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On April 27, the Financial Stability Board Workstream on
Securities Lending and Repos (WS5) under the FSB Shadow Banking
Task Force published an Interim Report documenting
WS5's progress to date. As someone trying to keep
track of regulatory developments in these areas, I found this
report to provide a very useful overview of the markets, their
relationship with each other and the market issues that these
activities raise and which may come in for further regulation in
future. If you are new to this area, I would also recommend
it as way to quickly bring yourself up to speed.
The market overview in Part 1 is a very high level description
of the functions and participants in four segments of the market,
namely securities lending, leveraged investment fund financing and
securities borrowing, interdealer repo and repo financing. Some
helpful charts describe the interrelationship between these
segments of the market, and further detail on each of these
segments can be found in Annex 1 of the Report.
Part 2 describes five key drivers in the markets, namely the (i)
demand for repo by certain risk averse institutions (such as money
market funds, entities reinvesting cash collateral from sec lending
activities, banks, pension funds, insurers, securitization
vehicles) as a near-substitute for money market instruments; (ii)
securities-based financing needs of leveraged intermediaries; (iii)
facilitation of hedge fund and other investment strategies
involving leverage and short selling; (iv) increasing need
for banks and broker-dealers to gain access to securities for the
purpose of optimizing the collateralization of repos, securities
loans and derivatives; and (v) seeking of additional returns by
institutional investors through the fees earned on lending
securities or in re-investing the cash collateral received or
posting it as collateral in other activities, such as OTC
derivatives.
Part 3 described the place of these markets in the shadow
banking system and notes the FSB's main focus will be on (i)
borrowing through repo financing markets; (ii) maturity
transformation and leverage; (iii) the chain of transactions
through which cash proceeds from short sales are transferred; and
(iv) collateral swaps.
Part 4 provides an overview of regulation in various
jurisdictions. Areas of regulation include:
capital rules;
limits on rehypothecation that apply to dealers;
securities and pension regulatory requirements applicable to
fund investments;
concentration limits;
restrictions on eligible counterparties for certain
participants;
restrictions on the term or maturity of securities loans and
repos (in Canada for example, for money market funds);
collateral guidelines (such as minimum collateral value,
criteria for acceptable collateral based on such things as credit
rating, currency, restrictions on rehypothecation by investment
funds and insurance companies, restrictions on cash collateral
reinvestment (eg in Canada for 81-102 funds)); and
disclosure requirements.
WS5 has identified in Part 5 of the report seven preliminary
issues that could be considered to have financial stability
implications that apply to some or all of the market segments.
Lack of transparency – can it be improved? One
point made here is that there may be insufficient disclosure of the
rehypothecation activities by prime brokers to hedge fund
clients.
Potential for heightened procyclicality resulting from:
Changing value of collateral securities.
Haircuts.
Collateral re-use and velocity (the length of the collateral
re-use chain).
Other risks resulting from re-use of collateral, including
increased interconnectedness between firms.
Market turmoil caused by collateral fire sales on default
during times of market stress.
Potential risks arising from agent lender practices,
particularly with respect to indemnities.
Performance of bank-like activities by reinvestors of cash
collateral, exposing portfolios to credit and liquidity risk.
Insufficient rigour in collateral valuation and
management.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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