On October 22, 2015, the prudential banking regulators (which includes the OCC, FDIC and the Federal Reserve Board) approved the final version of the non-cleared swap margin rule (available here). We will be considering many aspects of this rule in a series of postings, but in this posting we focus on a single discrete issue:

Whether a money market mutual fund (“MMF”) constitutes eligible collateral that can be posted in respect of a non-cleared swap. 

The answer, of course, is it depends. In sum, a MMF will constitute eligible collateral, as long as the following conditions are met:

Redeemable Shares Representing Proportional Ownership Interest – The fund must issue redeemable securities that represent a shareholder’s proportional ownership interest in the fund.  This requirement is consistent with the regulations under the Investment Company Act of 1940 (the “1940 Act”) that apply to the operation and management of MMFs, a type of redeemable fund or, in the language of the 1940 Act, an “open-end investment company”.

Daily Pricing Based on the Value of the Fund’s Net Assets – The fund must issue and redeem its shares on the basis of the market value of the fund’s net assets and the net asset value per share (“NAV per share”) of the fund must be determined on a daily basis and after the shareholder submits a redemption request.  This requirement is consistent with existing regulations and requirements under the 1940 Act.  However,  it is unclear whether this requirement would still be met if a MMF adopted a proposed form of pricing recently proposed by the SEC (known as “swing pricing”) that would allow the fund to give consideration to the economic costs of shareholder redemption activity when pricing its shares (i.e., the NAV per share would not be based exclusively on the market value of the fund’s net assets).

Investments Must Be Treasuries and Immediately Available Cash – The fund can only invest in:

“(A) securities that are issued by, or unconditionally guaranteed as to the timely payment of principal and interest by, the U.S. Department of Treasury, and immediately available cash funds denominated in U.S. dollars; or

(B) securities denominated in a common currency and issued by, or fully guaranteed as to the payment of principal and interest by, the European Central Bank or a sovereign entity that is assigned no higher than a 20 percent risk weight under the capital rules applicable to the swap dealer, and immediately available cash funds denominated in the same currency.”

In summary, the universe of eligible MMFs would be those that are limited to investing in Treasury securities (or an equivalent type of non-U.S. fund that invests in certain, Treasury-equivalent foreign securities).

No Use of Repos by Eligible MMFs? – Section 6 of the final margin rule provides that eligible MMFs may not “transfer assets of the fund” through “repurchase agreements, reverse repurchase agreements, or other means that involve the fund having rights to acquire the same or similar assets from the transferee”.  By its express terms, the final rule appears to prohibit the use of repos for investment purposes (e.g., Treasury-backed repos used to invest cash on an overnight basis).  However, language in the preamble suggests that there may be some flexibility for MMFs to use Treasury-backed repos.

In particular, the preamble to the final margin rules suggests that the restriction in section 6 on the use of repos and reverse repos was intended to ensure consistency with section 7 of the rule, which:

1) mandates that an unaffiliated, third-party custodian hold initial margin posted to or by the swap dealer; and

2) prohibits such custodian from re-hypothecating the assets posted by the swap dealer.

Interestingly, section 7 of the final margin rule allows the custodian to hold cash collateral in a general deposit account to “purchase an asset” that constitutes eligible collateral under the new rule.  The use of the phrase “purchase an asset” in section 7 (i.e., in the context of describing an acceptable investment of cash-collateral) suggests that the term “asset” could mean non-cash collateral, since an interpretation permitting the use of cash collateral to “purchase” cash simply makes no sense.  Under such an interpretation, the use of repos backed by Treasuries or other eligible collateral may not be prohibited by section 6 of the final margin rule since section 7 would permit the custodian to invest cash in the types of assets backing the repo (i.e., Treasuries).

Pursuant to this interpretation, the section 6 prohibition on the use of repos would not apply if cash is invested in a Treasury-backed repo, as compared to using the repo to transfer assets (i.e., Treasuries) out of the fund in exchange for cash.  For purposes of Section 6 of the new margin rule, investing in Treasury-backed repo would be viewed as a permissible investment by the MMF instead of a prohibited “transfer of assets” (i.e., on the basis that cash is not an “asset” that is being “transferred” when the MMF uses it to invest in repo backed by eligible collateral). 

This interpretation of Section 6 seems plausible in light of:

1) the provisions in section 7 that permit the third-party custodian to use cash in a general deposit account to purchase eligible collateral; and

2) the policy objective in respect of Section 6 articulated in the preamble to the final rule (i.e., to ensure consistency with section 7).

However, in considering such an interpretation, it must be noted that the final margin rule does not define the term “asset” and the plain language of the rule provides that any “transfer of assets” under a repurchase agreement or reverse repurchase agreement by a MMF would make that fund ineligible for use as collateral on a non-cleared swap.  Given the prevalent use of Treasury-backed repos in MMFs, we respectfully encourage the prudential regulators to consider providing market participants with formal guidance as to whether or not MMFs that use repos for investment purposes may constitute eligible collateral.

Good day.  Good interpretation? DR2