Securities lending is a potentially pro-cyclical source of funding, raising the possibility that participants will have to dump securities during times of financial stress. It can lead to unexpected connections among disparate market players, such as insurance companies and hedge funds. As a result, securities lending may contribute to the opacity of the financial system and erode the willingness of participants to take on counterparty risk. In addition, it is a source of contagion, with the distress of one firm ramifying throughout the financial system in unpredictable ways.
In its November 18, 2102 consultation paper, Strengthening the Oversight and Regulation of Shadow Banking
, the Financial Stability Board (FSB) takes aim at the complex and rapidly evolving repo and securities lending markets. Despite their acknowledged benefits to the financial markets, aspects of securities lending and repo trouble the FSB, particularly their procyclical nature, their lack of transparency, and the ways they may help to transmit negative market events in one part of the globe to another.
As part of their comprehensive look at “shadow banking,” the international body comprised of regulators and finance ministers from the world’s top economies have come up with a slate of potential securities lending and repo reforms aimed at increasing transparency and containing the potential for contagion during times of market stress. These proposals are not merely tweaks to existing regulatory structures, but substantial changes in the ways that securities lending and repo businesses are conducted globally, changes many market participants may find a bitter pill to swallow.
To address what it sees as transparency issues in the securities lending and repo markets, the FSB recommends moving repos and securities lending transactions to trade repositories and clearing these trades through central counterparties (CCPs), and proposes that fund managers be required to disclose more to clients as to their use of repos. Although some in the industry have pointed out
that a wealth of market data is collected and disseminated by independent firms to market participants and investors on a commercial basis as well as to those regulators that request it, and this information has become widely used by market participants for benchmarking and peer comparisons, the FSB believes trade repositories will give regulators better access to market data and improve their oversight, allowing them to collect more granular data on securities lending and repo exposures amongst large international financial institutions.
CCPs were central to the FSB’s efforts to bring more transparency to the OTC derivatives markets, and many jurisdictions, including the U.S. have embraced the idea. With these proposals, the FSB hopes to establish some globally uniform standards for transparency for securities lending and repo transactions as well.
The FSB sees securities lending and repo as part of the larger shadow banking system which rewards risk-taking within the financial system in a procyclical and potentially destabilizing way. They propose to combat some aspects of procyclicality in the financial system by imposing minimum regulatory haircuts for repos and securities financing transactions (whether bilateral, tri-party or central counterparty). The FSB recommends:
Regulatory authorities should introduce minimum standards for the methodologies that firms use to calculate collateral haircuts. Those guidelines should seek to minimise the extent to which these methodologies are pro-cyclical. Standard setters (e.g. BCBS) should review existing regulatory requirements for the calculation of collateral haircuts in line with this recommendation.
They also recommend that these minimum standards for methodologies used by market participants to calculate haircuts include the long-run risk of the assets used as collateral and be calibrated at a high confidence level to cover potential declines in collateral values during liquidation.
Setting aside for the moment the problems of incorporating trade-by-trade haircut rules in an environment where haircuts are calculated on a portfolio basis (e.g. prime brokers), the FSB offers up two options for minimum haircut levels.
High level. The first option would be to set numerical floors at relatively high levels that may typically be closer to actual market practices in normal times. This approach would place a stronger limit on the potential build up of excessive leverage. But it is likely to have a potentially large negative impact on the liquidity of the repo and secondary markets for the affected securities if transactions currently take place at haircuts below the required levels. It will also reduce incentives for market participants to conduct their own haircut calculations with a risk that the numerical floors become de facto market standards.
Back Stop. The second option would be to set numerical floor framework at a level below the haircuts that would be used by a prudent market participant in normal times, but above the level to which haircuts declined at the height of the 2000s boom. This option would introduce a backstop against the build up of excessive leverage while maintaining stronger incentives than the High Level option for market participants to conduct their own analysis of the appropriate level of haircuts, following the minimum standards set out above. However, this approach would leave more scope for pro-cyclical variations in actual haircuts; and if these numerical floors became a de facto market standard (in spite of advice to the contrary), that would clearly be imprudent.
The specter of mandatory haircuts on collateral has been raised before by the FSB in earlier releases
. While acknowledging the relationship between haircuts on collateral and procyclicality, voices in the industry like SIFMA
, ISLA, PASLA, RMA
, and others responded that haircuts are only one factor in a larger system of adjustments to credit quality, and that mandatory haircuts set at an arbitrary level by regulators pose dangerous risks, potentially making the securities finance and repo uneconomic. They also fear that such minimums could remove the distinguishing characteristic between secured financing, like securities lending, and unsecured financing. A key characteristic of repo is that market participants set haircuts based on the nature of the underlying collateral and the credit profiles of counterparts. Mandatory minimums on haircuts could distort the relative pricing between secured and unsecured instruments and could reduce liquidity across a range of collateral, hence raising costs to issuers including governments. According to SIFMA, this could, in turn, have the unintended effect of making unsecured financing more attractive than secured financing. While admitting that minimum haircuts have some theoretical merit, many market participants believe it to be a blunt tool, and say that there are better ways of addressing procyclicality directly, rather than obliquely through the securities finance market.
In an effort to address at least some aspects of concern raised by their earlier proposals, the FSB does carve out an important exception to its proposed haircut standards. Because the purpose of the haircuts standards is to limit the build up of leverage in the financial system, they recommend that any numerical floors should apply only to securities financing transactions where the primary motive is financing, rather than to lend/borrow specific securities. They feel this exception may help mitigate the potential negative impact of minimum haircuts on the liquidity and functioning of securities lending and other related markets, in particular in cases where current regulation prohibits certain types of securities lenders from lending without receiving haircuts. In this regard, they feel there should be a carve-out for cash collateralised securities borrowing transactions.
Cash Collateral Reinvestment
The FSB feels strongly that minimum standards for cash collateral reinvestment by securities lenders or their agents are needed to ensure that they focus on limiting risks arising from cash collateral reinvestment, in particular liquidity risk. To this end, they propose:
- Regulatory authorities for non-bank entities that engage in securities lending (including securities lenders and their agents) should implement regulatory regimes meeting the proposed minimum standards for cash collateral reinvestment in their jurisdictions to limit liquidity risks arising from such activities.
- Authorities should ensure that regulations governing re- hypothecation of client assets address the following principles:
- Financial intermediaries should provide sufficient disclosure to clients in relation to re-hypothecation of assets so that clients can understand their exposures in the event of a failure of the intermediary;
- In jurisdictions where client assets may be re-hypothecated for the purpose of financing client long positions and covering short positions, they should not be re- hypothecated for the purpose of financing the own-account activities of the intermediary; and
- Only entities subject to adequate regulation of liquidity risk should be allowed to engage in the re-hypothecation of client assets.
- An appropriate expert group on client asset protection should examine possible harmonisation of client asset rules with respect to re-hypothecation, taking account of the systemic risk implications of the legal, operational, and economic character of re-hypothecation.
Because of the potential that market participants may seek to avoid the central clearing, haircut, and cash collateral requirements of one jurisdiction by booking transactions in different jurisdictions, the FSB believes it is imperative that a consistent regulatory scheme is implemented globally.
Comments on these proposals are due by January 14, 2013. The FSB has said it will complete its work on securities lending and repo and prepare final detailed recommendations for each aspect of shadow banking by September 2013.