In November 2012, the Financial Stability Board ("FSB") published policy recommendations for addressing financial stability risks in the securities lending and repo markets. On August 29, 2013, the FSB issued final policy recommendations with respect to certain of the November 2012 policy recommendations and reproposed policy recommendations regarding minimum haircuts and minimum standards for haircut methodologies. Comments on minimum haircuts and methodologies are due November 28, 2013. The report can be found here.
The finalized recommendations can be categorized into three main groups: (1) improvements in transparency, (2) regulation of securities financing, and (3) improvements to market structure.
- Improvements in Transparency
The FSB asserts that improvements in transparency must be made by giving authorities better access to data which would enable national authorities to be better equipped to spot over-exposures and enhance detection of risk concentration. Specifically, the FSB recommends that data such as trade-level (flow) for repo markets and regular snapshots of outstanding balances (position/stock data) for repo and securities lending markets be collected. The FSB recommends leveraging existing data gathering capabilities and implementing a global regime for data collection with national authorities aggregating their data with the FSB on a monthly basis.
The FSB further recommends that increased disclosures should be made by corporations and by fund managers to end investors. With respect to corporate disclosures, the FSB seeks more qualitative disclosures of "sources and uses of securities collateral." With respect to fund managers, the FSB recommends more frequent disclosures regarding the use of the securities and repo markets to leverage client portfolios. Disclosures would include the amount of securities on loan and repo/reverse repo books, the sources of borrowed cash and/or securities, drilldowns on the repo and securities lending data such as with collateral type and geography, data on re-hypothecation, managers’ return data for repos and securities lending, and how securities received by the counterparty are held (pooled or segregated).
- Regulation of Securities Financing
The FSB makes several policy recommendations regarding increased regulation of the securities lending market. The FSB first recommends that minimum standards should be set across all jurisdictions, to avoid regulatory arbitrage, for cash collateral reinvestment focusing on limiting risk from reinvestment where securities are lent at call or at short maturities. The recommendations are based, in part, on certain high level principals that the FSB asserts are appropriate for the use of cash collateral reinvestment and include (i) consideration of whether firms have sufficient liquidity to cover reasonably foreseeable recalls or in the event of unexpectedly large requests for recalls of loaned securities, (ii) capital preservation should be a primary objective of securities lending cash collateral reinvestment, (iii) cash collateral reinvestment should be consistent with the firm’s risk profile, (iv) investment guidelines for cash collateral reinvestment should be developed, disclosed, and frequently tested for compliance, and (v) the assets a securities lender holds should be highly liquid. The FSB recommends that authorities account for all of these principles in setting minimum standards for cash collateral reinvestment.
Additionally, the FSB recommends additional regulation on re-hypothecation and re-use, including requiring increased disclosures, preventing the use of re-hypothecation for financing own-account activities, and limiting the entities that should be permitted to re-hypothecate and/or re-use to those that are highly liquid. The FSB also recommends that minimum regulatory standards should be set for collateral valuation and management. These standards include limiting collateral to that which, following a counterparty failure (i) may be held for a period without breaching laws or regulations, (ii) be valued, and (iii) be risk managed appropriately. Additionally, the FSB recommends that collateral and lent securities should be marked to market daily and variation margin collected at least daily where a minimum threshold is exceeded. The November 2012 policy recommendation would have restricted collateral types to those that a firm can hold outright. Therefore, the final recommendation contains a more lenient standard requiring them to be able to be hold such collateral types for a period of time.
- Structural Aspects Of The Securities Financing Markets
The FSB evaluated the cost-benefit analysis of market use of central counterparties ("CCPs"). Although the FSB believes that CCPs can promote stability, CCPs are not suitable for all markets. Accordingly, the FSB recommends that authorities should evaluate whether CCPs would be beneficial in markets where they do not exist, and consider whether the use of existing CCPs should be encouraged. With respect to potential changes to bankruptcy law, the FSB indicated that they "should not be prioritized for work."
Reproposals of Minimum Haircuts and Methodologies
The FSB set forth recommendations for minimum haircuts for non-centrally cleared securities in Annex 2 of the report, which are intended to limit the build-up of excessive leverage outside the banking system. The proposed haircuts were "based in part on the results of a calibration exercise, undertaken as the first stage of a QIS [Quantitative Impact Study] (QIS1), in which a group of large financial intermediaries (17 firms in 12 FSB member jurisdictions) provided detailed historical data on haircut levels in 2006, 2008 and 2012, categorized by type of collateral and counterparty." The proposed haircut levels are generally lower than those proposed in November 2012. The haircuts would apply to non-centrally cleared securities financing transactions in which entities not subject to regulation of capital and liquidity/maturity transformation receive financing from financial entities subject to such regulation. Transactions in government securities are excluded from the proposed minimum haircuts. Also excluded from the minimum haircuts are cash collateralized securities lending transactions where the cash collateral is reinvested into a reinvestment fund and/or account meeting the minimum standards set out in the cash reinvestment policy recommendations (discussed above). The FSB is also undertaking a second stage of its QIS in the fourth quarter of 2013 "that will assess the scope, effectiveness and quantitative impact of the proposed framework more comprehensively, including the exemption of government securities."
The FSB offers considerations for developing minimum haircut standards. Such considerations include: (i) haircuts should be based on the long-term risks of the assets used as collateral and be calibrated at a high confidence level in order to cover potential declines in collateral values during liquidation, and (ii) haircuts should capture other risk considerations where relevant. The FSB recommends that authorities introduce minimum standards that firms must use for the methodologies used to calculate haircuts, and those standards should seek to minimize the extent to which methodologies are pro-cyclical.