In the wake of the so-called LIBOR scandal, the European Securities and Markets Authority (ESMA)—an independent EU Authority that fosters supervisory convergence both amongst securities regulators, and across financial sectors—published on Friday July 27, 2012, its response to the European Commission's Green Paper on Shadow Banking issued on March 19, 2012 (see.

http://ec.europa.eu/internal_market/bank/docs/shadow/green-paper_en.pdf).

Shadow banking i.e., non-bank credit activities, include, notably, securitization, securities lending and repurchase transactions ("repo") performed by a number of entities, among which special purpose entities which perform liquidity and/or maturity transformation (for example, securitization vehicles such as ABCP conduits, special investment vehicles (SIV) and other special purpose vehicles (SPV)). In its green paper, the Commission outlined that special attention should be given to global leverage resulting from securities lending, collateral management and repos transactions in order to ensure that supervisors have accurate information to assess this leverage, the tools to control it and to avoid its excessive procyclical effects. The Commission also suggested that bankruptcy laws and their impact on collateral should also be reviewed with a view to increasing international consistency along with the accounting practices of such transactions.

ESMA's response underlines (i) the lack of data available to regulators on lending (and repo) transactions and positions, and that (ii) there is little or no regulation on these matters and it is a market segment that is to some extent opaque to supervisors. As regards data collection, ESMA noted that repo and securities lending transactions are not included in the MiFID transaction reporting regime. It suggested that some less granular or more aggregated reporting regime more focused on position information, possibly outside the MiFID regime, could be worth exploring. It could be based on position reporting per firm and security on a periodic basis. On the regulatory front, ESMA favors the adoption of an appropriate and harmonized regulatory framework in the EU.

Such framework could take the form of a standalone initiative or build on existing regulation (MiFID, CRD, UCITS) depending on the assessment of the regulatory amendments required to address some of the issues arising out of securities lending and repo transaction. The design of such a framework (including the increased transparency it would introduce) should take into account the importance of securities lending and repo activity for a significant number of market participants.

The issues outlined include the absence of harmonized rules determining which part of the available securities are lent or sold in repo by the main lending firms at a certain point in time. Each custodian currently decides what will be the buffer per security, in terms of proportion of lending transactions compared to the total availability. This ratio determines, for instance, the availability of securities for short selling, for resolving settlement failures or for other legitimate purposes. ESMA considers that it would be appropriate to make sure that the total amount of securities available for securities lending and repo is adequately measured. A possible regulatory action would be to require the existence of written policies and procedures on the methodology to define buffers and ratios to be applied, including the duty to inform the competent securities supervisor of those policies and make them available to clients on request.

Finally, ESMA observed that recently the link between sovereign risk and bank risk strengthened in some EU Member States, causing many market participants to withdraw liquidity in the form of repos because of increased counterparty risk. It suggested that a possible regulatory option would be, in this respect, to require specific counterparty risk management procedures to manage repo exposures (central clearing would be one, among other instrument available to achieve that end).

Partners in our European offices will continue to monitor these developments and will report in due course on the future regulatory framework for securities lending and repo transactions in the EU.