Treasury Market Practices Group Fails Charge Market Practice Asset Management and Custodian Industry Procedures

The proposed industry procedures in this paper are subject to review by all market participants. Written comments are welcome and should be sent to Elisa Nuottajarvi ([email protected]) of the Asset Management Group/SIFMA staff.

April 23, 2009

Asset Management and Custodian Industry Procedures The Treasury Market Practices Group (TMPG) has recommended a new market practice for claiming a fails charge for a settlement fail in U.S. Treasury securities. The goal of this new practice is to enhance efficient functioning of the U.S. Treasury market. TMPG states: the cost to the party failing to deliver securities will provide a compelling incentive to resolve fails promptly. The fails charge market practice will take effect on May 1, 2009. The Asset Management Group of SIFMA and The Asset Managers Forum formed a working group composed of asset managers and global custodians to review the TMPG fails charge market practice and to develop procedures to implement buy side processes in relation to claiming a fails charge. These processes include, among other items, reporting, researching and tracking of fails, calculation of fail charges, determining who is responsible for the claim, sending/receiving claims, accounting for claims. A buyer who fails to receive Treasury securities on the originally scheduled settlement date of a transaction will submit a claim for a “fails charge” from the failing seller. The fails charge recommended by the TMPG applies to any delivery-versus-payment settlement in Treasury securities (including Repo) that failed to settle as scheduled, regardless of the transaction that led to the settlement obligation. The TMPG recommendation does not, however, cover “free deliveries,” where a recipient is not obliged to make a payment upon receipt of Treasury securities.

The TMPG recommends that fails charges be: (1) Accrued over the life of a delivery failure; (2) Submitted by the tenth business day of the following month; and (3) Either accepted or rejected by the last business day of the month in which they were submitted.

The plan for action includes target dates of: •

May 1, 2009, for commencing accruals of fails charges for transactions entered into on or after May 1, 2009;

•

June 12, 2009, for the first monthly submission of claims; and

•

June 30, 2009, for responding to the first monthly submission of claims.

The TMPG Fails Charge Formula: The fails charge is equal to 3 percent per annum minus the lower limit of the fed funds target rate at the close of business on the preceding business day, or zero, whichever is greater. When the fed funds target rate is greater than or equal to 3 percent under the formula below, there will be no explicit financial charge for failing, and under this formulation the fail charge will be capped at 3 percent per annum. C = 1/360 *.01* max(3 − R, 0) * P

  C = Claim amount, in dollars R = TMPG reference rate at the close of business on the business day preceding the fail, in percent per annum P = Total proceeds due from buyer in dollars. Under this formula, R = for each day, the TMPG reference rate at 5:00 p.m. New York time on the preceding business day. This means that if there is a change in the TMPG reference rate in the middle of the term of a delivery failure, "R" will be that new rate for subsequent days of the fail (assuming that the TMPG reference rate does not again change during the remaining term of the delivery failure). The current TMPG reference rate is the target federal funds rate specified by the Federal Open Market Committee (FOMC) (if the Committee specifies a target rate) or the lower limit of the target band specified by the FOMC (if the Committee specifies a target band in lieu of a target rate). In the event the FOMC specifies neither a target rate nor a target band, the TMPG will recommend some other similar, readily observable, short term interest rate. Minimum Claim Threshold The minimum claim threshold amount of $500.00 will be applied at the allocated trade level, on a tradeby-trade basis. The amounts will not be netted or aggregated for claim purposes, but may be aggregated and netted by custodian to facilitate the wire transfer at the end of the period. Accrual Method for Monthly Billing TMPG fails charge claims will be generated on an actual settlement basis and billed during the monthly period following the month in which the trade settles. Workflow • All claims should be sent to the asset manager who will determine who is responsible for the claim, i.e. the asset manager, custodian or dealer. If the asset manager determines that custodian is responsible, the claim will be sent to the custodian. This process will be aided by enhanced fail reporting received from custodians and dealers. • Asset managers will leverage the existing claims process to review penalty claims and work with dealers and custodians to facilitate resolution and payments. • Custodians will also leverage the existing claims process to compensate client accounts for custodian errors, including custodian securities lending operations. For this scenario, we would look to the custodian bank to cover the claim payment. • A summary workflow, outlining responsible parties and reporting flows for fail penalties is attached.

 

2

 

Custodian Bank Fail Reporting • Custodian banks will provide asset managers a cumulative fail report, detailing all Treasury fails during the period, by client account, by dealer. The cumulative report will be available on the first business day of the next month, or as soon as possible thereafter. The recommendation is to include the following data elements, including length of the fail and the calculated fail penalty amount for each fail as part of the report detail. (See a sample template in Appendix 1.) Account Number (Client Account Number at Custodian) Account Name (Client Name) Transaction Type (Buy/Sell) Client Reference (Asset Manager’s Client Reference Number or acronym) Security Identifier (CUSIP, SEDOL, ISIN, etc.) Security Name (Security Description) Quantity (Nominal Amount) Settlement Amount (Net/Principal Amount) Trade Date Contractual Settlement Date Actual Settlement Date Number of Days Failing Fail Reason Code (Brief Description of Fail) C/P (Broker ID – DTCC Participant Number) Counterparty Name Penalty Amount

 

3

  Dealer Fails Claims Reporting • In order to process fails claim charges, dealers will report to asset managers their Treasury fails to receive from the asset manager, custodian bank and/or client account. It is expected that to process fails claims the dealers will need to incorporate many of the same data elements as the custodian fails report noted above.   “Out of Box” Positions • Several scenarios can cause an operational fail, which may generate a fail penalty for a client account. The scenarios, such as securities lending and securities pledged as collateral for swaps, futures or other deposit requirements, may be subject to claims and/or reimbursement to the client account. Partial Deliveries • The asset manager may ask the dealer to accept partial deliveries if they are not able to deliver the full amount. If the dealer is willing to take in partial deliveries, the claim charge would only pertain to that portion that was not delivered. However, based on TMPG guidance, if the buyer wants to receive the full delivery from the seller, and seller only delivers partials, the buyer is entitled to claim on full amount of the underlying transaction. Custodian Product Offering • Service offerings differ across custodian banks. Each custodian will need to communicate their approach to providing “actual” fail reporting for contractually settling accounts and clarify whether or not they will provide fail penalty/claim management services for their client accounts. In the absence of custodian claim management services, asset managers are expected to send and receive claims leveraging their existing claims process. Securities Lending • The handling of fails charge claims resulting from securities lending transactions would follow the existing claims process. Once the asset manager determines that they did not cause the fail, the claim would be forwarded to custodian, which will work with either internal lending team to resolve the claim or a third party lending agent. Hedge Funds • Since settlement and clearance services are typically performed through a prime brokerage account, it is expected that fail charges will follow the dealer-to-dealer process. To the extent that the hedge fund follows the “institutional custody account” workflow, it will follow the processes outlined here. TMPG Fails Charge Start Date • The TMPG has recommended that the fails charge trading practice be implemented with respect to transactions entered into on or after May 1, 2009. Thus, fails charge calculations start with a contracted settlement date of May 1 or later. Open fails with a contracted settlement date prior to May 1, would not be eligible.

 

4

  Euroclear and Clearstream Settlements • The TMPG fails charge market practice applies to any delivery-versus-payment settlement in Treasury securities, including transactions settled in Euroclear or Clearstream. $50 Million Fedwire Good Delivery Increments • The Fedwire® Securities Service settlement limit for U.S. Treasury Securities is $50 million on the par value of individual securities transfers. The TMPG fails charge claims will be handled on that level, even though the actual trade amount may be larger. (E.g. a $55mm trade is delivered in two pieces, $50mm and $5mm, each of which will be assigned a separate confirm and will settle discreetly. If the entire $55mm trade fails, both the $50mm and $5mm will require a separate fails charge claim.) Custodian Bank Reporting will reflect the transaction as it was instructed. Dealer Time • The TMPG has indicated that the broader topic is under discussion by the Group. For the purposes of the fails charge market practice implementation, it is important that both asset managers and custodians understand how to handle the cutoff times for purposes of fail penalty calculation. Settlements during dealer time will be considered on a case-by-case basis and discussed with dealer. Asset managers may consider settlements that occur during dealer time as a failed trade for that business day, because asset managers/custodians cannot deliver securities back out in order to satisfy “turned” trades, thus possibly causing a mismatched fail in the client account. In this scenario, a delivery during dealer time would be considered as failing for that day and would likely result in a penalty charge to the dealer, as determined on a case-by-case basis. Accounting and Tax Treatment • The accounting for the fails charge should be made at the fund level, under the assumption that the fund would be the entity that is obligated to make any required payment to (or received from) the counterparty even if the fund would be reimbursed by one of the agents acting on behalf of the fund (i.e. asset manager or custodian), to the extent they were the actual party responsible for the fail transaction. The accounting for the failed charge should occur at the time of the transaction but in any case, as frequently as the entity is required to do financial reporting to the extent the items are material. On daily NAV funds there is a presumption that the NAV is computed on the basis of generally accepted accounting principles and therefore such amounts should be recorded daily, if material. On monthly NAV accounts, the asset manager may summarize the fails charges in aggregate and post to the accounts monthly. Some asset managers may choose to accrue fails charges on a daily basis for all their funds regardless of the frequency of the NAV computation. Since the charges relate to investment transactions, the fails charge should be recorded in a gain or loss account as opposed to operating expense or investment income account. In connection with tax treatment, asset managers and custodians are urged to seek the advise of their in-house tax counsel. Important Documents • Frequently Asked Questions: Claiming a Fails Charge for a Settlement Fail (3/31/2009) • U.S. Treasury Securities Fails Charge Trading Practice (3/31/2009) • Treasury Market Best Practices Revised (3/31/2009) • Claiming a Fails Charge for a Settlement Fail in U.S. Treasury Securities (1/5/2009)  

5

Account Name ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund

Account Name ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund ABC Fund

Account Number 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567

Account Number 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567 1234567

Trans Type DVP DVP DVP DVP DVP DVP DVP DVP DVP DVP DVP DVP DVP

Trans Type RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP RVP

Client Ref # B82391 B8120 B2283 B3838 B7272 B2018 B3712 B9801 B9182 B77212 B2765 B2341 B83463

Client Ref # A70105 A712335 A754123 A75643 A756894 A75694 A1259 A45973 A36754 A1964 A12223 A75493 A1874 A32366 A327996 A19548 A11779 A45998

Sec Identifier 912795-S3-6 912828-HF-0 912803-CX-9 912828-JR-2 912828-JR-2 912828-EQ-9 912828-GR-5 912828-HM-5 912828-KB-5 912833-7Q-7 912828-HR-4 912795-Q7-9 912828-HR-4

Sec Identifier 912828-KD-1 912828-HR-4 912828-HF-0 912828-HM-5 912828-JR-2 912828-JR-2 912828-GR-5 912820-EM-5 912803-CX-9 912833-2D-1 912828-GL-8 912833-7Q-7 912828-HR-4 912795-Q7-9 912833-7Q-7 912828-KB-5 912795-S3-6 912828-EQ-9

Sec name UST BILLS DUE 9/24/09 US TREAS NTS 3.625% 10/31/09 US TREAS PRIN STRIP 0% 2/15/36 US TREAS NTS 3.75% 11/15/18 US TREAS NTS 3.75% 11/15/18 US TREAS NTS 4.375% 12/15/10 US TREAS NTS 4.5% 05/15/10 US TREAS NTS 3.625% 12/31/12 US TREAS NTS 1.125% 01/15/12 US TREAS BD STRIPS 0% 11/15/31 US TREAS NTS 3.5% 02/15/18 US T Bill ZCB 06/04/09 US TREAS NTS 3.5% 02/15/18

Sec name US TREAS NTS 2.75% 02/15/19 US TREAS NTS 3.5% 02/15/18 US TREAS NTS 3.625% 10/31/09 US TREAS NTS 3.625% 12/31/12 US TREAS NTS 3.75% 11/15/18 US TREAS NTS 3.75% 11/15/18 US TREAS NTS 4.5% 05/15/10 US TREAS PRIN STRIP 0% 2/15/10 US TREAS PRIN STRIP 0% 2/15/36 US TREASURY BILL 0% 4/15/09 US TREAS NTS 4.5% 03/31/09 US TREAS BD STRIPS 0% 11/15/31 US TREAS NTS 3.5% 02/15/18 US T Bill ZCB 06/04/09 US TREAS BD STRIPS 0% 11/15/31 US TREAS NTS 1.125% 01/15/12 UST BILLS DUE 9/24/09 US TREAS NTS 4.375% 12/15/10

Quantity 30,000,000 30,000,000 3,000,000 50,000,000 50,000,000 40,000,000 40,000,000 1,000,000 10,000,000 25,000,000 25,000,000 20,000,000 50,000,000

Quantity 46,000,000 11,800,000 41,000,000 10,000,000 50,000,000 50,000,000 36,000,000 1,206,000 4,365,000 1,305,000 14,000,000 50,000,000 50,000,000 41,000,000 50,000,000 16,000,000 20,000,000 50,000,000

Settlement Amount $29,124,000.00 $32,544,000.00 $1,230,000.00 $54,244,000.00 $54,244,000.00 $43,166,000.00 $41,255,000.00 $1,131,000.00 $12,875,000.00 $11,244,000.00 $26,005,000.00 $17,364,000.00 $51,184,000.00

Settlement Amount $47,369,000.00 $11,879,380.00 $44,200,000.00 $11,124,000.00 $54,236,000.00 $54,236,000.00 $36,875,000.00 $1,199,475.00 $1,791,000.00 $1,284,628.00 $14,717,500.00 $22,341,000.00 $51,125,000.00 $38,451,000.00 $22,546,000.00 $19,100,000.00 $19,354,000.00 $54,187,000.00

Contractual Trade date Settlement Date 5/3/2009 5/3/2009 5/1/2009 5/1/2009 5/5/2009 5/6/2009 5/4/2009 5/4/2009 5/4/2009 5/4/2009 5/5/2009 5/5/2009 5/11/2009 5/11/2009 5/12/2009 5/12/2009 5/16/2009 5/17/2009 5/18/2009 5/19/2009 5/21/2009 5/22/2009 5/21/2009 5/22/2009 5/24/2009 5/24/2009

Trade date 5/1/2009 5/1/2009 5/1/2009 5/4/2009 5/1/2009 5/1/2009 5/4/2009 5/8/2009 5/11/2009 5/12/2009 5/13/2009 5/18/2009 5/21/2009 5/21/2009 5/25/2009 5/11/2009 5/27/2009 5/28/2009

Contractual Settlement Date 5/4/2009 5/4/2009 5/4/2009 5/4/2009 5/4/2009 5/4/2009 5/4/2009 5/8/2009 5/14/2009 5/12/2009 5/13/2009 5/18/2009 5/22/2009 5/22/2009 5/25/2009 5/14/2009 5/27/2009 5/28/2009

Appendix 1

Actual Settlement Date 5/4/2009 5/4/2009 5/7/2009 5/8/2009 5/8/2009 5/8/2009 5/14/2009 5/14/2009 5/18/2009 5/25/2009 5/25/2009 5/25/2009 5/26/2009

Actual Settlement Date 5/5/2009 5/5/2009 5/6/2009 5/6/2009 5/8/2009 5/8/2009 5/8/2009 5/12/2009 5/15/2009 5/15/2009 5/15/2009 5/19/2009 5/25/2009 5/27/2009 5/27/2009 5/28/2009 5/28/2009 5/29/2009

# days failing 1 3 1 4 4 3 3 2 1 6 3 3 2

# days failing 1 1 2 2 4 4 4 4 1 3 2 1 3 5 2 14 1 1

Fail Reason Code

Fail Reason Code

C/P 9335 8397 274 573 573 5186 8397 274 901 9335 642 642 53

C/P 901 901 53 8397 274 274 642 573 53 53 9335 642 5186 9335 8397 9335 5186 573

Penalty $2,427.00 $8,136.00 $102.50 $18,081.33 $18,081.33 $10,791.50 $10,313.75 $188.50 $1,072.92 $5,622.00 $6,501.25 $4,341.00 $8,530.67 $94,189.75

Total Claims to be Received

$128,763.85

Total Claims to be submitted

Counterparty Name BZW Secs Societe Generale Citigroup Global Mkts Inc Deutsche Bank Securities Inc Deutsche Bank Securities Inc Chase Securities Inc Societe Generale Citigroup Global Mkts Inc Bank of NY BZW Secs UBS Securities Inc UBS Securities Inc BNP Paribas Securities Corp

Penalty $3,947.42 $989.95 $7,366.67 $1,854.00 $18,078.67 $18,078.67 $12,291.67 $399.83 $149.25 $321.16 $2,452.92 $1,861.75 $12,781.25 $16,021.25 $3,757.67 $22,283.33 $1,612.83 $4,515.58

Counterparty Name Bank of NY Bank of NY BNP Paribas Securities Corp Societe Generale Citigroup Global Mkts Inc Citigroup Global Mkts Inc UBS Securities Inc Deutsche Bank Securities Inc BNP Paribas Securities Corp BNP Paribas Securities Corp BZW Secs UBS Securities Inc Chase Securities Inc BZW Secs Societe Generale BZW Secs Chase Securities Inc Deutsche Bank Securities Inc