The FRB recently released an interpretive letter addressed to Morgan Stanley Bank, N.A. (“Morgan Stanley Bank”) in which the FRB’s General Counsel addressed the manner in which Morgan Stanley Bank should determine the value of transactions involving the novation to Morgan Stanley Bank of certain foreign exchange (“FX”) derivatives contracts between affiliates of Morgan Stanley Bank and third parties.
As described in the interpretive letter, through the novation process, Morgan Stanley Bank would succeed to the rights and obligations of its affiliates with respect to the FX derivatives. The interpretive letter states that the proposed novations are covered transactions for purposes of Section 23A of the Federal Reserve Act because Morgan Stanley Bank would purchase an asset—the right to receive payments from the counterparties to the FX derivatives being novated—from each affiliate novating FX derivative contracts in exchange for agreeing to assume all of such affiliate’s obligations under those contracts. The interpretive letter explains how Morgan Stanley Bank should value the transactions for purposes of determining the aggregate amount of covered transactions outstanding between Morgan Stanley Bank and its affiliates. For this purpose, under the methodology described in the letter, Morgan Stanley Bank would be required to determine, on a daily basis, its full risk exposure resulting from the novations from any single affiliate by adding (i) the amount of all payments made by Morgan Stanley Bank to or for the benefit of the affiliate in connection with any novation, (ii) the aggregate absolute value of the negative current exposure of all novated contracts or derivative netting sets that have negative current exposure at the time of novation (i.e., an amount by which the contracts are “out of the money”), (iii) the amount of a “counterparty credit risk measure” determined in the manner specified in the interpretive letter (which takes into account both current and potential future credit exposure to the counterparties), and (iv) the amount of a “market risk measure” determined in the manner specified in the interpretive letter. However, Morgan Stanley Bank would be permitted to reduce this amount by deducting (i) any payments made by the affiliate to Morgan Stanley Bank, (ii) the aggregate amount of any qualifying collateral or margin held by Morgan Stanley Bank with respect to the novated derivative contracts or netting sets, and (iii) the amount of qualifying collateral or margin previously posted by the affiliate to a counterparty so long as the affiliate transfers to Morgan Stanley Bank all current and future rights to the collateral. The interpretive letter states that it applies only to FX derivatives contracts and only in the context of the specific transactions proposed by Morgan Stanley Bank and that other types of derivatives or other transactions may be subject to a different valuation methodology. Further, the interpretive letter states that Morgan Stanley Bank would be required to comply with any valuation methodology required by any revision of the FRB’s Regulation W, as applicable.
As summarized in the November 13, 2012 Financial Services Alert, at a meeting held on November 13, 2012, the Financial Stability Oversight Council (“FSOC”) approved proposed recommendations for the structural reform of money market mutual funds (“MMFs”). As set forth in a release from the FSOC (the “Release”), FSOC is proposing three alternatives for public comment (the “Reform Alternatives”). Before discussing each of the Reform Alternatives, this article first provides background information on MMFs, including the 2010 reforms described in the Release, as well as FSOC’s mission and authority.
Importantly, the Release constitutes the beginning of a process through which FSOC may, but is not required to, issue a formal recommendation to the SEC as MMFs’ primary regulator. At this stage, FSOC is requesting public comment on (1) whether MMFs could create or increase the risk of significant liquidity and credit problems spreading among financial companies and markets and (2) the advisability of the Reform Alternatives and other reform options, such as liquidity fees and redemption gates. After considering comments, FSOC may issue a final recommendation to the SEC, which would be required to follow the recommendation or an alternative acceptable to FSOC, or to explain in writing to FSOC within 90 days why it has determined not to follow FSOC’s recommendation.
Money Market Funds and the “2010 Amendments”
A mutual fund that holds itself out as a “money market fund” is subject to the same legal and regulatory requirements as mutual funds in general, except that Rule 2a-7 under the Investment Company Act of 1940 (the “1940 Act”) allows a MMF to maintain a stable net asset value (“NAV”) per share of $1.00, provided that the MMF complies with the conditions of the Rule. A MMF typically stabilizes its share price at $1.00 by using the Amortized Cost Method. Among other requirements, Rule 2a-7 imposes certain “risk-limiting conditions” relating to portfolio maturity, credit quality, liquidity and diversification.
In 2010, the SEC adopted significant amendments to Rule 2a-7 and other rules under the 1940 Act that affect MMFs (the “2010 Amendments”). The 2010 Amendments, which are discussed in detail in the March 5, 2010 Financial Services Alert, resulted in changes to the “risk-limiting conditions” set forth above and imposed changes to operational and disclosure requirements. In this regard, the 2010 Amendments resulted in, for example, shortened maturity requirements, a reduction in the amount of “second-tier” securities that may be held by a MMF and heightened liquidity requirements. The 2010 Amendments also imposed specific “stress testing” requirements and added requirements that MMFs disclose their portfolio holdings on a more frequent basis and disclose the “shadow” price of their shares, which reflects the actual market value of a MMF’s holdings.
As described in the Release, in FSOC’s opinion, the 2010 Amendments did not fully address certain characteristics of MMFs that make them vulnerable to potentially destabilizing runs.
The Financial Stability Oversight Council
The Dodd-Frank Act established FSOC to identify systemic risks to the financial stability of the United States, end the expectation that some institutions are “too big to fail” and respond to emerging threats to the U.S. financial system. FSOC is composed of ten voting members and five non-voting members. The ten voting members of FSOC are the Treasury Secretary (who serves as the chair of the Council), the FRB Chairperson, the Comptroller of the Currency, the Bureau of Consumer Financial Protection Director, the SEC Chairperson, the FDIC Chairperson, the CFTC Chairperson, the FHFA Director, the NCUA Chairperson and an independent member having insurance expertise appointed by the President with the advice and consent of the Senate. The five non-voting members of the Council are the Office of Financial Research Director, the Federal Insurance Office Director, a state insurance commissioner, a state banking supervisor and a state securities commissioner.
In issuing the Reform Alternatives, FSOC is asserting its authority under Section 120 of the Dodd-Frank Act. Under Section 120, FSOC may recommend to a primary regulator (in the case of MMFs, the SEC) new or heightened prudential standards and safeguards for activities FSOC determines create systemic risk. In order to designate a financial activity as systemically significant, FSOC must determine that the conduct, scope, nature, size, scale, concentration, or interconnectedness of the activity or practice could create or increase the risk of significant liquidity, credit or other problems spreading among bank holding companies and nonbank financial companies, U.S. financial markets or low-income, minority or underserved communities. Under the Dodd-Frank Act, as described in the Release, FSOC asserts that it has other options at its disposal, which include FSOC’s designation authority with respect to Systemically Important Financial Institutions (so called, SIFIs) and with respect to financial market utilities or payment clearing or settlement activities that FSOC determines are, or likely to become, systemically important, as well as the potential involvement of primary banking regulators.
Threshold Determination that MMFs Could Create or Increase the Risk of Significant Liquidity and Credit Problems Spreading Among Financial Companies and Markets
In order to issue a recommendation under Section 120, “FSOC must determine that the conduct, scope, nature, size, scale, concentration, or interconnectedness of MMFs’ activities or practices could create or increase the risk of significant liquidity, credit, or other problems spreading among bank holding companies and nonbank financial companies or U.S. financial markets.” As described in the Release, FSOC believes that MMFs are vulnerable to destabilizing “runs,” which, in its view, could impair liquidity broadly and curtail the availability of short-term credit. The Release includes a list of factors that FSOC believes make MMFs vulnerable to “runs.” For example, the Release states that a MMF’s stable NAV exacerbates investors’ incentive to redeem their MMF shares when there are indications that the price could fluctuate. The Release also discusses the concept of “maturity transformation,” noting that MMF investors typically have the ability to redeem their investment on demand while the portfolio maturity profile of a given MMF would likely be longer in duration. The Release also cites the lack of explicit loss absorption capacity as providing an incentive for investors to redeem at signs of stress.
The Reform Alternatives
The Release includes three Reform Alternatives for public comment. Each of the Reform Alternatives is described below, followed by key points from the Release.
Reform Alternative 1: Floating Net Asset Value. Require MMFs to have a floating NAV per share by removing the special exemption that currently allows MMFs to utilize amortized cost accounting and/or penny rounding to maintain a stable NAV of $1.00.
Key Points from the Release:
- Rule 2a-7’s “risk-limiting” provisions would continue to apply to any fund that called itself a “money market fund,” despite the shift to a floating NAV.
- A MMF would re-price its shares at $100.00 per share (as opposed to the current $1.00 share price) to be more reactive to fluctuations in the value of the portfolio’s underlying securities. The Release highlights that shareholders would be able to purchase and redeem fractional shares.
- Under this alternative, Rules 22e-3 (orderly liquidation) and 17a-9 (sponsor support) under the 1940 Act would be rescinded.
- The Release also provides for a potential “phase-in” or “grandfathering” provision for existing MMFs and seeks comment on the length of time involved with, and structure of, such a provision.
- FSOC seeks comment on the tax and accounting considerations involved with a transition to a floating NAV. The Release acknowledges that the transition to a floating NAV would result in taxable gains or losses, like those experienced with respect to non-money market mutual funds. These tax implications could be exacerbated in light of the large volume of MMF share transactions compared to other mutual funds. The Release also notes that U.S. generally accepted accounting principles currently treat investments in MMFs as an example of a cash equivalent and that shareholders and their accountants would need to evaluate whether a floating-NAV MMF meets the characteristics of a cash equivalent under relevant accounting guidance.
Reform Alterative 2: Stable NAV with NAV Buffer and “Minimum Balance at Risk.” Require MMFs to have a NAV buffer with a tailored amount of assets of up to 1 percent to absorb day-to-day fluctuations in the value of the funds’ portfolio securities and allow the funds to maintain a stable NAV. The NAV buffer would be paired with a requirement that 3 percent of a shareholder’s highest account value in excess of $100,000 during the previous 30 days — a minimum balance at risk (“MBR”) — be redeemed only on a delayed basis.
Key Points from the Release:
- In the event that an MMF suffers losses that exceed its NAV buffer, those losses would be borne first by the MBRs of shareholders who have recently redeemed.
- These requirements would not apply to Treasury MMFs, and investors with balances of less than $100,000 would not be subject to the MBR requirement.
- The size of a MMF’s NAV buffer would be tailored to the nature of the MMF’s holdings, using the following formula: (i) no buffer requirement for cash, Treasury securities and repurchase agreements collateralized solely by cash and Treasury securities (Treasury repos); (ii) a 0.75% buffer requirement for other daily liquid assets (or for weekly liquid assets, in the case of tax-exempt funds); and (iii) a 1.00% buffer requirement for all other assets.
- A MMF whose NAV buffer falls below the required minimum amount would be required to limit any new investments to cash, Treasury securities and Treasury repos until its NAV buffer was restored.
- A number of sources could be used to fund the NAV buffer, including establishing an escrow account funded by a MMF’s sponsor, issuing subordinated buffer shares and retaining earnings of a MMF. Certain provisions of the 1940 Act would need to be amended to facilitate certain of these funding options. There also could be tax implications if a MMF funded its NAV buffer by retaining earnings that it would normally pass-through to shareholders.
- MMFs would be required to apply the MBR requirement to each of their recordholders. This would include recordholders that are financial intermediaries, such as banks or broker-dealers that hold shares on behalf of their customers, absent transparency into the identity of the underlying beneficial owners.
- Absent action by the Commodity Futures Trading Commission (the “CFTC”) to reassess customer funds investment regulations as they pertain to MMFs other than Treasury MMFs, futures commissions merchant and derivatives clearing organizations would not be able to invest customer funds in MMFs subject to an MBR because such MMFs would not meet existing CFTC requirements that such MMFs be legally obligated to redeem shares and make payment in satisfaction thereof by the business day following a redemption request.
Reform Alternative 3: Stable NAV with NAV Buffer and Other Measures. Require MMFs to have a risk-based NAV buffer of 3 percent to provide explicit loss-absorption capacity that could be combined with other measures to enhance the effectiveness of the buffer and potentially increase the resiliency of MMFs. Other measures could include more stringent investment diversification requirements, increased minimum liquidity levels, and more robust disclosure requirements. To the extent that it can be adequately demonstrated that more stringent investment diversification requirements, alone or in combination with other measures, complement the NAV buffer and further reduce the vulnerabilities of MMFs, FSOC could include these measures in its final recommendation and would reduce the size of the NAV buffer required under this alternative accordingly.
Key Points from the Release:
- Similar to Reform Alternative 2, the NAV buffer could be funded by establishing an escrow account, issuing subordinated buffer shares and retaining earnings, and Treasury MMFs would be excluded from the requirement.
- Reform Alternative 3 differs from Reform Alternative 2 in that the NAV buffer in Reform Alternative 2 is primarily designed to absorb day-to-day variations in the mark-to-market value of MMFs’ portfolio holdings, and the MBR serves as the primary tool to reduce investors’ incentive to redeem their shares when a fund encounters stress. Under Reform Alternative 3, the NAV buffer would be designed to both absorb day-to-day variations in the mark-to-market value of portfolio holdings and reduce their vulnerability to runs.
- The size of a MMF’s NAV buffer would be tailored to the nature of the MMF’s holdings, using the following formula: (i) no buffer requirement for cash, Treasury securities and Treasury repos; (ii) a 2.25% buffer requirement for other daily liquid assets (or for weekly liquid assets, in the case of tax-exempt funds); and (iii) a 3.00% buffer requirement for all other assets.
- The additional measures that may complement the NAV buffer in mitigating run vulnerabilities include more stringent investment diversification requirements, increased minimum liquidity levels and additional disclosure requirements. With respect to diversification requirements, FSOC is requesting comment on two proposed modifications: (i) reduce the 5 percent diversification limit currently in Rule 2a-7; and (ii) revise the definition of “issuer” in this context to include all affiliates of a consolidated group. With respect to modification (ii), the Release observes that stress at a financial holding company would often occur at the same time as its bank or broker-dealer subsidiaries. The Release also proposes increasing liquidity buffers by raising, for example, the required level of daily liquidity from 10% to 20% of a MMF’s assets, and the minimum weekly liquidity requirement from 30% to 40%. This would be coupled with enhancements to the existing “know your investor” requirements applicable to MMFs in order to provide MMFs with increased visibility into the underlying shareholders in omnibus accounts, as well as further disclosures regarding a MMF’s actual holdings.
The Release highlights that the Reform Alternatives are not mutually exclusive recommendations and that FSOC may determine to recommend an alternative with elements of more than one of the Reform Alternative or other options.
Alternatives 1 and 2 essentially track the reform options advanced by SEC Chairman Schapiro earlier in the year that, as discussed in the August 28, 2012 Financial Services Alert, were ultimately withdrawn due to a lack of support from a majority of the SEC Commissioners.
In the Release, FSOC acknowledged that other reform options may achieve similar outcomes. In this regard, FSOC is also seeking public comment on other potential reforms that FSOC could consider in making its final recommendation, including, for example, standby liquidity fees and redemption gates. As described in the Release, standby liquidity fees, when triggered, would directly charge shareholders who redeem their shares to compensate MMFs and the remaining MMF investors of the potential cost of withdrawing liquidity from the funds. On the other hand, “gates,” when triggered, would prohibit investors from redeeming and provide a period of time for a fund to adjust to market stress. According to the Release, the standby liquidity fee or gating arrangements could be imposed automatically based on specific measures indicating stress on a MMF, such as a decline in the MMF’s mark-to-market NAV or a reduction in liquidity.
Comments are due by January 18, 2013. Under the Dodd-Frank Act, if FSOC issues a recommendation for the structural reform of MMFs, the SEC is required to “impose the recommended standards, or similar standards that [FSOC] deems acceptable, or explain in writing to [FSOC] within 90 days why it has determined not to follow the recommendation.” In the alternative, the Release states that “[i]f the SEC moves forward with meaningful structural reforms of MMFs before [FSOC] completes its Section 120 process, [FSOC] expects that it would not issue a final Section 120 recommendation to the SEC.”
The Secretary of the Treasury issued a final written determination exempting foreign exchange swaps and foreign exchange forwards from the definition of “swap.” The Commodity Exchange Act, as amended by the Dodd-Frank Act, authorizes the Secretary of the Treasury to determine that foreign exchange swaps and/or foreign exchange forwards should not be regulated as swaps under the Commodity Exchange Act and are not structured to evade the Dodd-Frank Act. The determination, which is summarized in an accompanying fact sheet, includes a discussion of the Secretary of the Treasury’s analysis of the various factors statutorily required to be considered in determining whether to exempt foreign exchange swaps and foreign exchange forwards from the swap definition.
The two terms are defined in Section 1a of the Commodity Exchange Act as follows:
(24) Foreign exchange forward
The term “foreign exchange forward” means a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange.
(25) Foreign exchange swap
The term “foreign exchange swap” means a transaction that solely involves—
(A) an exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange; and
(B) a reverse exchange of the 2 currencies described in subparagraph (A) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange.
The determination notes that the Secretary of the Treasury does not have the authority to exclude other types of derivatives, including foreign exchange options, currency swaps, and non-deliverable forwards, which therefore remain within the “swap” definition. The determination notes that a material distinction between foreign exchange swaps and foreign exchange forwards, on the one hand, and instruments such as currency swaps, on the other, is that the payment obligations of the latter instruments are variable and change due fluctuations in underlying references such as interest rates, with the result that payment obligations cannot be accurately predicted at the inception of the instrument. The payment obligations arising under foreign exchange swaps and foreign exchange forwards, on the other hand, are fixed and known to all parties when the instruments are first executed.
The determination notes that foreign exchange swaps and foreign exchange forwards remain subject to certain CFTC reporting and anti-evasion rules as well as business conduct standards.
The CFTC voted to appeal a federal court decision that vacated and remanded its rule imposing a position limits regime for derivatives contracts tied to twenty-eight different agricultural, metal, and energy commodities. Ruling on a challenge filed by the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association, the court held that the CFTC is required to determine that the rule is necessary and appropriate prior to adopting it. Although the court’s decision does not preclude the CFTC from re-issuing the rule after making a finding of necessity, three of the CFTC’s commissioners voted to appeal the ruling, with two opposing.