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.

  1. 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.
  2. Potential for heightened procyclicality resulting from:

    1. Changing value of collateral securities.
    2. Haircuts.
    3. Collateral re-use and velocity (the length of the collateral re-use chain).

  3. Other risks resulting from re-use of collateral, including increased interconnectedness between firms.
  4. Market turmoil caused by collateral fire sales on default during times of market stress.
  5. Potential risks arising from agent lender practices, particularly with respect to indemnities.
  6. Performance of bank-like activities by reinvestors of cash collateral, exposing portfolios to credit and liquidity risk.
  7. 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.