A focus on repo markets post U.S. tri-party reform | December 2015
This is a time of important change in the wholesale funding markets and calibrating your approach to the fundamental shifts in the market will be essential. This article provides you with some market insight and understanding as you develop and execute your strategies moving forward.
An efficient and effective wholesale funding marketplace is critical to the proper functioning of the U.S. and global financial system. The Financial Crisis of 2007-2009 (the “Crisis” or “Financial Crisis”) exposed weaknesses in the system, cash providers fundamentally lost confidence in banking organizations (“banks”) and the wholesale funding marketplace essentially collapsed. This, in turn, prompted unprecedented government intervention and the creation of a series of support programs, many of which continue to this day.
The Crisis brought to light unique risks of the excessive use of short term wholesale funding and repurchase agreements or “repo”, in particular, to the financing of bank operations and inventory. In short, a combination of the maturity mismatch (i.e., the liquidity of short term/ overnight funding used to finance longer term assets) endemic to wholesale funding, tri-party repo’s settlement mechanism and high reliance on secured intraday credit created fissures in the system that needed to be addressed in order to return the market to long term stability and lessen the risks of a future crisis. Additionally, money funds tended to regard the repo market as equivalent to a bank deposit from a risk perspective, creating additional issues in times of crisis, including a potential run on the system. Throughout the Crisis, this risk manifested when the threat of several funds “breaking the buck” shattered investor confidence in the money fund market and prompted further government intervention.
As a result of these factors, wholesale funding reforms became a cornerstone of U.S. regulators’ post Crisis efforts to reduce risk in the financial system. Much of the change was channeled through the Tri-party Repo Infrastructure Reform Task Force (the “Task Force”), which drove direct changes to market operations – partially redefining the value propositions of the bilateral and tri-party settlement mechanisms in the process. In April 2015, tri-party infrastructure providers marked the completion of the largest mandate of Tri-party Repo Infrastructure Reform (“Tri-party Reform”) – the “practical elimination” of secured intraday credit.1 While Tri-party Reform has a further significant outstanding directive – the elimination of fire-sale risk – market participants agree that efforts to date led to a substantial improvement in the safety and soundness of the system.
As the wholesale funding industry marks a turning point, it is our hope that this paper helps preview a period of continued reform and market driven change. We, BNY Mellon, believe that our position as both the U.S.’s largest tri-party agent and holder of collateral gives us a unique perspective on this time of transition. The creation, adoption, and operationalization of regulations has dominated financial literature since the Crisis. In addition to progress made through Tri-party Reform, users of repo – most notably certain Global Systemically Important Banks (G-SIBs) – are working toward compliance with Basel III capital and liquidity measures and have largely reached compliance at the holding company level. It is important to note that this paper’s use of the term G-SIB(s) excludes ourselves and State Street, given the significant differences in business models and relationship with the wholesale funding markets. Continued retrenchment among the majority of G-SIBs is more likely to be driven by internal strategy and capital allocations than by overt regulatory pressure. While regulation and reform are not complete and will likely continue as mainstays of wholesale funding, strong market forces and the underlying structure and profitability of the business will likely begin to affect repo volumes, participant interactions, and views of risks in the system. This leads us to believe that it is time to change the narrative on wholesale funding away from the pure macro effects of reform to include firm specific strategies for implementation and the re-emergence of market driven change.
In creating this paper, we conducted in-depth interviews as well as a broad-based survey, receiving feedback from a comprehensive spectrum of market participants.2 We conducted this research not only to understand the current drivers of the use of wholesale funding, but also to explore participants’ points of view and strategies for the future. Total interviews and survey respondents included nearly 100 repo market participants across the spectrum: large dealers with matched books, collateral providers, cash investors, interdealer brokers, and potential cleared repo providers. As a result, we drew three primary conclusions regarding the future of wholesale funding and the use of the repo markets:
1. Adopting the recommendations of the Task Force materially improved the safety and soundness of the system, but further change is yet to come from regulations affecting repo users. 75% of surveyed participants agree that the wholesale funding markets are less vulnerable to a future crisis than before reform. Tri-party Reform simplified the trading day or processing day, reducing the need for secured intraday credit provided by the clearing banks. Furthermore, Tri-party Reform improved trading transparency and decreased operational risk through process improvements such as automated three-way deal matching. While Tri-party Reform drove direct changes to market operations, pending regulations will likely further affect repo users’ behavior, most notably G-SIBs as regulated by the Supplementary Leverage Ratio (SLR)3, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). To become largely compliant, interviewed market participants expect G-SIBs to push the economics of these reforms to individual businesses and trading desks, causing downward pressures on repo activity in the next 12-18 months. Given certain G-SIB’s traditional use of tri-party repo to finance their inventories, we expect these downward pressures will likely be reflected through lower overall tri-party volumes, although some new or existing entities less burdened by regulation are providing increased liquidity in the space.
2. Material involvement by the Federal Reserve (the “Fed”)4 in the repo market is a near certainty for the foreseeable future. The effort to increase the safety and soundness of the global financial sector has materially increased demand for high quality liquid assets (HQLA). This is because collective actions taken since the Crisis (i.e., the regulatory imperative to clear and collateralize over the counter swaps, the requirement to hold HQLA to meet liquidity standards, and the increased amount of cash in the system due to stimulus) create ongoing concerns around the availability of liquid collateral.5 In short, “collateral is the new cash,” as HQLA can now be viewed as the financial system’s most important commodity. Over 70% of survey respondents agreed that this increased demand will lead to a shortage of HQLA in tri-party repo in the next 12-18 months. To date, the Fed has provided HQLA to support cash investing needs through its Reverse Repurchase (RRP) facility. The RRP is now one of the largest participants in tri-party repo, an effective monetary policy tool and a buffer to market anomalies. While certain market developments, such as increasing G-SIB repo volumes post the expansion of cleared repo, may provide the Fed with an easy exit from the RRP, interviewees –with near unanimity – feel that conditions will demand its prolonged existence. One such condition is pending Money Market Reform. These reforms, which are expected to be implemented in the second half of 2016, will potentially move up to $1 trillion of cash from financing prime securities to government securities, in the process exacerbating the concerns around the supply of HQLA and increasing reliance on the RRP.
3. Expanding the availability of cleared repo in the U.S. is the clearest path to giving G-SIBs balance sheet relief and addressing Tri-Party Reform’s largest remaining concern – fire sale risk.6 77% of our surveyed participants agree on the need for a robust cleared repo solution, but this does not come without challenges. To support this conclusion, we review four relevant points regarding the adoption and evolution of cleared repo: (A) Repo volumes have faced downward pressures since the Crisis, with the prospect of more to come. Given this trend, many interviewed participants see cleared repo as giving some flexibility back into the marketplace. The participation of cash investors in a CCP is also key to increasing the size and scope of netting (i.e. the ability to use offsetting positions to calculate a single balance sheet value7) in the U.S. cleared repo market; however, cleared repo providers will need to create the appropriate value proposition to attract involvement from the buy-side. (B) Secondly, a CCP platform would be in the unique position to provide coordination to dealers and other counterparties in both pre and post-default fire sale situations. (C) Additionally, while there is general agreement on the inevitability of expanded cleared repo services in the U.S., key questions remain regarding the potential market structure of the repo industry such as the number of cleared repo platforms that will be offered and what asset classes they will clear. (D) Finally, while Tri-party Reform provided for more efficient movement of cash, we expect the next market evolution to result in a more seamless movement of collateral, culminating with the linkage of international central security depositories (ICSDs) and more integrated global operations of market participants.
The significant structural reform of the repo market is largely complete, and the changes we see on the horizon do not appear to be a continuation of the last six years. The equation facing market participants is now more complicated than that of simply addressing the ongoing requirements of regulation. Understanding and preparing for this more complex future is essential for anyone participating in or affected by the wholesale funding markets. To help participants prepare for what is to come, we developed four priorities in order to be prepared to meet the challenges ahead:
This is a time of important change in the wholesale funding markets and calibrating your approach to the fundamental shifts in the market will be essential. We hope that this paper provides you with some market insight and understanding as you develop and execute your strategies moving forward. Let us thank PwC for their objective perspectives and contributions to the development of the conclusions within this paper, and we are grateful to our interviewed and surveyed colleagues for their invaluable time and industry perspectives.
We welcome and look forward to receiving your feedback and ideas.
Leading up to the Financial Crisis, from 2003-2007, market participants increasingly relied on wholesale funding, as trading expanded from 15% to 22% of industry revenues.8 This growth in revenues resulted predominantly from a growth in trading volumes and made the financial system more reliant on short term funding of trading inventories and other assets. Two specific types of wholesale funding – commercial paper (CP) and repo were used to facilitate the increased funding needs of broker dealers and certain other banks.
The Crisis influenced the composition of volumes within wholesale funding. By 2010, CP had declined to half of its previous volume. As money market funds found the asset class more unattractive, and CP issuers found it increasingly difficult to place paper with investors.9 Since 2012, volumes have remained constant, but financial CP declined in usage, while nonfinancial issuances helped to stabilize overall volumes within this asset class. The total CP market was $987 billion as of June 2015. Large time deposits (including CDs) are near their 2005 levels and comprise roughly $1.9 trillion as of Q1 2015. Volumes grew consistently over the last three years, with foreign bank holdings accounting for more than U.S. chartered depository institutions. The interbank lending market became an important tool for the Fed to control the excess bank reserves of primary dealers by paying interest on deposits. The Fed’s participation drove volumes in the interbank market, which grew from less than $85 billion in 2007 to over $2.5 trillion today.10 Activity in the repo market dropped over 30% in the wake of the Crisis.11 In 2010, total repo volumes stabilized, and repo remains the most material component of the wholesale funding markets (comprising 41%-48% of total volumes over the period). The U.S. repo market, consisting of tri-party, bilateral, and General Collateral Finance (GCF) repo was estimated at $3.7 trillion as of Q1 2015.12
U.S. WHOLESALE FUNDING MARKET ($T)
Going into the Crisis, repo markets were mainly of interest to their participants and the tri-party clearing banks. Primary dealers dominated repo, principally running “matched book” businesses. Leverage in the financial system increased substantially. Additionally, many cash investors were counterparty focused, with less attention paid to the collateral risk they took. In addition to generating direct trading revenues, repo books supported dealer businesses across product areas. Primary dealers provided liquidity to the repo market - acting as buyers and sellers of collateral for clients, who included governments, sovereign wealth funds, money market funds, corporates, and other financial institutions. The large inventories of treasury collateral that dealers acquired assisted with the liquidity of smooth functioning U.S. Treasury markets, contributing to the largest and most liquid bond market in the world.13
The increased supply of repo during this period was met by an equivalent increase of demand from cash investors, as bank risks were viewed as well-diversified and investors had little concerns about providing banks with increased leverage. At the height of the market in 2007, repo books ballooned to over an estimated $5 trillion, with tri-party repo representing nearly half of the volumes. In a Feb ’13 speech, NY Fed CEO, William Dudley, succinctly summarized the convergence of supply and demand that drove this volume increase and ultimately made the risks of repo – most notably the mismatch of maturity and liquidity between repo assets and their financing – central to the broader financial community:
“On the demand side, it was more profitable to use shorter-term funds to finance longer-term assets. On the supply side, such funding was plentiful because it was viewed as safe and because of the growing institutionalization of savings with corporations and institutional investors in need of deposit-like products in which to place their cash balances. After all, the funds were only exposed for a short period of time, and in the case of repo, secured by collateral.” 14 READ MORE
A stable and well-functioning tri-party repo market is critical to the health and stability of the U.S. financial markets and the U.S. economy.
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The tri-party repo market underwent substantial change over the years following the Financial Crisis. At the request of the FRBNY, the Payments Risk Committee (PRC) founded the Task Force in 2009.16 The Task Force, made up of various market participants from clearing banks and hedge funds to dealers and the SEC, formed a common platform where tri-party market participants and regulators jointly created a set of recommendations to reduce systemic risks in the market. Implementing these recommendations shaped a distinct period in the history of tri-party with clearing banks, cash lenders, and collateral providers coordinating efforts to advance and safeguard the industry.
The Task Force identified three primary risks in the tri-party market structure, including: 1) the system’s excessive reliance on secured intraday credit provided by clearing banks; 2) the settlement processes that left credit and liquidity risk largely unknown to collateral providers and cash lenders; and 3) the inability to ensure against a destabilizing fire sale of collateral following a dealers default.17 Subsequent to this, members of the Task Force published draft recommendations on specific weaknesses within the infrastructure of tri-party repo including: operational arrangements, liquidity management, margining practices, contingency planning and transparency of the market.18 Overall, the Task Force’s recommendations provided the foundation for the “practical elimination” of secured intraday credit – defined as 90% reduction of intraday risk related to tri-party.19 READ MORE
While reform is not complete and will continue as a mainstay of wholesale funding, strong market forces – most notably the post regulatory imperative for cleared repo and the profitability of repo – will likely begin to affect repo volumes, participant interactions, and views of risks in the system. The three primary conclusions drawn from our research support this thesis that repo markets are in a time of transition:
1. Market participants agree that adopting the recommendations of the Task Force materially improved the safety and soundness of the system. Additionally, pending regulations on collateral providers and cash investors – designed to increase safety and soundness of the broader system – will put downward pressure on repo volumes in the near term.
2. Continued high demand for HQLA to meet liquidity ratios and collateralize transactions, implies that “collateral is the new cash.” The combination of this new dynamic – the short term downward pressure on repo volumes and likely developments that will further increase demand for HQLA (such as Money Market Reform) – implies that involvement by the Fed in the repo market, through its RRP facility, is a near certainty for the foreseeable future.
3. Expanding the availability of cleared repo services in the U.S. is the most direct path toward giving G-SIBs balance sheet relief (through netting) and addressing the Tri-party Reform’s remaining concern – fire sale risks. This, coupled with the current development of several cleared repo platforms, leads us to believe that several cleared repo solutions will likely be introduced into the U.S. market in 2016 and at least one will be successfully adopted in the near to medium term.
As we look to the future of U.S. wholesale funding, we expect repo to serve as the circulatory system for broader financial markets who have become increasingly reliant on the smooth transfer of collateral. This section addresses the transformation that is occurring within the industry across reform and regulation, the Fed’s involvement in tri-party, and the likely expansion of cleared repo in the U.S. While there is a range of potential outcomes, some scenarios are thought to be more likely than others. We address these and more as we consider the future of the industry.
Adopting the recommendations of the Task Force materially improved the safety and soundness of the system. 75% of market participants feel that tri-party repo is less vulnerable to a crisis than before reform. The risk reduction initiative that encompassed tri-party repo took four years. We provided approximately a $100 million investment in technology to achieve their “practical elimination” of daylight risk.20 This reduced our exposure in the tri-party market from roughly $1.4 trillion of uncapped daily credit to less than 10% of our total tri-party book. Furthermore, it afforded us the opportunity to develop new and innovative technology solutions for us and our broker-dealer and investor client base as well as the ability to accommodate any future growth in the repo market. The implementation was a multi-year collaboration with broker dealers, regulators, and institutional investors (among others) and resulted in a more technologically advanced and safer secured funding marketplace where transactions are settled efficiently. READ MORE
While there has been a reduction in dealer leverage and collateral provided to the market, the buy-side remains awash with cash after the easing of recent years, creating concerns about the availability of collateral available for repo. The Fed’s RRP facility mitigates these concerns by supplying collateral, predominantly to money market funds. Additional reforms, however, affecting cash investors, specifically Money Market Reform, risk disrupting what most feel is a tenuous balance. In this section, we review these important dynamics and expectations for market participants in the near to medium term. READ MORE
Like most members of the financial community, repo participants are optimistic that post-Crisis challenges are drawing to a close, regulations are nearing complete implementation, and the next wave of industry change will be market driven. As repo market participants emerge with stronger clearing and settlement processes and compliant with the new reforms and regulations, finding ways to increase profitability in the new environment is at the forefront of their agendas. Repo’s traditional low risk/ high leverage structure makes change impacting the bottom line most likely to come in the form of a unique cleared repo solution for the U.S. market. G-SIBs look to such a solution as the most likely path to shrink balance sheets, reduce capital, and/ or, perhaps, to increase repo volumes without changing allocated capital. Moreover, in the absence of a clearing solution (and if leverage based capital is directly allocated to the repo desk), interviewed participants believe that repo rates and spreads will need to increase significantly to make an acceptable return on capital. READ MORE
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1 Please note that JPMorgan Chase completed their secured intraday credit risk reduction and capped credit facilities goal (excluding GCF) as of March 2014. “Tri-Party Repo Infrastructure Reform.” NewYorkFed.org. Federal Reserve Bank of New York. Web. November 2015.
2 The key objective of the research conducted by BNY Mellon was to gauge the opinions of senior wholesale funding industry leaders on the possible future shape of the U.S. wholesale funding industry. The themes included were: repo market trends, current market risks, data and analytics, liquidity, central clearing, industry/ market reforms, fire sales, and market disruptions. BNY Mellon’s Market Research & Client Insight group distributed and analyzed this survey. The survey was developed in collaboration with PwC subject matter experts. The target population was senior heads of repo desks and of institutions across the wholesale funding landscape. A total of 57 surveys were completed from senior respondents across cash investors, collateral providers, matched book intermediaries, and advisors, with average repo books ranging from less than $10B to greater than US$100B. The survey was live during a four week period from August 5th to August 31st 2015.
3 We refer to all national/ regional implementations generally as the SLR. Where appropriate, we refer to the U.S. final rule as the eSLR while other national implementations retain the SLR designation.
4 The majority of oversite of the repo industry (including the implementation of the Reverse Repurchase facility) has been conducted through the Federal Reserve Bank of New York; however, we use a more general term to account for influence from other parts of the Federal Reserve System.
5 “Collateral Management: A Review of Market Issues.” BNYMellon.com. BNY Mellon, October 2015. Web. November 2015.
6 GCF integration with the full tri-party repo settlement process also remains incomplete according to the reform proposals laid out by the Task Force. “Update on Tri-Party Repo Infrastructure Reform.” newyorkfed.org. Federal Reserve Bank of New York. Web. November 2015.
7 “Netting Definition.” investopedia.com. Investopedia, 24 November 2003. Web. 19 November 2015.
8 Includes trading revenue for all US and EU G-SIBs (excluding State Street and BNY Mellon). Source: Capital IQ
9 Adrian, Tobias, Karin Kimbrough, and Dina Marchioni. “The Federal Reserve’s Commercial Paper Funding Facility.” NewYorkFed.org. Federal Reserve Bank of New York. Web. November 2015.
10 The interbank lending market before the 2007-2008 Financial Crisis, interbank lending was made up mostly of transactions between financial institutions - i.e., banks with excess reserves loaned to those with short-term funding shortfalls. At the same time, a small amount of bank excess reserves (<$75b) was left with the Fed, earning no interest. Post 2007-2008 Financial Crisis and as part of its effort to stabilize the economy, the Fed began paying interest on these excess reserve balances (IOER). The volume of excess reserves grew to $2.5 trillion as of Q1 2015. This $2.5 trillion is included as part of the total interbank lending volume and functions as a series of short-term loans that the Fed pays interest on. However, this financing is a source of risk-free return for banks, and may not be considered funding. Interbank lending in its traditional form still exists, but is dwarfed by the volume of funds held at the Fed (~$400B vs. $2.5T).
11 Bilateral repo numbers are estimated based on overall primary dealer volumes.
12 “Financial Accounts of the United States.” FederalReserve.gov. Board of Governors of the Federal Reserve, 18 September 2015. Web. 19 November 2015.
13 “Has U.S. Treasury Market Liquidity Deteriorated?” Liberty Street Economics. Federal Reserve Bank of New York, 17 August 2015. Web. 23 Nov. 2015.
14 Dudley, William C. “Fixing Wholesale Funding to Build a More Stable Financial System.” NewYorkFed.org. Federal Reserve Bank of New York, 1 February 2013. Web. September 2015.
15 “Tri-Party Repo Infrastructure Reform.” NewYorkFed.org. Federal Reserve Bank of New York. Web. November 2015.
16 “The Payments Risk Committee is a private sector group of senior managers from U.S. banks that is sponsored by the Federal Reserve Bank of New York.” “Payments Risk Committee.” Ny.frb.org. Federal Reserve Bank of New York. Web. 23 Nov. 2015.
17 “New York Fed Releases White Paper On Tri-Party Repurchase Agreement (Repo) Reform.” NewYorkFed.org. Federal Reserve Bank of New York, 17 May 2010. Web. November 2015.
18 Jaswal, Anshuman. “Triparty Repo in the US Well Begun But Far from Done.” Celent (2011). Web. 9 June 2015.
19 “As a result, the share of triparty repo volume that is financed with intraday credit from a clearing bank has dropped markedly, from 100 percent as recently as 2012, to a level averaging 3 to 5 percent today (as compared with the Task Force’s original target of no more than 10 percent).” “Update on Tri-Party Repo Infrastructure Reform.” NewYorkFed.org. Federal Reserve Bank of New York, 24 June 2015. Web. November 2015.
20 Clarke, Kevin, Charles Andrews, and Steve Pearson. “Ten Key Points about the New US Supplementary Leverage Ratio.” PwC Financial Services/ Regulatory Services. PwC, 9 April 2014. Web. 19 November 2015.
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CEO of Broker-Dealer Services & Head of Banks, Broker-Dealer and Investment Advisors Market and Alternative Asset Manager Segments