Regulation of repo and securities loan in Europe will increase the burden of reporting
Amid the unceasing output of the regulatory reporting machine, one proposal advanced by the European Commission has not garnered much attention.
This is the regulation on the reporting and transparency of securities financing transactions published by the European Commission on 29 January 2014. Yet the demands it makes of fund managers are potentially far from trivial.
First, securities financing transactions will have to be reported to trade repositories in exactly the same way as exchange-traded and OTC derivatives are reported already under the European Market Infrastructure Regulation (EMIR). Reports are likely to encompass the principal amount, the currency, the type of transaction, the quality and value of the collateral, the haircut levied on the collateral, whether the collateral can or has been substituted or re-hypothecated, the repo rate or lending fee, the counterparty, and the duration of the transaction.
The data will be made available to the European Securities and Markets Authority (ESMA), the European Systemic Risk Board (ESRB), the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Central Bank (ECB). It will be made available to national regulators as well, through co-operation agreements between trade repositories.
Secondly, fund managers must disclose to their investors their policy on the use of client assets in securities financing transactions, and indeed seek their permission to re-hypothecate them in advance. That entails managers explaining to investors why they need to re-finance assets, which assets are open to being re-financed, any ceilings imposed on re-hypothecation, how opportunities are allocated between clients, which forms of collateral are deemed acceptable, how collateral is valued, what risks are incurred, how cash collateral is reinvested and what it earns, and what third parties – such as agent lenders or custodians- are used.
The policy of a manager on the use of client assets in securities financing transactions will be added to fund prospectuses and other disclosures to investors. Details of re-hypothecated assets, including the transaction types, the amounts and maturity of assets on loan, the collateral held in return, and the type and location of the counterparties, will be included in the regular reports fund managers - whether they are running Undertakings for Collective Investment in Securities (UCITS) funds or Alternative Investment Funds (AIFs) - send to their investors.
Thirdly, the regulation proposes that the owner of any assets liable to be re-hypothecated must be fully informed of the risks. It also stipulates that counterparties holding collateral be allowed to re-hypothecate them only with the express consent of the original owner, and only after the assets are transferred to an account in the name of the receiving counterparty.
Fourthly, counterparties will be obliged to keep a detailed record of any securities financing transaction that they entered, or modified or terminated for at least ten years after the transaction closed.
Non-compliance will be punished by fines geared to the size and strength of the offending firm or individual – at least €5 million in the case of a “natural person,” and a tenth of annual turnover in the case of a company – and trading licence revocations, profit claw-backs plus exemplary fines of at least three times any gains, management dismissals and public naming and shaming.
The goal, as the text of the regulation puts it, is not to prohibit securities financing transactions but to make them more transparent. This may not kill the securities financing markets, but it will certainly inflate reporting costs for counterparties to securities lending and borrowing and repo and reverse repo transactions – which include, of course, fund managers.
There is little prospect of the measure being withdrawn, and not just because the political process to implement it is now under way. The European Commission states explicitly in the preamble to the regulation that it is concerned that the "shadow banking" industry could undermine the division of the formal banking industry between utility and investment banking, as advanced in the Vickers (for the United Kingdom) and Liikanen (for the European Union as a whole) reports, by shifting lending into less regulated areas.
Collecting data on securities financing – to spot systemic risks building in advance, to ensure investors know what is happening to their assets, and to guarantee disclosure of re-hypothecated assets – is simply the method chosen for policing that risk.
As the regulation preamble puts it, "contrary to other financial institutions, investment funds' managers are using investors' money when engaging in securities financing transactions." This is a legal rather than a practical distinction, given that banks take risks with client deposits on a daily basis, but it explains why regulators are not going to relax their stance on this issue: they think the savings of retail investors, who have votes, are at risk.
It is also worth noting that the regulation addresses only one aspect of the five policy recommendations adopted by the Group of 20 (G20) at St Petersburg in September 2013 on the regulation of the so-called "shadow banking" sector.
The G20 selection was made on the basis of a report from the Financial Stability Board (FSB) published on 29 August 2013, which included 11 policy recommendations (see the list below). The securities financing regulation covers FSB recommendations 1, 2, 5 and 7 only. The other areas, as the list shows, concern collateral reinvestment, collateral valuation, re-hypothecation and the role of CCPs in the inter-dealer repo market.
Quite what impact the securities financing regulation will have is hard to predict exactly, but it is almost certain to be negative. In November last year the FSB put the size of the global shadow banking industry at Euro 53 trillion, the bulk of it concentrated in Europe (Euros 23 trillion) and the United States (Euros 19.3 trillion).
That is large, but much smaller than it was before the financial crisis. Since then, investment banks have shrunk their balance sheet-intensive repo books, and the securities lending market has shrivelled up as well. The regulation is likely to put both under further pressure.
In other words, the cost and complexity of the reporting burden may not be the heaviest aspect of the securities financing regulation. That job can always be delegated to a third party anyway. The real impact may be felt in a further squeeze on the price and availability of finance for hedge funds.
FSB Policy recommendations on securities lending and repos
Recommendation 1: Authorities should collect more granular data on securities lending and repo exposures amongst large international financial institutions with high urgency. Such efforts should to the maximum possible extent leverage existing international initiatives such as the FSB Data Gaps Initiative, taking into account the enhancements suggested in this document.
Recommendation 2: Trade-level (flow) data and regular snapshots of outstanding balances (position/stock data) for repo markets should be collected. Regular snapshots of outstanding balances should also be collected for securities lending markets and further work should be carried out on the practicality and meaningfulness of collecting trade-level data. Such data should be collected frequently and with a high level of granularity, and should also capitalise on opportunities to leverage existing data collection infrastructure that resides in clearing agents, central securities depositories (CSDs) and/or central counterparties (CCPs). National/regional authorities should decide the most appropriate way to collect such data, depending on their market structure, and building on existing data collection processes and market infrastructure where appropriate. Trade repositories are likely to be an effective way to collect comprehensive repo and securities lending market data. Regulatory reporting may also be a viable alternative approach.
Recommendation 3: The total national/regional data for both repos and securities lending on a monthly basis should be aggregated by the FSB which will provide global trends of securities financing markets (e.g. market size, collateral composition, haircuts, tenors). The FSB should set standards and processes for data collection and aggregation at the global level to ensure consistent data collection by national/regional authorities and to minimise double-counting at the global level.
Recommendation 4: The Enhanced Disclosure Task Force (EDTF) should work to improve public disclosure for financial institutions’ securities lending, repo and wider collateral management activities, taking into consideration the items noted above.
Recommendation 5: Authorities should review reporting requirements for fund managers to end-investors against the FSB’s proposal, and consider whether any gaps need to be addressed.
Recommendation 6: Regulatory authorities for non-bank entities that engage in securities lending (including securities lenders and their agents) should implement regulatory regimes meeting the minimum standards for cash collateral reinvestment in their jurisdictions to limit liquidity risks arising from such activities.
Recommendation 7: Authorities should ensure that regulations governing re-hypothecation of client assets address the following principles: (a) 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; (b) 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 (c) only entities subject to adequate regulation of liquidity risk should be allowed to engage in the re-hypothecation of client assets.
Recommendation 8: 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.
Recommendation 9: Authorities should adopt minimum regulatory standards for collateral valuation and management for all securities lending and repo market participants.
Recommendation 10: Authorities should evaluate, with a view to mitigating systemic risks, the costs and benefits of proposals to introduce CCPs in their inter-dealer repo markets where CCPs do not exist. Where CCPs exist, authorities should consider the pros and cons of broadening participation, in particular of important funding providers in the repo market.
Recommendation 11: Changes to bankruptcy law treatment and development of Repo Resolution Authorities (RRAs) may be viable theoretical options but should not be prioritised for further work at this stage due to significant difficulties in implementation.
Source: Annex 1, Financial Stability Board, Strengthening Oversight and Regulation of Shadow Banking, Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, 29 August 2013, pages 20 -21.