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Forward Repos for Broker/Dealers

March 4, 1996

Mr. Michael A. Macchiaroli
Associate Director
Division of Market Regulation
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Dear Mr. Macchiaroli:

The Government Securities Act of 1986 (the “GSA”), as amended,/1/ authorized the Department of the Treasury (“the Department”) to adopt rules requiring, among other things, that government securities brokers or dealers make and keep current records relating to the operation of their business. Based on discussions with, and inquiries from, market participants, the Department understands that there may be some uncertainty regarding the applicability of the federal securities recordkeeping requirements, including the GSA recordkeeping regulations (17 CFR Part 404), with respect to certain transactions -- forward repurchase agreement transactions (“forward repos”) -- being conducted by government securities brokers and dealers. Further, we understand that government securities brokers or dealers may not be following consistent recordkeeping practices in recording forward repos on their books and records.

This interpretative letter (“Interpretation”) is intended to: (1) clarify the requirements of the recordkeeping and other applicable GSA regulations, and (2) foster consistent recordkeeping rules with respect to the forward repo transactions of those firms registered with the Securities and Exchange Commission (SEC) as specialized government securities brokers or dealers under Section 15C of the Securities Exchange Act of 1934 (i.e., registered government securities brokers or dealers).

Forward repos are repurchase and reverse repurchase agreements that settle in the future (i.e., these transactions settle in a longer timeframe than same-day settlement)./2/ Typically involving when-issued trades, forward repos are treated as off-balance sheet items since there is usually no exchange of funds or securities until the settlement date. This Interpretation addresses the two primary types of forward repo transactions, generally referred to as specials and general collateral trades./3/

Recordkeeping

The Department views the recording of all government securities transactions, including the recording of any unsettled future transactions, such as forward repos, as important in meeting the purposes of the GSA and as an appropriate and prudent business practice. The maintenance of current books and records for forward repo transactions facilitates a firm's ability to conduct timely and effective risk management. As a result, firms are in a better position to anticipate and fulfill their obligations and responsibilities to other firms or to customers with whom they transact business.

Section 404.2 of the GSA regulations (17 CFR 404.2), which incorporates SEC Rule 17a-3 (17 CFR 240.17a-3), with modifications, requires each registered government securities broker or dealer to prepare records of transactions and dealings in government securities. In applying Rule 17a-3, the SEC has stated that each registered broker or dealer is required to prepare records for the accounts of customers as well as for its own risk and account, and to prepare records of other financial transactions related to the business of the firm./4/ To eliminate confusion and to foster uniform recordkeeping practices in the government securities market, the Department, by this Interpretation, is clarifying that, in particular, paragraphs (a)(1), (a)(6) and (a)(7) of Rule 17a-3, as incorporated by section 404.2 of the GSA regulations, apply to the recording of all government securities transactions, including forward repos.

Paragraph (a)(1), as incorporated, requires that registered government securities brokers or dealers make blotters or other records of original entry reflecting all government securities transactions. The blotter is the basic record of original entry maintained by brokers or dealers, and it contains an historical account of all the daily transactions of a broker or dealer and its customers. Paragraph (a)(6), as incorporated, requires that registered government securities brokers or dealers make and keep current a memorandum of each brokerage order, and any instructions related to transactions involving the purchase and sale of government securities. Paragraph (a)(7), as incorporated, requires that registered government securities brokers or dealers make and keep current a memorandum of each principal government securities transaction. The blotter should reflect transactions as of trade date and should be prepared no later than the following business day. Brokerage and principal “order tickets” should be prepared at the initiation of the transaction./5/

Accordingly, pursuant to 15 U.S.C. 78o-5(b), we interpret the provisions of 17 CFR 404.2 to require registered government securities brokers or dealers to record each forward repo transaction in a blotter and on an order ticket at the time such entities agree to the terms of such transactions with their counterparties (i.e., on trade date). Further, such records should be preserved by registered government securities brokers or dealers in accordance with the provisions of 17 CFR 240.17a-4, as incorporated by section 404.3.

The Department has consulted and coordinated with the staffs of the SEC and certain self-regulatory organizations on this issue to ensure that the same recordkeeping requirements apply to all government securities brokers and dealers. Based on discussions with the staffs of the SEC and the New York Stock Exchange (NYSE), it is the Department's understanding that they intend to issue an information memo clarifying that, for registered brokers or dealers that conduct or effect forward repo transactions, paragraphs (a)(1), (a)(6) and (a)(7) of Rule 17a-3 would require similar treatment as is being described in this Interpretation. Accordingly, compliance by registered brokers or dealers with the GSA regulations at section 404.1, which adopts Rule 17a-3, ensures consistent treatment among all government securities brokers or dealers registered with the SEC.

Capital Requirements

Forward repo transactions, which include both repo and reverse repo transactions that settle in a longer timeframe than same-day, of registered government securities brokers or dealers (i.e., 15C firms) are subject to haircuts under Treasury's capital rules. This Interpretation pertains to the capital requirements with respect to the forward repo transactions of such firms only.

Under section 402.2 of the GSA regulations, registered government securities brokers or dealers must apply market risk haircuts to forward repos. As discussed below, this treatment applies to both specials and general collateral types of forward repo transactions. All computations and haircuts should begin being made as of the trade date. Although 15C firms have the potential to incur credit risk on trade date for forward repos, the firms should not include credit risk haircuts on such transactions in their liquid capital computations until settlement date, unless the firms deliver funds (e.g., margin), securities, or other inventory to their counterparties before settlement date. If a 15C firm delivers funds, securities, or other inventory to its counterparty before settlement date, then these items must be included in its credit risk haircut as defined in paragraph 402.2(g)(1).

Accordingly, pursuant to 15 U.S.C. 78o-5(b), we interpret the provisions of 17 CFR 402.2 to require registered government securities brokers or dealers to maintain capital for forward repo transactions as follows. In applying the GSA capital rules to forward repos, each transaction must be classified according to the haircut maturity categories as defined in paragraph 402.2(f)(1). The appropriate category for a transaction scheduled to settle more than five business days in the future (Schedule D) is determined by the sum of the remaining time to maturity of the forward contract and the remaining term to maturity of the repo transaction itself. A forward repo with a shorter forward period is placed in the category corresponding to the term to maturity of the repo transaction (Schedule B). The maturity of the underlying collateral is not factored into these determinations.

A forward repo is essentially treated as a hybrid of both financing and forward positions which are identified under section 402.2a, Appendix A (Calculation of market risk haircut for purposes of paragraph 402.2(g)(2)). In applying the capital rules and calculations, if the settlement date of the forward repo is scheduled for more than five business days in the future, then the haircut based on the contract value should be reported in the appropriate forward contract column of Schedule D (i.e., column 13 or 14)./6/ Otherwise, when the settlement date of the forward repo is between one and five business days in the future, the contract value should be reported in the appropriate financing position column of Schedule B (i.e., column 1 or 2).

The contract value of the forward repo is determined for the respective schedule as follows. On trade date, the contract value (i.e., the amount of the funds to be borrowed or loaned) is identified in a general collateral forward repo trade./7/ However, the contract value of the trade is not usually identified in a special repo trade until settlement date, so between trade date and settlement date, a registered government securities broker or dealer should use, as a proxy for the contract value, the market value of the par amount of the specific security collateral (which is identified) as determined by its market price on the date of the calculation.

Since the Treasury capital rules apply only to registered government securities brokers or dealers, questions regarding the capital treatment of forward repos for registered brokers or dealers should be directed to the SEC.

Confirmations

The Department views the issuance of confirmations as a fundamental instrument for strengthening customer protection and a prudent business practice for all government securities brokers or dealers conducting any type of government securities transaction, including forward repos. A confirmation has significant value to investors in identifying the specific securities that may be the subject of the transaction and verifying that the appropriate terms of the transaction have been recorded. Confirmations also enable investors to initiate a claim for their securities in cases of dispute or insolvency.

The Department notes that the Public Securities Association (PSA) recently adopted guidelines for confirmations of forward repo transactions and supports sending a confirmation for all forward repo transactions on trade date. PSA's Repo Trading Practices Bulletin No. 9, which became effective September 1, 1995 (copy of the provision relating to forward repos is enclosed), states that confirmations of forward repos should be sent on the trade date of the transaction and specifies information to be included on the confirmations.

We have consulted with the staffs of the SEC, the NYSE, and the National Association of Securities Dealers in considering the issues in this letter. This letter is being sent to each of these agencies as guidance. Your assistance in disseminating this letter and advising the institutions that your organization supervises of this information is appreciated. Any questions regarding this letter or questions pertaining to interpretations of the GSA regulations should be directed to the Government Securities Regulations Staff at (202) 219-3632.

Pursuant to 17 CFR 400.2(c)(7)(i), this letter will be made immediately available to the public.

Sincerely,
Richard L. Gregg
Commissioner

Enclosure

cc:  Marianna Maffucci, Public Securities Association
Larry Clark, Office of Thrift Supervision

Footnotes:

/1/ 15 U.S.C. 78o-5.

/2/ It is the Department's understanding that most repos are settled on a same-day basis. Accordingly, the Department views repos that settle in a next-day or longer timeframe as forward repos.

/3/ With specials, details that are set on trade date include the following: the identification of a specific security as collateral, the par amount of the security collateral, and the repo interest rate. On settlement date, the counterparties agree on a price for the security and then exchange funds and securities. With general collateral and mortgage repos, details that are set on trade date include: an agreement to use a range of possible securities as collateral, either the amount of funds to be borrowed or the par amount of the collateral, and the repo interest rate. On settlement date, the specific securities collateral and either the par amount of securities or the amount of funds to be borrowed are identified, and the counterparties exchange funds and securities.

/4/ Exchange Act Release No. 10756 (April 26, 1974).

/5/ Ibid.

/6/ The haircut should be calculated by multiplying the haircut factor that corresponds to the term to maturity of the repo contract by the contract value.

/7/ In the case of many mortgage forward repos, neither the contract value nor the specific security is known until the settlement date. In such cases, between trade date and settlement date, a registered government securities broker or dealer should use, as a proxy for the contract value, the market value of securities that would be eligible for delivery under the terms of the forward repo.