchase agreement transaction. SSgA's average total U.S. dollar 
repurchase transaction volume outstanding consistently exceeds $100 
billion, most of which settle and are collateralized through the tri-
party mechanism. While these transactions involve counterparty credit 
risk, the collateralization of the trades provides diversification away 
from unsecured credit obligations and a generally favorable risk/return 
dynamic. The tri-party mechanism provides significant operational 
efficiencies and settlement risk reduction, while also delivering 
transaction scale and investment capacity. Without these benefits of 
scale and efficiency provided by this important settlement mechanism, 
our repurchase transaction investment activities would be a fraction of 
what they are today. A diminished capacity in this core money market 
asset would likely cause investors to raise their holdings of unsecured 
debt, with increased exposure to potential credit loss and asset price 
volatility.
    Tri-party repurchase transactions provide asset managers an 
excellent alternative for maintaining core, low-risk daily portfolio 
liquidity, as well as an instrument to enhance returns through term 
repurchase transactions involving a broad range of collateral. Core 
portfolio liquidity is typically maintained through repurchase 
transactions collateralized with ``traditional'' forms of collateral 
including U.S. Treasury Bills, Notes and Bonds, Government agency 
obligations, and Government agency mortgage-backed securities. These 
core liquidity trades typically are executed for tenors of 1 to 7 days. 
In comparison, portfolio yield enhancement is often achieved through 
repurchase transactions that are collateralized with ``nontraditional'' 
or ``alternative'' forms of collateral, including investment grade 
corporate bonds, money market instruments, municipal obligations, 
asset-backed securities, high yield bonds and equities. These yield 
enhancement trades are typically executed for periods ranging from one 
week to one year. SSgA has considerable resources committed to ongoing 
support of these transactions and managing the risks associated with 
them, including dedicated senior portfolio managers, specialized 
technology infrastructure, operational personnel, designated collateral 
analysts, legal expertise, risk managers, and senior management 
oversight. We actively review, assess, stress test, and manage 
repurchase transaction collateral daily.
Task Force Recommendations
    The ongoing implementation of the Task Force recommendations has 
resulted in considerable progress toward reducing the system risk 
associated with these transact ions. Through altering transaction 
processing timelines and protocols, the industry has been able to 
achieve real progress. However, there is still work to be done to 
eliminate these risks. Additional systems enhancements and trade 
processing efficiencies and timing disciplines are required to reach 
this objective and are in-process.
    It should be noted, however, the industry has made significant 
progress in transaction risk mitigation through ongoing Task Force 
discussions and findings, Specifically, participants are now more aware 
of the need for counterparty default contingency planning, the 
requirement of knowing both your counterparty and your collateral, the 
benefits of maturity extension, required analysis and judgment 
concerning collateral suitability, the need for focus on detailed 
repurchase transaction collateral schedules and the benefits of dynamic 
margining. Enhanced awareness and transparency of these issues all 
contribute toward an informed marketplace and a consistent source of 
funding and investment returns. SSgA, on behalf of its clients, has a 
strong interest in ensuring that these important money market 
investment arrangements and supporting tri-party settlement mechanism 
continue to be a viable and vibrant aspect of the money and capital 
markets. I look forward to further industry progress on improving the 
efficient functioning of this key market mechanism.
    Thank you again for the opportunity to be here today to speak on 
this subject. I would be pleased to answer the Committee's questions.
                                 ______
                                 
                  PREPARED STATEMENT OF THOMAS G. WIPF
 Managing Director and Global Head of Bank Resource Management, Morgan 
                                Stanley
                             August 2, 2012
    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, thank you for inviting me to appear before you today. My 
name is Thomas Wipf and I am a Managing Director at Morgan Stanley and 
responsible for the firm's Bank Resource Management including Secured 
Funding, Securities Lending, and Counterparty Portfolio Management. 
Thank you again for the opportunity to discuss this very important 
issue in the markets for secured funding.
    As an active member participant in the work of the Tri-Party Reform 
Committee (Committee), Morgan Stanley remains fully committed to 
accomplishing the goals laid out by the Committee within a timeline 
that is ambitious and acceptable to all stakeholders. Our firm views 
this work as a top priority and critical path in our own funding and 
liquidity strategy. As the Committee's recommendations continue to be 
processed, we have seen meaningful benefits and risk reduction on a 
market wide basis. Morgan Stanley agrees with the Financial Stability 
Oversight Council that more needs to be done and the delay in soundly 
eliminating intraday credit risks is ``unacceptable.''
    Secured funding is an important funding source and a foundational 
component of our centralized liability management strategy. We are 
committed to and have taken significant steps to put all the 
recommendations into practice at our firm. We have heard clearly from 
the secured funding investor community that the collateral management 
services provided by the clearing banks are an important element of 
their collateral valuation and risk management process.
    The significant stability issues that appeared in 2008 provided the 
Committee, our regulators and all market participants (bank dealers, 
cash investors, and the two clearing banks) with a road map for reform. 
Many long held assumptions around durability, settlement, credit 
exposure, agent versus principal relationships and contingency planning 
were proven wrong or overly optimistic during a period of significant 
stress in the broad funding markets. The major factors for the 
instability were the short tenor of funding particularly for less 
liquid assets; lack of transparency regarding collateral for investors; 
insufficient overcollateralization on less liquid assets; and 
uncertainty regarding credit counterparties during the period between 
trade maturity and settlement. Additionally, the overall reduction of 
counterparty risk as well as a heightened market wide aversion to 
counterparty risk contributed to the instability of the platform. We 
believe the Tri-Party Reform Committee identified these weaknesses and 
defined the issues requiring remediation. In implementing these 
recommendations, we see the remaining strategic issues falling into 
three categories:

    Complete clarity on the terms and limits for credit 
        extension between the clearing banks and the bank dealers by 
        asset class

    Full implementation of a transparent settlement process 
        with a clear timeline that enables all market participants to 
        understand and manage their settlement risk and

    Further building investor confidence and reducing intraday 
        risk by a meaningful and systematic reduction of collateral 
        turnover between trade execution and maturity

    Many of the challenges faced by the Committee were a result of 
mixing the issues. Credit extension, collateral management and 
settlements are separate and distinct issues that all impact the Tri-
Party funding market. The extension of intraday credit is a major focus 
issue for the bank dealers and the two clearing banks. While our 
investors are focused on the collateral management services provided by 
the clearing banks, the operational issues are relevant to all three 
parties to the transaction. Part of the challenge faced by the 
Committee was to separate these issues although there are certain 
codependencies among them. We believe that the work ahead will only be 
successful if the issues are treated individually going forward.
    At Morgan Stanley, we have taken a number of steps to meaningfully 
reduce our daily settlement exposures ahead of the Committee's 
deadlines, most notably in the area of prudent liability and collateral 
management. Our firm has taken proactive steps to extend the maturity 
of our secured funding liabilities in a rules based governance process 
that requires minimum term of maturities consistent with the 
fundability characteristics of our assets. We additionally have imposed 
investor diversification and maturity limits to reduce our maturities 
with any investor in a given period and an overall limit on maturities 
during any given period. Our investors have focused on transparency of 
collateral, a reduction in collateral turnover during the period of the 
transaction and clarity on their credit exposure through execution, 
settlement and maturity. We have seen firsthand a marked increase in 
pretrade collateral due diligence by secured funding investors.
    We fully acknowledge there is considerable work remaining for the 
industry that requires senior leadership focus, commitment and 
investment by all participants in this market. We are committed to 
continuing to collaborate with investors, the two clearing banks and 
our regulators to complete the remaining workstreams and to advocate 
for a timeline that is acceptable to all stakeholders. Morgan Stanley's 
overarching goal in Tri-Party reform is investor confidence. The 
meaningful reduction in intraday credit extension, transparency in 
collateral and advance rates combined with a more sound and durable 
operational platform are all positive steps toward this goal. 
Nevertheless, from our firm's perspective, we have prioritized our 
resource commitments in the context of the Tri-Party reform committee's 
agenda on initiatives designed to retain the confidence of our secured 
funding investors, the cash providers.
    With lessons learned following the crisis, Morgan Stanley has 
worked over the past several years to add significant risk management 
enhancements to our secured funding model. As mentioned above, we have 
added significant term to the maturities in our secured funding 
liabilities and since a large portion of those liabilities come from 
investors who utilize the Tri-Party repo platform, our pro forma and 
actual intraday credit from our clearing banks has been meaningfully 
reduced. Since 2008 we have extended the weighted average maturity of 
our secured funding book from less than 30 days in 2008 to now well in 
excess of 120 days. This is now a disclosure metric in our public 
filings. Extending the maturity and limiting rollover risk are the most 
powerful tactical steps that can be taken by bank dealers immediately 
to reduce the intraday extension of credit. Since the credit extension 
takes place at the unwind of the trade, creating a longer and staggered 
maturity profile can yield significant risk reduction.
    The Tri-Party Reform Committee has worked to identify the issues 
and put forth recommendations for the remediation of the gaps that 
became apparent in 2008. Many of those recommendations are now in 
practice or in scope on a clear timeline. Many of the enhancements to 
the settlement and confirmation processes have created increased 
stability and added clarity. It is clear, however, that the main and 
most important goal of reducing intraday credit extension has not yet 
been achieved. It is also clear, however, that the responsibility for 
this cannot be solely assigned to the two clearing banks. We in the 
bank dealer community have to take the immediate and incremental steps 
available through our liability management practices to become a bigger 
part of the solution. There is no single operational solution or system 
development that can solve this issue completely. What is required is 
collaboration between the bank dealers and the two clearing banks to 
provide a set of strategic steps to begin a tactical but meaningful 
reduction of intraday credit extension in parallel to building 
operational and system enhancements. We believe that the status quo is 
unacceptable and by beginning this reduction through prudent liability 
management, we can reduce risk during the proposed build out by the 
clearing banks. At Morgan Stanley, we have seen considerable results 
achieved by working directly with our clearing banks to take 
significant tactical steps to reduce our reliance on intraday credit.
    Morgan Stanley is committed to taking the steps necessary to build 
investor confidence in this important funding channel. The markets' 
liquidity is provided by investors who seek to have transparency to 
their collateral, a clear understanding of the settlement process and 
the information they need in real time, to make appropriate risk 
decisions and to effectively manage their collateral and counterparty 
exposures.
    We have worked with the Tri-party Committee and other industry 
groups to move this reform forward. Morgan Stanley is committed to 
achieving the entirety of goals laid out in the Committee's report and 
has invested and executed on changes to our processes well in advance 
of the scheduled timelines with the goal of meeting the needs of our 
investors. This work is a top priority of our firm and we will continue 
to work at both an industry and a firm level along with our regulators 
to add stability and durability to this funding platform.
    Again, we are appreciative of the opportunity to discuss these 
important issues and look forward to providing this Committee with any 
level of detail and information that will be helpful as you deliberate 
on the path forward.
        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                    FROM MATTHEW J. EICHNER

Q.1. We heard testimony from the witnesses about some broker-
dealers' continued reliance on tri-party repo financing for 
less liquid collateral and the challenges such collateral would 
present for risk-averse investors such as money market funds in 
the event of a large dealer default. In discussing the need for 
counterparty default contingency planning, Mr. Steven Meier, 
who represented State Street Global Advisers at the hearing, 
recommended that the Federal Reserve audit the contingency 
plans of all the market participants to make sure they have 
addressed the requirement of collateral suitability. What steps 
is the Federal Reserve taking to monitor the actions of market 
participants around collateral liquidation plans? Should the 
Federal Reserve do more?

A.1. The Federal Reserve continues to be very concerned about 
the possibility that a default by a dealer of significant size 
would lead to a rapid and potentially disorderly liquidation of 
collateral, including but not limited to less-liquid 
securities, by risk-averse tri-party cash investors. In fact, 
we have continued to highlight both in our public 
communications and in our supervisory conversations with bank-
affiliated participants in this market that, even after the 
current program aimed at materially reducing reliance of the 
tri-party market on large amounts of discretionary intraday 
credit from the clearing banks is fully implemented, this 
``fire sale'' problem will remain an issue to be addressed.
    While we are monitoring the default contingency plans of 
those firms we supervise, robust firm-specific plans do not 
fully guard against this risk. We continue to believe that 
successfully addressing the fire sale problem will require 
development of some type of market-wide mechanism or process to 
ensure a coordinated, orderly liquidation of collateral by 
investors in the wake of a dealer's default. The challenges in 
designing and implementing a robust mechanism are appreciable. 
One key challenge is to establish adequate capacity for market 
participants to hold and finance collateral for a time even 
under adverse market conditions. Another is the need to develop 
prespecified rules to govern how any losses on the assets would 
be allocated among market participants in the event that these 
occur. Of course these issues have been successfully addressed 
in other contexts. Backup liquidity sources and loss allocation 
have long been features of a number of financial market 
utilities that govern other payment and settlement processes.
    Our view is that the best way forward would be for market 
participants to join together to develop a process or mechanism 
to ensure the orderly liquidation of collateral by creditors of 
a defaulted dealer, to eliminate the risk of fire sales. We are 
certainly open to models meeting these challenges that are 
constructed around the current market structure, with a key 
role in the settlement process played by the two clearing 
banks. But, in the event that a satisfactory model cannot be 
devised by the market, we believe other solutions should be 
considered, including those that would involve the 
establishment of a single marketwide platform to manage the 
collateral of a defaulting dealer. Any solution is likely to be 
a very challenging undertaking, in light of the formidable 
substantive issues and the diverse group of market participants 
that would need to be involved. We think it is important for 
market participants to begin working on such a mechanism now, 
as a solution may take considerable time to design and 
implement. In the interim, the Federal Reserve is very actively 
monitoring the operational and risk management capacities of 
institutions subject to its supervision that would be relevant 
in the event of a dealer's default on its tri-party repo 
obligations, notably the holding companies of the two clearing 
banks. Note that the Federal Reserve does not have direct 
supervisory authority over some of the largest cash lenders or 
broker-dealers in this market.

Q.2. If a large bank offering tri-party repo clearing were to 
suddenly fail for some reason unrelated to repo markets, is 
there a plan for how to keep the tri-party repo market from 
freezing up and allow it to continue operating? Why or why not?

A.2. In the event that either of the two tri-party clearing 
banks was to suddenly fail, the options for avoiding 
significant short-term disruptions would be limited. This 
remains the case even after the inclusion in the Dodd-Frank Act 
of provisions that provide some potentially important 
additional tools to facilitate the orderly liquidation of 
certain financial institutions affiliated with banks, including 
their ultimate holding companies. The critical role of the 
clearing banks in the tri-party settlement process could 
probably not be immediately assumed by other institutions. For 
this reason, the Federal Reserve, along with other relevant 
supervisors, focuses continuously on both the financial and 
operational condition of such firms. Concerns about the 
centrality of these institutions to the orderly functioning of 
financial markets also motivated the enactment in 2010 of 
statutory requirements that these firms be subject to enhanced 
prudential standards, including risk-based capital, liquidity, 
and leverage requirements. The Federal Reserve is now in the 
process of developing and implementing these standards.

Q.3. As the primary regulator of broker-dealers and many cash 
lenders, notably money market funds, how can the SEC use its 
supervisory powers to help improve the resiliency and stability 
of the tri-party repo platform?

A.3. The most important single step that the SEC can take to 
enhance resiliency in the tri-party repo market is to move 
forward expeditiously with meaningful reforms that would reduce 
the vulnerability of money market funds, which currently 
provide about one-third of all tri-party financing, to 
destabilizing runs. Rapid redemptions from money market funds 
by highly risk-averse investors responding to the first mover 
advantage conferred by the use of a rounding mechanism to 
maintain a stable share price can quickly create stress in the 
tri-party market and in the financial system as a whole, as was 
observed during the financial crisis. The importance of 
effectively addressing the susceptibility of money market funds 
to runs cannot be overstated, and the SEC is, by virtue of its 
longstanding experience with regulating investment companies 
and existing statutory authority with respect to money market 
funds, uniquely well-positioned to take action.
    In addition, the SEC has been helpful in encouraging 
broker-dealers, the borrowers in the tri-party market, to 
actively manage their funding risk, for example using longer-
dated transactions to finance less-liquid positions and by 
avoiding large volumes of transactions all maturing 
simultaneously. Recent proposed rules issued by the SEC for 
comment that would, inter alia, impose liquidity requirements 
on large broker-dealers that, if finalized, would represent a 
significant step in the right direction.
              Additional Material Supplied for the Record
        STATEMENT SUBMITTED BY THE INVESTMENT COMPANY INSTITUTE
    The Investment Company Institute \1\ is pleased to provide this 
written statement in connection with the Subcommittee's hearing on the 
tri-party repo market.
---------------------------------------------------------------------------
     \1\ The Investment Company Institute is the national association 
of U.S. investment companies, including mutual funds, closed-end funds, 
exchange-traded funds (ETFs), and unit investment trusts (UITs). ICI 
seeks to encourage adherence to high ethical standards, promote public 
understanding, and otherwise advance the interests of funds, their 
shareholders, directors, and advisers. Members of ICI manage total 
assets of $13.1 trillion and serve over 90 million shareholders.
---------------------------------------------------------------------------
    Registered investment companies--including mutual funds, ETFs, 
closed-end funds, and UITs (collectively, ``registered funds'')--have a 
significant interest in the subject of this hearing. Tri-party repo is 
a key source of short-term financing for a wide range of borrowers such 
as banks and brokerage firms. \2\ The Federal Reserve Bank of New York 
(the ``FRBNY'') reports that as of June 2012, borrowers financed $1.8 
trillion through this market. \3\ Likewise, cash investors such as 
corporations, State and local governments, financial institutions, and 
registered funds use this market to invest short-term cash. Among 
registered funds, money market funds have the largest presence in this 
market with $519 billion invested in repos in June 2012, while stock 
and bond funds invested an additional $96 billion. Most of these repos 
are tri-party repo.
---------------------------------------------------------------------------
     \2\ The Federal Reserve Bank of New York's white paper on tri-
party repo provides a comprehensive description of the repo market. 
See, ``Tri-Party Repo Infrastructure Reform'' (May 17, 2010), available 
at http://www.newyorkfed.org/banking/nyfrb_tri-party_whitepaper.pdf.
     \3\ See, ``Tri-Party Repo Statistics as of 06/11/2012'', available 
at http://www.newyorkfed.org/tri-partyrepo/pdf/jun12_tpr_stats.pdf.
---------------------------------------------------------------------------
    The ICI and several representatives from ICI member firms 
participated on a special Task Force on Tri-Party Repo Infrastructure 
(the ``Task Force''), which was formed in September 2009 under the 
auspices of the Payments Risk Committee, a private sector body 
sponsored by the FRBNY. The Task Force recently concluded its work, 
highlighting a number of areas in which significant progress was made 
to meaningfully reduce both the potential for systemic risk and the 
magnitude of the risk associated with the tri-party repo 
infrastructure. \4\
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     \4\ See, ``Task Force on Tri-Party Repo Infrastructure Payments 
Risk Committee'', Final Report (February 15, 2012), available at http:/
/www.newyorkfed.org/tri-partyrepo/pdf/report_120215.pdf.
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    These reforms include increased transparency, significant reduction 
in the extension of intraday credit by the clearing banks, improved 
collateral substitution and management practices, and best practices 
for cash investors for disposing of securities in the event of a 
failure of a tri-party repo counterparty. Each of these reforms is 
described briefly below.
    Increasing Market Data for Repos. Beginning in May 2010, the FRBNY 
began publishing market data on the tri-party repo market on its web 
site. \5\ This data highlights the overall size of the market, 
collateral, concentrations, and margin requirements that exist within 
the market. This reporting has provided greater transparency into the 
broader market, giving all market participants and regulators the 
ability to monitor repo exposures and highlight repo market trends.
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     \5\ See, http://www.newyorkfed.org/banking/tpr_infr_reform.html.
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    In addition, in response to a Task Force recommendation, dealers, 
cash investors, and tri-party repo clearing banks are now fully 
implementing three-way trade confirmations. These added operational 
enhancements allow the tri-party clearing banks and regulators to 
monitor ``real-time'' credit exposures. It also provides the tri-party 
repo clearing banks an additional level of transparency within the repo 
market and reduces the risk of the occurrence of failed or intraday 
defaulted repo trades for all market participants. \6\
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     \6\  In addition to the increased transparency in the tri-party 
repo market, registered funds are required to provide additional 
disclosure about their repo activities. This disclosure appears in the 
fund's prospectus and statement of additional information, both of 
which are available to investors, regulators, and the public. Twice a 
year, registered funds also prepare financial statements that are filed 
with the Securities and Exchange Commission (SEC) and sent to 
shareholders. In addition to the semi-annual financials in these 
shareholder reports, registered funds also file Form N-Q after the 
first and third quarters, which include a detailed listing of the 
fund's portfolio.
     Money market funds have additional disclosure requirements. They 
are required to post their portfolio holdings on their Web sites each 
month within five business days after month end. Money market funds 
also are required to file Form N-MFP with the SEC on a monthly basis. 
This provides details on the fund and its portfolio holdings (including 
detail on each security held as collateral), and has given regulators 
and the public significantly enhanced transparency with respect to 
money market funds' role in tri-party repos.
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    Delaying the ``Unwind.'' Changes have recently been implemented to 
cause the daily ``unwind'' of most tri-party repo transactions to move 
from early morning to mid-afternoon, greatly reducing the duration of 
intraday credit extensions by the tri-party repo clearing banks to the 
dealers. The delay in the unwind has been very significant, in that the 
tri-party banks now have much greater clarity into the ability of 
borrowers to finance their repo book. The situation was much more 
opaque with a morning unwind. Work on this front continues, with the 
ultimate goal of reducing credit extensions by the tri-party repo 
clearing banks to the dealers to no more than 10 percent of a dealer's 
notional tri-party book.
    Improving Collateral Substitution/Collateral Management. Both tri-
party repo clearing banks have recently implemented automated 
collateral substitution capabilities as a result of recommendations 
from the Task Force. The introduction of such automated systems has 
allowed cash investors and other industry participants to monitor and 
manage their intraday collateral positions and ensure that their repo 
exposures are adequately collateralized on a ``real-time'' basis. 
Industry participants continue to actively work with the tri-party repo 
clearing banks to build out the capabilities of this technology and 
improve the transparency and the efficiency of this important 
monitoring system. The ability to efficiently substitute collateral 
helps to prevent disruptions to regular market activity as dealers have 
full access to their positions throughout the day.
    SEC guidelines require that registered funds involved in a repo 
transaction receive at least 100 percent of the value of the cash 
invested. In practice, virtually all investors over-collateralize repos 
at levels ranging from 102 to 110 percent, demonstrated by the 
collateral haircut data published monthly by the FRBNY. The tri-party 
clearing banks price the collateral on at least a daily basis using 
various independent pricing sources, which ensures centralized and 
consistent valuation across all market participants. The clearing banks 
continually review the pricing sources to ensure that the repo 
transactions are marked-to-market daily and are adjusted so that the 
obligations remain fully collateralized at all times.
    Dealing With the Potential for Counterparty Defaults. Money market 
funds are distinct from other lenders in the repo market in that they 
are required to determine that counterparties present ``minimal credit 
risk,'' assuring that the funds are only dealing with the highest 
quality counterparties. Nevertheless, money market funds and other 
registered funds share the common goal of minimizing counterparty risk 
in tri-party repo, and have strongly supported the Task Force's efforts 
in this regard.
    And as a result of the recommendations from the Task Force, the 
repo markets are better prepared to deal with potential dealer 
defaults. The tri-party clearing banks are working toward adopting 
``waterfall'' recommendations of the Task Force that will mandate the 
priority of payments or distribution of assets in the event of a 
default. In addition, various industry groups continue to work with the 
tri-party repo clearing banks and industry participants to develop a 
process for the orderly liquidation of collateral. For example, in 
consultation with its members, the ICI published a checklist for cash 
investors in the event of the insolvency of a tri-party repo borrower. 
\7\ This checklist includes preliminary steps that registered funds 
investing in tri-party repo should have in place as well as actions 
that would need to be taken in the event of a default, including 
guidelines on collateral valuation, board notification, and regulatory 
filings.
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     \7\ See, Investment Company Institute, ``Checklist for Fund 
Investors of Repurchase Agreement in the Event of Dealer Insolvency'', 
available at http://www.ici.org/policy/current_issues/
11_mmf_repo_checklist.
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    With the ongoing implementation of these and other Task Force 
recommendations, the tri-party repo markets are better prepared to deal 
with potential defaults. As the Task Force's final report noted, 
additional work is needed to put in place the infrastructure to meet 
the Task Force's goal of ``the practical elimination of intraday credit 
associated with the settlement of tri-party repo transactions.'' ICI 
and its members continue to support that important goal.
    In any event, market participants and regulators have become much 
more attuned to the risks of overreliance on short-term financing. Cash 
investors and borrowers regularly engage in discussions about the 
degree to which borrowers are relying on the repo markets, and 
regulators are encouraging banks and other borrowers to extend the 
terms of their borrowing to reduce their reliance on short-term 
financing. \8\ These efforts have reduced the chances that a firm's 
inability to access the short-term markets would lead to its immediate 
collapse, as was the case with Bear Stearns and Lehman Brothers.
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     \8\ See, e.g., ``FRBNY Update on Tri-Party Repo Infrastructure 
Reform'' (July 18, 2012) (``Broker-dealers are expected to reduce their 
reliance on short-term tri-party repo financing, particularly for less 
liquid assets, to achieve the necessary reductions in the usage of 
intraday clearing bank credit.''), available at http://
www.newyorkfed.org/newsevents/statements/2012/0718_2012.html.
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    We appreciate the opportunity to share our views with the 
Subcommittee on the tri-party repo market, and we look forward to 
working with Congress in addressing these important issues in a manner 
that benefits the millions of American investors who rely on registered 
funds to achieve their investing goals.

```