In dual releases published on January 25, 2017, the Financial Stability Board (FSB) expressed concern that reuse of collateral and rehypothecation of client assets may pose financial stability issues. The financial crisis demonstrated that collateral re-use and re-hypothecation can transmit and amplify shocks to financial markets. While regulators have responded and prime brokers and clients have improved their risk management and practices since the crisis, the FSB has formulated recommendations to address residual financial stability risks associated with collateral re-use. In these releases, the FSB finalizes its data collection plans, and also explores whether uniform implementation of its recommendations is truly necessary, or whether a more flexible principles-base approach might be more effective.
Re-hypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches
In this report (“first report”), the FSB takes the opportunity to review the evolution and overall market benefits of the practices of client collateral re-use and re-hypothecation. The report also examines the risks to financial markets posed by re-hypothecation and client collateral re-use as revealed in the financial crisis, as well as possible residual stability risks associated with the practices, including:
- contributing to the build-up of excessive leverage in the financial system,
- increasing interconnectedness of market participants creating risk of contagion,
- increasing the sensitivity of market participants to counterparty credit risk, and
- amplifying stress in markets.
It also examines the FSB’s prior recommendations and the regulatory responses as well as the challenges present in attempting a globally uniform or even harmonized regulatory approach.
Non-Cash Collateral Re-use: Measure and Metrics
The FSB highlights in the second report the need to review the scope, measure and metrics of collateral re-use. Using the comments and input received from its 2016 consultation, the publication finalizes the securities financing transaction non-cash collateral re-use metrics that authorities will monitor for financial stability purposes. The release also sets a deadline of January 2020 to start collecting national aggregated securities financing data from FSB members.
Common Principles, Not Uniform Regulations
Setting uniform global financial standards could be considered the FSB’s raison d’être. In the interest of heading off regulatory arbitrage, global financial regulatory uniformity typically has been the FSB’s favored approach. In this instance, however, the FSB recognizes that for myriad practical reasons, some variation in regulations between jurisdictions may be necessary. They demonstrate this in the first report by contrasting the U.S. and E.U. approaches to re-hypothecation, and special considerations in the United Kingdom, where most European re-hypothecation takes place. The FSB concludes that "there would be some significant operational challenges to harmonising regulatory approaches to re-hypothecation." These challenges include the following:
- Regulatory approaches to re-hypothecation are deeply correlated with securities and insolvency laws, as well as structures of markets (cash- or securities-collateral driven, tri-party or bilateral repos), which are very different among jurisdictions;
- Individual jurisdictions pursue different rationales in the design of re-hypothecation laws and regulations (from financial stability issues to client asset protection);
- Different financial intermediaries have different funding models (banks vs. broker- dealers); and
- Other laws and regulatory regimes (e.g. property law) directly impact the suitability of specific measures to implement re-hypothecation rules.
In addition, at least in in the case of collateral re-use and re-hypothecation, regulatory arbitrage does not seem to be a great concern:
“[I]t appears that differences in regulatory approaches to re-hypthecation do not appear to be a significant contributor to cross-border regulatory arbitrage, but instead are one of many factors considered by financial instermediaries and/or their clients in determining where to open an account."
Consequently, the FSB concludes in the first report that in this instance regulatory variations between markets and jurisdictions are acceptable, perhaps even preferable to strict uniformity, so long as they provide adequate protections to investors and market participants. While the FSB believes that there is no immediate case for harmonizing regulatory approaches to re-hypothecation of client assets, it does recommend that set of common principles underlie regulations across jurisdictional lines. The FSB encourages its member jurisdictions to implement Recommendation 7 of the FSB’s August 2013 Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, as they believe it serves to provide the common basis for authorities to design their regulations with respect to re-hypothecation of client assets.
With respect to collateral re-use, the FSB recommends continued monitoring of collateral reuse at the global level, seeing it as an effective method of obtaining a clearer understanding of global collateral re-use activities in the securities financing markets. The authors urge the implementation of its Standards and Processes for Global Securities Financing Data Collection and Aggregation published in November 2015, which will now include data elements for non-cash collateral re-use measures and some associated indicators.