An excellent post in COO Connect “Regulation of repo and securities loan in Europe will increase the burden of reporting” (October 6, 2014) by Dominic Hobson caught our eye. He writes about the creation and complexity of European trade repositories for securities finance and how it impacts fund managers.
From the article:
“…First, securities financing transactions will have to be reported to trade repositories in exactly the same way as exchange-traded and OTC derivatives are reported already under the European Market Infrastructure Regulation (EMIR). Reports are likely to encompass the principal amount, the currency, the type of transaction, the quality and value of the collateral, the haircut levied on the collateral, whether the collateral can or has been substituted or re-hypothecated, the repo rate or lending fee, the counterparty, and the duration of the transaction…”
Who will receive the information?
- European Securities and Markets Authority (ESMA)
- European Systemic Risk Board (ESRB)
- European Banking Authority (EBA)
- European Insurance and Occupational Pensions Authority (EIOPA)
- European Central Bank (ECB)
- National regulators, through co-operation agreements between trade repositories
The rules are part of the implementation of FSB recommendations on shadow banking and market transparency. The information will go to a trade repository and reporting will include some sort of public disclosure, although exactly how granular it is remains to be seen.
Beneficial owners will need to sign off that their paper is being lent out. This will involve fairly detailed information on rehypothecation and the risk entailed. From the article (citing Annex 1, Financial Stability Board, Strengthening Oversight and Regulation of Shadow Banking, Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, 29 August 2013, pages 20 -21)
“…Recommendation 7: Authorities should ensure that regulations governing re-hypothecation of client assets address the following principles: (a) Financial intermediaries should provide sufficient disclosure to clients in relation to re-hypothecation of assets so that clients can understand their exposures in the event of a failure of the intermediary; (b) In jurisdictions where client assets may be re-hypothecated for the purpose of financing client long positions and covering short positions, they should not be re-hypothecated for the purpose of financing the own-account activities of the intermediary; and (c) only entities subject to adequate regulation of liquidity risk should be allowed to engage in the re-hypothecation of client assets…”
So what does all this mean? First, beneficial owners will hear what they (hopefully) already know about securities lending and sign off on rehypothecation in advance. Some investors will inevitably be scared off, take their securities out of lending programs, and the market will shrink some. From the article:
“… fund managers must disclose to their investors their policy on the use of client assets in securities financing transactions, and indeed seek their permission to re-hypothecate them in advance. That entails managers explaining to investors why they need to re-finance assets, which assets are open to being re-financed, any ceilings imposed on re-hypothecation, how opportunities are allocated between clients, which forms of collateral are deemed acceptable, how collateral is valued, what risks are incurred, how cash collateral is reinvested and what it earns, and what third parties – such as agent lenders or custodians- are used…”
Putting the compliance and reporting apparatus in place will be cumbersome and expensive, increasing costs. It will become a big opportunity for IT vendors.
All this data will have to be sifted through, both by the submitters and the trade repositories. Trade repositories have had a tough time getting everything right. Lots of information and tons of double counting lead to inconsistent results or worse yet, incorrect conclusions. This should be a great opportunity to use Legal Entity Identifiers (LEI) as well as develop standard trade types and collateral type identifiers. Ideally the information can be analyzed to determine if market risk is tilted one way or another, but it will need access to all the pieces of the puzzle – inter-dealer repo and sec lending, synthetic financing and collateralized commercial paper (that mimics repo) – as well as go across borders. That is a very tall order and would require a gargantuan effort. This is the land of big data.
Using the rules to insure clients are informed and understand the risks is a good thing. How that message is crafted will be crucial. Securities lending can get very complicated very quickly and the explanation could easily spook investors.