Asset managers, sec lending, and shadow banking: regulators continue to try to connect the dots

An article in the FT “US regulator gets tough on asset managers’ shadow banking” (May 24, 2015) by Chris Flood (sorry behind the pay wall) reminds us that regulators are still obsessed with connecting dots between shadow banking, securities financing, and asset managers.

Last summer the FSOC pulled back from designating large asset managers with SIFI status. There was a collective sigh of relief at managers like Blackrock and Fidelity. They wondered why, as investors in markets, would the regulators think they created systemic risk? Perhaps it was driven by their size; should Fidelity decide to sell good chunks of their portfolios, it could create extraordinary volatility in the markets. This could lead to the financial system being stressed, fire sales, banks start to fail, etc. etc. While it might be hard to disprove, it is difficult to think that large asset managers should be regulated as SIFIs because of it.

A June 2nd FT had an article by Philip Stafford “UK markets regulator warns against systemic risk label for funds” (sorry, also behind the pay wall) that quoted Martin Wheatley, head of the Financial Conduct Authority on the same point:

“…’I’d find it perverse if we ended up putting handcuffs on a set of players in markets — the asset managers — just because they’re regulated and we know them, and yet allow people on the lakeside in Switzerland and sovereign wealth funds in the Far East and central banks to play with free rein in those markets,’’ Mr Wheatley told the Financial Times…”


“…’My view is that it’s not the players that are systemic, generally, it’s the markets that they operate in,’ he said, adding: ‘So you’ve only constrained one set who themselves represent maybe 15 per cent of liquidity flow in markets’…”

The debate on big asset managers seems to have shifted as of late, morphing into a discussion more about securities financing. The May 24th FT article said:

“…The Securities and Exchange Commission last week tabled plans for a vast increase in data reporting that will require US-registered funds to provide monthly data on securities lending activities, repurchase agreements and counterparty exposures…”

The response to the idea of more reporting was as to be expected: this would have cost a lot of money and the first step on a slippery slope toward leverage limitations. From the same article:

“…The new reporting rules will result in extra costs, no question,” said Jay Baris, chairman of the investment management practice at Morrison & Foerster, a law firm…Mr Baris added that the reporting of derivatives could be a preliminary step towards imposing limits on the use of leverage by fund managers, an issue that divides regulators…”

Frankly, collecting sec lending trade information from asset managers doesn’t sound like a terrible idea. With accurate LEI and trade type identifiers, it could be incorporated into trade depositories to give regulators a broader picture of the markets. We have been skeptical about the regulators ability to process all that data, much less make sense of it, but that is a different topic (which we covered in the March 2015 Finadium report, “The Design and Impact of Trade Repositories for Securities Lending and Repo“).

It feels like underneath it all is a debate about securities lending. Is it risky? Is there collateral and maturity transformation embedded in the business? Is sec lending shadow banking? The term shadow banking has come to be code for the part of banking that escapes regulation and is therefore up to no good. Does sec lending suffer from guilt by association?

First, is there collateral and maturity transformation in securities lending? Sure. If a beneficial owner lends a long dated US Treasury or equity and reinvests the cash collateral into a short dated investment pool, the maturity profile has changed. In a default situation, the beneficial owner ends up with the short duration asset and has to buy back what they lent. Is that egregious enough to need regulation beyond what is already in place (primarily on the cash reinvest side)? Not really. There seems to us to be more risk on securities versus securities sec lending trades given the potential difficulty in selling the collateral received.

In May, Blackrock put out a thought piece “Securities Lending: The Facts” that did a good job of addressing the regulators issue one by one. It is worth a read, although it does feel somewhat spin’y.

The regulators will continue to look at securities lending through the shadow banking prism. It’s hard to tell if they will eventually succeed in imposing additional regulations and exactly what those could be. Maybe minimum overcollateralization rules, in parallel with minimum haircuts for repos? Mandated central clearing? We are not sure what the SEC was thinking when they tabled additional reporting requirements, but they sounded like a decent idea — hopefully folded into other securities financing trade repository efforts.

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