United States: A Smart Haircut For Securities Financing Transactions?

Last Updated: October 27 2014
Article by Peter Green and Jeremy C. Jennings-Mares


On 14 October 2014, the Financial Stability Board ("FSB") published its "Regulatory framework for haircuts on non-centrally cleared securities financing transactions" (the "FSB Paper").1

The FSB Paper forms part of its policy recommendations in relation to strengthening the oversight and regulation of shadow banking as mandated at the G20 Leaders' summit in Seoul in 2010. In developing these policies the FSB has focused on five workstreams covering money market funds, securitisation, systemic risks from other shadow banking entities, the interaction between the regular banking system and the shadow banking system and securities financing transactions. The FSB Paper is part of its work on securities financing transactions.

In relation to this workstream, the FSB has acknowledged that the securities lending and repo markets play a crucial role in international finance and support price discovery and market liquidity for many public and private securities and are central to the ability of many financial intermediaries' to make markets in securities and facilitate risk management and are core to the funding needs of many financial institutions. On the other hand, the FSB has also expressed concern at the large number of repo and securities lending transactions entered into by non-banks which it believes can give rise to risks arising from maturity and liquidity transformation.

On 29 August 2013, the FSB published a report entitled "Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos"2 that sets out 11 final policy recommendations. These included requiring non-bank entities engaging in securities lending to be subject to minimum regulatory standards for cash collateral reinvestment, encouraging more central clearing of securities financing transactions, requiring regulatory authorities to adopt principles in respect of the rehypothecation of securities (particularly requiring sufficient disclosure to clients to enable them to understand their potential exposure in the event of a failure of the financial intermediary) and limiting rehypothecation to entities subject to adequate regulation of liquidity risks. The recommendations also included a requirement for authorities to adopt minimum regulatory standards for collateral valuation and management.

The FSB's August 2013 Report also contained consultative proposals on a regulatory framework for haircuts on certain non-centrally cleared securities financing transactions. Following this consultation, the October 2014 FSB Paper sets out the FSB's final recommendations in relation to qualitative standards for methodologies used by market participants to calculate haircuts and the introduction of a numerical haircut floor framework and adds five further recommendations outlined below to those set out in its August 2013 Report. In addition, the FSB Paper sets out a consultation on the application of numerical haircut floors to cover non-bank to non-bank transactions backed by collateral other than government securities. On 14 October 2014, the FSB also published a background document entitled "Procyclicality of Haircuts: Evidence from the QIS1"3 setting out the FSB's findings on the procyclicality of haircuts on non-centrally cleared securities financing transactions during the financial crisis.

Methodologies for Calculating Haircuts

The FSB's work here culminates in one further recommendation that regulatory authorities should set qualitative standards for the methodologies that firms use to calculate collateral margins or haircuts, whether on an individual transaction or a portfolio basis, and should review those standards against the guidance set out in the FSB Paper by the end of 2017. In particular, the FSB believes that regulatory authorities should seek to minimise the extent to which haircut methodologies are procyclical.

The FSB states that haircuts should be based on the market risks of the assets used as collateral and be calibrated using a long historical time period, including at least one period of stress with a view to reflecting a potential decline in value of the collateral during liquidation. The FSB believes that potential procyclical fluctuations in haircuts can be limited by moderating the extent to which such fluctuations are reduced in benign market conditions (with low volatility and rising prices) to mitigate the magnitude of the potential increase in volatile markets. In addition, the assumed timeframe for collateral liquidation should be conservative and reflect the expected liquidity or illiquidity of the asset in stressed market conditions and take account of market characteristics of the collateral including trading volumes and market depth. Haircuts should also take into account other relevant risk considerations including the risk of liquidating large concentrated positions, wrong-way risk (when the exposure to a particular counterparty is positively correlated with the probability of default of the collateral issuer due to the nature of the transactions with the counterparty), specific characteristics of the collateral and any foreign exchange risk.

Where margin is calculated on a portfolio basis (where portfolios may include long and short positions in securities and related derivatives), the FSB states that care should be taken to ensure that the methodologies for the haircut calculation are not procyclical and should consider the market risk of the portfolio, geographic and sectorial concentrations, illiquidity risks and risks arising from non-correlated price and spread relationships between lent securities and collateral portfolio assets. The FSB also recommends that regulators should consider regular testing of the adequacy of margin methodologies used by market participants through regular hypothetical portfolio exercises with a view to identifying any market-wide changes in levels of margin requirements over time and any firms with unusually low margin requirements.

Numerical Floors on Haircuts

Here, the FSB sets out four further recommendations:

  • For non-centrally cleared securities transactions where banks and broker-dealers provide financing to non-banks against collateral other than government securities, the Basel Committee should review its capital treatment of securities financing transactions and incorporate a framework of numerical haircut floors into the Basel III framework by the end of 2015.
  • Following the incorporation of the framework of haircut floors into Basel III as specified above, national authorities should implement such framework by the end of 2017.
  • Taking into account the findings the FSB's consultation on proposed approaches for applying the framework of numerical haircut floors to non-bank to non-bank transactions set out in Annex 4 of the FSB Paper, national authorities should introduce the framework of numerical floors for haircuts applicable to such transactions by the end of 2017.
  • The FSB, in coordination with the relevant international standard setting bodies, will monitor the implementation of the framework of numerical haircut floors and will consider reviewing the framework, including its scope and levels as necessary.

The FSB states that through the introduction of numerical haircut floors for non-centrally cleared securities financing transactions in which financing against collateral other than government securities is provided to non-banks, it aims to limit the possible build-up of leverage outside the banking system and reduce the procyclicality of that leverage. It envisages that the haircut floors will act as a backstop in a benign market environment. The FSB stresses, however, that the floors are not intended to dictate market haircuts and participants should conduct their own assessment as to the appropriate level of haircuts.

The FSB explains that it is focusing on transactions involving non-banks because applying floors to securities financing received by banks and broker dealers subject to adequate capital and liquidity regulation on a consolidated basis is likely to duplicate existing regulations. It has also excluded transactions backed by government securities as it believes that price movements in these securities generally tend not to be procyclical and haircuts on these transactions have been comparatively stable over time at zero or a very low level.

The proposed levels for numerical haircut floors in respect of securities against cash transactions based on the FSB's consultation exercise are set out below:

Residual maturity of collateral Haircut level
Corporate and other issuers Securitised Products
≤ 1 year debt securities, and Floating Rate Notes (FRNs) 0.5% 1%
> 1 year, ≤ 5 years debt securities 1.5% 4%
> 5 year, ≤ 10 years debt securities 3% 6%
> 10 years debt securities 4% 7%
Main index equities 6%
Other assets within the scope of the framework 10%

The proposal is therefore relatively simple with the FSB deciding against a more granular approach and avoiding basing the floors on external credit ratings. It believes this approach is consistent with the Basel III capital rules and with the standardised schedules adopted by the Basel Committee and IOSCO in their margin requirements for non-centrally cleared derivatives. The final haircut levels are also higher than originally envisaged by the FSB. In particular, the haircut for main index equities is set at 6%, increased from 4% as proposed in the August 2013 Report.

The FSB notes that the numerical haircut floors are intended to apply both where haircuts are applied at the transaction level and where margin is applied at the portfolio level. The FSB states that special repos (transactions conducted to finance assets in high market demand) are not exempt from the scope of its proposals on haircut floors.

The FSB also states that "collateral upgrade transactions" involving the borrowing of securities against other securities that attract higher haircuts as collateral could potentially be used to circumvent the requirement on numerical haircut floors. It therefore proposes that the floors should apply to such collateral upgrade transactions with the floor being equal to the difference between the floors that would apply to repos of the collateral types on the two legs of the transaction effected separately.

In relation to implementation of numerical haircut floors, the FSB suggests three possible approaches:

  1. Entity-based regulation: numerical haircut floors would be implemented through regulations targeted at each type of entity that engages in securities financing transactions.
  2. Product-based regulation: floors would be implemented through product-based regulation or market regulation targeted at the activity of providing securities financing to non-banks. The providers of the securities financing would be required to conduct transactions above the numerical haircut floor or collect minimum margin amounts consistent with the floor.
  3. Hybrid approach: floors would be implemented through a combination of the above approaches.

In conjunction with its recommendations, the FSB states that, in coordination with relevant international standard setting bodies, it will establish a monitoring framework involving the relevant regulatory authorities seeking to capture the trends and risks in securities financing transactions. The results may be included in the FSB's annual global shadow banking monitoring exercise. It indicates that based on the monitoring results, it could in the future consider reviewing the level of the floors or the counterparty and collateral scope of its requirements.

Consultation on Application of Haircut Floors to Non-bank to Non-bank Transactions

Annex 4 of the FSB paper sets out, for consultation, proposed approaches applying numerical haircut floors to non-bank to non-bank transactions backed by collateral other than government securities. The FSB state this is part of its objective of limiting the build-up of excess leverage outside the banking system and to maintain a level-playing field between bank and non-bank lenders. It also wishes to reduce the risk of regulatory arbitrage and avoid parties avoiding regulatory requirements by shifting securities financing to non-bank to non-bank transactions.

The FSB outline three general approaches for the application of a framework of numerical haircut floors to non-bank to non-bank transactions, again being entity based regulation, product based regulation or a hybrid approach.

Entity-based regulation would involve national authorities modifying existing regulatory requirements for non-bank entities such as insurance companies, pension funds and other funds to implement the floors. The FSB notes this would provide challenges including not being able to capture transactions by entities that are not subject to some type of regulation. In relation to product-based or market regulation, the FSB envisages market regulation being used to prohibit market participants from conducting in-scope transactions below the numerical haircut floors. Unregulated lenders that conduct such transactions could be subject to registration and reporting requirements to enable authorities to monitor compliance. Although the FSB believes this would provide the widest coverage of entities, it notes that there are challenges for this approach including there being no harmonised international standards specifically in relation to securities financing activities and it being possible for market participants to seek to restructure transactions to circumvent the regulations. A hybrid approach would allow a tailoring of existing regulatory rules and provide authorities with flexibility in implementing the haircut floors in the way considered to be most appropriate for the relevant jurisdiction which may involve a mix of entity based and market regulation. The FSB notes this would be the most complex approach and could result in overlapping requirements.

The FSB asks for views on the strengths and weaknesses of these possible approaches or any alternatives. It also asks for views on the length of any phase-in period in relation to any regulation. Responses are requested by 15 December 2014.

Implementation of the FSB's Recommendations

As indicated above, the FSB's aim is for the Basel Committee and other standard setters to work towards revising the existing regulatory rules for methodologies in calculating collateral and margin haircuts for non-cleared securities financing transactions by the end of 2017. In respect of its recommendations for numerical floors, the FSB would like to see this incorporated into Basel III by the end of 2015 with implementation by national authorities by the end of 2017. In relation to its proposals for the application of numerical haircut floors for non-bank to non-bank transactions, the FSB Paper provides that, following the end of its consultation process in December 2014, it intends to complete its recommendations by the end of the second quarter of 2015.

In the responses to the FSB's consultation on the methodologies for calculating haircuts and the introduction of a haircut floor, concerns were raised that, although the FSB stresses these are minimum requirements and parties should conduct their own assessment as to the appropriate level of haircuts, the FSB minimums will be treated by the market as becoming the de facto norm. Respondents also highlighted the difficulty in calibrating mandatory minimum haircut levels so as to strike an appropriate balance between reducing procyclical risks and the building up of excess leverage as against avoiding compromising market efficiency and liquidity. Although the responses did not suggest the FSB's initially proposed minimum haircuts were likely to cause undue difficulties to the market, the final minimum haircuts are higher in some respects and it remains to be seen what effect these will have on securities financing transactions and the types of collateral used.

These recommendations complete the initial work of the FSB in relation to securities financing transactions with work already well underway by many authorities to implement the recommendations set out in the August 2013 Report. In the EU, the European Commission published a draft Regulation in January 2014 focusing on rules relating to transparency, disclosure and rehypothecation.4 The draft Regulation is still working its way through the EU legislative process and is likely to be finalised either in late 2014 or early 2015. This Regulation does not seek to deal with methodologies for calculating collateral haircuts or the imposition of numerical haircut floors. The EU Commission is likely to wait for the Basel Committee to complete its work on revising Basel III to reflect the FSB's recommendations before publishing its proposals in this regard, likely to be set out in a separate draft Regulation.

Overall, the FSB now has set out detailed proposals and recommendations for all of its five shadow banking workstreams in conjunction with the Basel Committee and IOSCO. In addition, in all of these areas, there has been considerable work by the EU institutions and national regulators in Europe, the United States, and elsewhere to implement the wide number of FSB recommendations across all these workstreams. The FSB is, however, likely to remain active in this area for many years to come and to put increased focus on its global monitoring of shadow banking, of which securities financing transactions form just a part.


1. http://www.financialstabilityboard.org/publications/r_141013a.pdf.

2. http://www.financialstabilityboard.org/publications/r_130829b.pdf.

3. http://www.financialstabilityboard.org/publications/r_141013b.pdf.

4. Proposal for a Regulation of the European Parliament and of the Council on reporting and transparency of securities financing transactions, http://ec.europa.eu/internal_market/finances/docs/shadow-banking/140129_proposal_en.pdf.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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Peter Green
Jeremy C. Jennings-Mares
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