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Tri-party vs. HIC Repos

This letter was addressed to each of the Appropriate Regulatory Agencies for Depository Institutions, the Securities and Exchange Commission, the National Association of Securities Dealers and the New York Stock Exchange. Additional names and addresses appear at the end of this document.

May 7, 1990

Mr. Owen Carney
Office of the Comptroller of the Currency
6th Floor
Washington, D.C. 20219

Dear Mr. Carney:

The Department has received a number of inquiries from government securities broker-dealers and financial institutions regarding whether the repurchase agreement transactions (repos) being conducted by their institutions are subject to the hold-in-custody repo requirements set out at 17 CFR 403.4(e) and 403.5(d) of the regulations promulgated pursuant to the Government Securities Act of 1986 (GSA). In many instances, the callers represented that the repos conducted by their institutions were in fact tri-party repos, and thus not subject to the hold-in-custody rules in sections 403.4(e) or 403.5(d) of the GSA regulations. Additionally, some callers requested guidance in determining whether the repos being effected by their institutions were hold-in-custody or tri-party transactions.

As a result of conversations with these callers, it became apparent that much uncertainty exists regarding whether or not certain transactions would be considered to be hold-in-custody repos. In light of the many uncertainties and questions still being raised concerning the distinction between hold-in-custody and tri-party repos, the Department is issuing this clarification of the GSA regulations to provide additional guidance to government securities broker-dealers, financial institutions and other participants in repo transactions and to make clear the Department's intent with respect to these transactions.

Specifically, some entities represented that they were conducting tri-party repos (i.e., a repurchase transaction involving a Repo Seller, a Repo Buyer, and a separate custodian with specific responsibilities to both parties) because they did not have possession of the repo securities which had been delivered to a third-party custodian institution, even though they (i.e., the Repo Seller) still retained control over the securities. This issue of possession or control of securities and the corresponding funds during the term of the repo transaction is a primary factor in determining whether a transaction will be considered a hold-in-custody or a tri-party repo. A common misunderstanding appears to be a belief that repo transactions that involve another custodian would not be considered “hold-in-custody” transactions and, therefore, not subject to the requirements of sections 403.4(e) or 403.5(d). However, the single factor of another custodian's involvement does not, by itself, determine whether a transaction is a tri-party or deliver-out repo, rather than a hold-in-custody transaction. What must be examined (and should be clearly stated in the governing written agreement) is the role of the third party custodian, the custodian's relationship to the Repo Buyer and Repo Seller, and the entity that ultimately exercises control over the securities or funds during the course of the transaction.

In a tri-party repo, an independent institution enters into a tripartite agreement with the two counterparties to the transaction. The third-party custodian assumes certain responsibilities with respect to safeguarding the interests of both counterparties and is involved in effecting the transfer of funds and securities between the two parties. In a deliver-out repo, the securities are actually delivered to the investor or its designated custodial agent who has no relationship with the Repo Seller. A hold-in-custody repo is characterized by the investor's counterparty (i.e., Repo Seller) retaining control of the securities and by serving simultaneously throughout the transaction not only as principal but also as the investor's custodial agent.

In the government securities market, and particularly with book-entry securities, it is not uncommon for a broker-dealer or financial institution to hold securities through another custodian institution. For example, this occurs in connection with a correspondent or clearing arrangement. Where an entity that is the Repo Seller is holding securities that are the subject of a repo through such a custodian institution, the Repo Seller would be considered to be engaging in hold-in-custody repos if the custodian institution is acting solely for the Repo Seller. The fact that the Repo Seller must request the custodian institution to maintain the repo securities in an account specifically designated for its Repo Buyers and may even provide the custodian institution with a listing of the names of the Repo Buyers does not change the hold-in-custody nature of the repo, since the Repo Seller is still viewed as retaining control over the repo securities. Additionally, repo transactions would also be considered hold-in-custody if the Repo Seller is in a position to control the funds of the Repo Buyer. For example, an arrangement where the Repo Buyer has funds on deposit with the Repo Seller which are invested in repos, without the funds either flowing through or the funds transfer being independently verified by an intermediary, would be considered a hold-in-custody repo. This is because the custodian of the repo securities is unable to determine whether the funds have been returned to the Repo Buyer when the custodian transfers the securities back to the Repo Seller.

On the other hand, a repo transaction would not be considered to be a hold-in-custody where the Repo Buyer instructs the Repo Seller to deliver the securities against payment to a custodian institution that is acting as custodian solely for the Repo Buyer and has no custodian relationship with the Repo Seller (i.e., deliver-out repo). The confusion arises in distinguishing among the various types of repo arrangements where the Repo Buyer and the Repo Seller may have or be represented as having a relationship with the same custodian institution.

In structuring a tri-party repo that would not be subject to the requirements of sections 403.4(e) or 403.5(d) of the GSA regulations, the Department believes that the parties to the written repurchase agreement must include the Repo Seller, Repo Buyer and the third-party custodian. Under this agreement, the custodian undertakes responsibilities to act on behalf of both the Repo Seller and the Repo Buyer. The custodian must be informed of the essential terms of the specific repo transaction being conducted (e.g., types of acceptable securities, purchase price, maturity, value of securities including margin to be transferred). The information should be in sufficient detail to enable the custodian to carry out its responsibilities to both parties for verifying that sufficient cash has been received by the Repo Seller and that eligible and proper securities of value have been received on behalf of the Repo Buyer. Upon verification, the funds should be transferred to the Repo Seller and the securities transferred to the account of the Repo Buyer on a simultaneous basis.

During the term of a tri-party repo, the custodian is responsible for maintaining specific repo securities (i.e., specific CUSIP or mortgage-backed security pool number and in an amount that is tradeable), directly in the name of the Repo Buyer, free of any third party lien, charge or claim. Therefore, pooling of securities is not permitted under a tri-party repo, just as it is prohibited for hold-in-custody repos. In addition, these securities must also be segregated from the Repo Seller's own securities that may be held at the custodian. Thus, the custodian must be able to determine, on the basis of its own books and records, the specific securities that it is receiving and holding for an individual customer.

To accomplish this segregation, the custodian would normally be expected to maintain separate funds and securities accounts for the Repo Buyer and Repo Seller. The custodian is also responsible for determining, throughout the term of the transaction, that the valuation of all securities or cash in the Repo Buyer's account is sufficient. If the securities or cash collateral is less than the required amount for the transaction, the custodian should inform the Repo Buyer of the repo collateral deficiency and then follow the instructions of the Repo Buyer to satisfy the deficit.

In a tri-party repo, the custodian must exercise independent control over the exchange of securities between the Repo Buyer and Repo Seller. With regard to the funds, if the custodian is unable to independently control the transfer of funds between the two counterparties, it must, at a minimum, be able to independently verify the movement of the funds between the Repo Buyer and Repo Seller. The Department is aware of situations, particularly those involving sweep repos, in which some financial institutions are investing customer funds in repos and are attempting to structure the transactions as tri-party agreements by using another custodian to maintain the repurchase securities. Unless these transactions are structured in a manner whereby, at the unwinding of the transaction, either the custodian has independent control over the flow of funds, or alternatively it is able to independently verify the movement of funds back to the Repo Buyer, it is the Department's view that such arrangements cannot be considered tri-party repurchase transactions, but are hold-in-custody repos. This is because the custodian institution would not be involved in or be aware of the actual movement of funds between the Repo Buyer and Repo Seller.

Since the custodian represents both parties, neither the Repo Buyer nor the Repo Seller should be able to instruct the custodian to release the funds or securities that are being held for the benefit of its repo counterparty without first returning to the control of the custodian, for the benefit of the counterparty, the appropriate funds or securities. In those instances where the custodian does not have control over movement of the funds, it must be able to confirm the transfer of the funds back to the Repo Buyer before releasing securities to the Repo Seller.

In the event substitution of securities is permitted under the terms of the written agreement for a tri-party repo, the replacement securities or other acceptable collateral must be delivered to the custodian for the account of the Repo Buyer before, or simultaneous with, the release of the original repo securities from the Repo Buyer's account back to the account of the Repo Seller. Otherwise, the Department would consider the transaction to have reverted back to a hold-in-custody arrangement during the substitution process until such time as the replacement securities were credited to the Repo Buyer's account.

The third-party custodian maintaining customer securities on behalf of the Repo Buyer must, pursuant to 17 CFR 450.4(b)(1), issue a safekeeping receipt or a confirmation acknowledging receipt of all securities for the account of the Repo Buyer. The confirmation or safekeeping receipt must identify and list specific securities. This confirmation requirement applies to all depository institutions that hold government securities as custodian for the account of a customer, including securities held resulting from hold-in-custody, tri-party, or deliver-out repo transactions. In addition, since the confirmation or safekeeping receipt must list specific securities, pooling of securities (i.e., the failure to identify specific securities) for any type of repo transaction is not permitted.

Consistent with the view that the custodian should retain control over the repo securities in a tri-party arrangement, the Department believes that the written agreement should include a provision providing that, in the event of default of the Repo Seller, the Repo Buyer has the right, either directly or through instructions to the third-party custodian, to dispose of the securities and apply the proceeds in satisfaction of any Repo Seller liability.

This letter is intended to provide general guidance and direction regarding distinctions between tri-party and hold-in-custody repos; it is not meant to be an all inclusive list of criteria for reaching a final determination in every situation. The facts and circumstances of a particular transaction will dictate the ultimate conclusion regarding the type of repo being conducted.

This letter is being sent to the Securities and Exchange Commission, the appropriate regulatory agencies for depository institutions, the National Association of Securities Dealers, and the New York Stock Exchange. Pursuant to 17 CFR 400.2(c)(7)(i), this letter will be made immediately available to the public.

Richard L. Gregg

Additional Addressees:

Mr. Robert Plotkin
Division of Banking, Supervision and Regulation
Federal Reserve Board
Washington, D.C. 20551

Mr. Thomas O'Nell
Review Examiner, Compliance
Federal Deposit Insurance Corporation
550 17th Street, N.W.
Washington, D.C. 20429

Mr. Jonathan Fiechter
Senior Deputy Director
Office of Thrift Supervision
1700 G Street, N.W.
Washington, D.C. 20552

Mr., Mark Fitterman
Division of Market Regulation
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549

Mr. Thomas R. Cassella
Vice President, Financial Responsibility
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20219

Mr. Edward Kwalwasser
New York Stock Exchange
11 Wall Street
New York, New York 10005