The UK’s Prudential Regulation Authority (PRA) wrote to chief risk officers of UK regulated firms warning on liquid fixed income financing based on findings from a thematic review, which focused on the financing of developed market sovereigns and liquid credit fixed income instruments and was widened to cover lessons learned from the large fluctuations in gilt prices in September and October 2022 impacting Liability Driven Investment (LDI) funds.
The PRA found a number of shortcomings in firms’ counterparty risk management processes and margining arrangements that should be remediated. Many of these counterparty risk management themes are consistent with previous findings in relation to cash prime brokerage and synthetic equity financing following the default of Archegos.
“While firms have made progress in strengthening their counterparty risk management controls for hedge fund clients within their prime brokerage businesses, more focus is needed on other business lines where leverage is provided to clients through secured or synthetic financing facilities,” the PRA wrote.
Among the recommendations is that firms should prioritize necessary enhancements to downstream systems and controls where such weaknesses and inefficiencies in workflow processes exist.
“Messaging protocols and dispute resolution processes supporting clients’ top up margining flows for matched book repo exposures remain highly manual for a material number of counterparties. While we have observed some recent progress by firms in this area, the overall lack of automation of these workflow processes creates additional operational risks for firms. These risks are heightened during periods of stress due to the large volume and scale of margin calls and associated collateral flows, reflecting the sheer notional size of matched books,” the review noted.
Another related to Treasury Liquidity Pool collateral monetization controls: “Liquidity risk analysis should consider the potential monetization requirements of the Treasury HQLA liquidity pool in relation to the overall maturity profile of the matched book assets and liabilities. Firms should factor into their analysis the likely roll over rates for repo and reverse repo exposures of key clients who are important to the matched book franchise, together with additional sources of repo funding capacity, such as central bank facilities that are available across different jurisdictions. Where firms’ modelled liquidity stresses assume the use of additional central bank facilities globally Liquidity Risk Management should assess fully any internal operational frictions or constraints on the mobilization of collateral across legal entities and address these restrictions.”