Wednesday, May 21, 2014

FSOC's 2014 Annual Report Addresses Some Securities Lending and Repo Risks

The US Financial Stability Oversight Council has published its 2014 Annual Report which highlights, among other things, the activities of the Council, significant financial market and regulatory developments, an assessment of those developments on the stability of the financial system, and potential emerging threats to the financial stability of the United States. The report highlights two forward-looking risks specifically in securities finance and collateral management, and remarks on uncertainties that remain for money fund regulation.

Asset managers and securities lending indemnification.

“Some asset managers are now providing indemnification to securities lenders as part of their securities lending business. There are likely benefits for asset managers from combining indemnification provision with securities lending, but there also is the potential for enhanced risks. Unlike banks, asset managers are not required to set aside capital when they provide indemnification. Also, although asset managers have access to management fees, they do not have access to banks’ stable deposit funding base. Consequently, the indemnification that asset managers provide may be a source of stress on their own balance sheets, while at the same time resulting in lower protection for the lenders relative to indemnities provided by banks.”

Bilateral repo and securities lending data.

“regulators and policymakers currently have no reliable, ongoing information on bilateral repo market activity, which is more difficult to collect because activity in this segment does not flow through a settlement agent like tri-party and GCF repo transactions do…. There are similar data gaps regarding the securities lending activities of financial institutions. “

In addition to these two forward looking risks, the FSOC identified some improvement in the wholesale short-term funding markets.

The influx of customer deposits in recent years has afforded banks the opportunity to reduce their dependence on short term wholesale funding. Although the usage of commercial paper (CP), repo, time deposit, and other sources of wholesale funding fell this past year, financial institutions without access to customer deposits and prohibited from using customer cash and securities for proprietary purposes, such as broker-dealers, remain dependent on wholesale markets for funding. Since the Council’s inaugural annual report nearly three years ago, the structural vulnerabilities of the tri-party repo markets have been highlighted. This past year witnessed important progress in tri-party repo reform. For example, through supervisory authority, the Federal Reserve has worked with the two clearing banks and market participants to greatly improve operational efficiencies and controls in the management and transfer of tri-party repo collateral. As a result, intraday credit exposure was reduced below the 10 percent goal for one clearing bank while the other is expected to have less than 10 percent of this exposure by the end of 2014.

The annual report also makes note that the uncertainties that remain for money market reforms leaves an unresolved potential for runs on money funds.

In addition, reform efforts continue for MMFs, with the SEC releasing a proposed rulemaking in June 2013. Currently, the SEC is assessing comment letters and other data and information to determine the best approach to prevent possible runs on MMFs in the event of a severe liquidity or credit shock to MMFs, such as occurred during the
financial crisis. Until structural reforms are adopted, the potentialfor run risk remains significant. Similarly, the possibility of tri-party repo collateral fire sales still poses significant risks for the financial system. Policymakers continue to examine ways to minimize potential tri-party repo spillover effects if such fire sales were to occur.

The full text of the FSOC's 2014 Annual Report is available at: