Repurchase Agreements (Repos)

This post is Part 2 of a series of posts that addresses the impact of recent regulatory developments on the use of limited recourse provisions in futures customer agreements entered into between a futures commission merchant (an “FCM”) and an investment manager on behalf of one or more of the manager’s clients.

In this post, we provide an overview of recent regulatory pronouncements from two divisions of the Commodity Futures Trading Commission (the “CFTC”) and the Joint Audit Committee (the“JAC”) of several large futures exchanges and the National Futures Association that prohibit the use of limited recourse provisions in futures customer agreements.
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Historically, many investment managers have negotiated limited recourse provisions into derivatives trading agreements entered into by the managers on behalf of their clients with banks, broker-dealers, and futures commission merchants (FCMs).  In short, these provisions state that only the assets in the specified account under the control of that particular manager can be used to make the other party to the agreement whole for losses and costs that relate to the specified account.

However, recent regulatory pronouncements from two divisions of the Commodity Futures Trading Commission (the “CFTC”) and the Joint Audit Committee (the “JAC”) of several large futures exchanges and the National Futures Association prohibit the use of limited recourse provisions in futures customer agreements.  This blog post is Part 1 of a series of posts that will address the impact of these recent regulatory developments on investment managers.

We start with the basics – investment management relationships and the use of limited recourse provisions in derivatives trading documents.  Additional posts in this series will address the regulatory pronouncements and how those pronouncements may impact relationships that investment managers have with their clients and the FCMs through which the managers are trading on behalf of their clients.
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Repo rates were steadier last week, as compared to the wild swings of the prior week,  as the Secured Overnight Financing Rate (SOFR)—a broad measure of the overnight Treasury repo market—fluctuated between 1.82% and 2.01%. The week started with the SOFR rate at 1.85% on Monday, it then increased a bit on Tuesday and Wednesday to 1.96% and 2.01% respectively before falling back to 1.85% on Thursday and to 1.82% on Friday.
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Last week saw a wild ride for repo rates as the Secured Overnight Financing Rate (SOFR)—a broad measure of the overnight Treasury repo market—fluctuated between 1.95% and 5.25%. The week started with the SOFR rate moving higher to a range of 2.43-4.60% on Monday which was a significantly higher range from the prior Friday (2.16-2.40%). Then on Tuesday SOFR spiked to 5.25% with a print in the 99% percent of the range of trades at 9.00%. The rate stabilized a bit on Wednesday falling to a range of 2.10-5.00% with a rate of 2.55%. Then following the Fed Reserves announcement on Wednesday of a 0.25% rate cut to the Fed Funds Rate, SOFR fell to 1.95% on Thursday and to 1.86% on Friday.
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On Monday, June 24, 2019, U.S. Securities and Exchange Commission Chairman Jay Clayton, U.S. Commodity Futures Trading Commission (“CFTC”) Chairman J. Christopher Giancarlo, and U.K. Financial Conduct Authority Chief Executive Andrew Bailey issued a joint statement (“Joint Statement”) regarding collaboration to monitor the credit derivatives markets.  The Joint Statement states, in part, that:

The continued pursuit of various opportunistic strategies in the credit derivatives markets, including but not limited to those that have been referred to as “manufactured credit events,” may adversely affect the integrity, confidence and reputation of the credit derivatives markets, as well as markets more generally.  These opportunistic strategies raise various issues under securities, derivatives, conduct and antifraud laws, as well as public policy concerns.

The Joint Statement also notes that the agencies’ collaborative efforts would not preclude any of the agencies from taking independent actions under their respective authority.
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Both the SEC and FINRA recently released their 2019 Examination priorities, (available here and here) highlighting primary areas of focus for 2019.  While there are no surprises, there are some items that have a unique twist that warrant attention.  In this post we provide an overview of the regulators focus on Reg SHO and short selling.

Both regulators will continue to focus on aspects of Reg SHO compliance.  FINRA will be focused on the exception to the netting required in Rule 200(c).  Rule 200(c) states that a person shall be deemed to own securities only to the extent that he has a net long position in such securities.  Rule 200(f) grants an exception to the netting requirement by allowing broker-dealers to break into independent aggregation units for purposes of determining the trading unit’s net position.  To take advantage of the exception, broker-dealers must demonstrate four criteria to establish separateness and independence.  Of note, only broker-dealers can rely on 200(f).  During the adoption of Reg SHO Rule 200, commenters requested that the SEC extend the relief beyond broker-dealers, and the SEC declined to do so, stating that the lack of oversight by a self-regulatory organization might facilitate the creation of units that are not truly independent or separate. The SEC will be looking at Reg SHO compliance more broadly in the context of microcap securities. 
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On the heels of remarks by his U.S. Commodity Futures Trading Commission (“CFTC”) counterpart, U.S. Securities and Exchange Commission (“SEC”) Chairman Jay Clayton recently commented on ongoing benchmark reform and the transition to the Secured Overnight Financing Rate (“SOFR”).  As we noted earlier this week, Chairman J. Christopher Giancarlo of the CFTC recently advocated for the adoption of SOFR as the appropriate replacement for LIBOR and added that the CFTC is already working on the transition.  He implored market participants and firms to immediately begin transacting in SOFR derivatives for the health of the transition.

In remarks on December 6, 2018, Chairman Clayton mentioned the transition away from LIBOR as a market risk that the SEC is currently monitoring.  For Chairman Clayton, the key risk stems from the fact that there are approximately $200 trillion in notional transactions referencing the U.S. Dollar LIBOR and that more than $35 trillion will not mature by the end of 2021, when banks currently reporting information used to set LIBOR are scheduled to stop doing so.  Listing potential issues with a transition away from LIBOR, Chairman Clayton raised questions such as what happens to the interest rates of the instruments that will not mature before 2021 but reference LIBOR?  Does an instrument’s documentation include any fallback language?  If not, will consents be required to amend the documentation?
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On November 29, 2018, in remarks before the 2018 Financial Stability Conference in Washington, D.C., Chairman J. Christopher Giancarlo of the U.S. Commodity Futures Trading Commission (“CFTC”) supported the adoption of the Secured Overnight Financing Rate (“SOFR”) as the new benchmark for short-term unsecured interest rates.  SOFR is currently produced by the Federal Reserve Bank of New York (“New York Fed”) and is based on transactions in the repurchase agreement transaction (“repo”) markets.  Chairman Giancarlo’s statements and support of SOFR come on the heels of a series of market and regulatory developments relating to benchmark reform.

Since 2017, regulators and financial market industry leaders have been working to design alternative interest rate benchmarks.  Significantly, in June 2017, the Alternative Reference Rates Committee (“ARRC”), an organization convened by the Federal Reserve Board (“FRB”) and the New York Fed, selected a broad repo rate as its preferred alternative reference rate.  In choosing a broad repo rate, ARRC considered factors including the depth of the underlying market and its likely robustness over time; the rate’s usefulness to market participants; and whether the rate’s construction, governance, and accountability would be consistent with the IOSCO Principles for Financial Benchmarks.
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On November 6, 2018, the U.S. Securities and Exchange Commission (“SEC”) brought an enforcement action against a (formerly) registered investment adviser (“Adviser”), for failing to meet its diligence and compliance responsibilities under the Investment Advisers Act (“IAA”) relating to certain repurchase agreement (“repos”) facilities it offered to

Last month, on July 10, 2018, the Office of Financial Research (“OFR”), an agency of the U.S. Department of the Treasury, proposed a new rule that would require collection of data with respect to centrally cleared repurchase agreement transactions (“repos”) (the “Proposed Rule”).  The proposal stems from a multi-year effort by the Financial Stability Oversight Council (“FSOC”) to expand and make permanent the collection of repo data.

The Proposed Rule seeks to enhance the ability of FSOC and OFR to identify and monitor risks to financial stability, as well as support the calculation of certain reference rates for repos.  Particularly for the calculation of certain reference rates, OFR asserted that the new data from the Proposed Rule would support and enhance the calculation of both the Secured Overnight Financing Rate (“SOFR”) and the Broad General Collateral Rate (“BGCR”).
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