Drafting regulation to address perceived risks to financial stability stemming from haircuts, in particular the role of haircuts in constraining leverage, is nothing new, writes the European Repo and Collateral Council (ERRC) of the International Capital Market Association (ICMA) in a recent white paper.
In November 2012, the Financial Stability Board (FSB) floated the idea of mandatory minimum haircuts. In July 2021 the Basel Committee on Banking Supervision (BCBS) published its recommendations for setting minimum haircut floors for securities financing transactions. The latter framework sets out minimum haircuts to be paid by non-prudentially regulated entities in the case of them borrowing cash against non-government securities, including non-cash collateral upgrades. It further provides a formula for the netting of haircuts on a repo portfolio basis.
However, to date no major jurisdiction, to ICMA’s knowledge, has attempted to implement the Basel recommendations, recognizing the inherent limitations: namely the impact on security-driven lending (where negative haircuts are justified); the inappropriateness of a one-size fits all haircut calibration; and the argument for margining counterparties holistically.
When thinking about policy interventions with respect to haircuts, perhaps the starting point should be to ask the question: what are we trying to solve? If the aim is to constrain leverage, is regulating haircuts on individual transactions the most effective and direct policy tool? It is true that in the case of financing trades repo can provide leverage, and that haircuts, or any form of initial margin, naturally reduce the quantum of leverage. However, different entities have very different leverage profiles, the appropriateness of which can vary over time, and that can only be measured meaningfully at a holistic entity level. Furthermore, haircuts are not intended to curb leverage: they are primarily a management tool for liquidation risk.
It has also been touted that applying minimum haircuts in the non-centrally cleared market would create a level playing field for CCPs in the bid to attract more repo into clearing. But comparing bilateral transactions with central clearing is a misleading parallel, with a different set of risk management considerations and objectives. If anything, a better solution would be to work on removing any unnecessary barriers to central clearing, such as capital costs for sponsors, counterparty concentration limits with CCPs, collateral eligibility, or limitations on collateral re-use by certain entities.
Since haircuts are effectively an opaque additional transaction level cost for one of the counterparties, they potentially have a distortive effect on pricing and activity, which has implications for market efficiency. This needs to considered in light of the many uses of repo, which is far broader than leveraged finance, and includes funding market making and liquidity provision in the underlying market, as well as central bank monetary policy transmission. A further unintended outcome could be to incentive market participants to transition from using repo to economically equivalent products such as securities lending or total return swaps (TRS).
“Just as haircut data do not tell us very much about systemic leverage or potential risks to financial stability, the conclusion may be that nor are haircuts an effective policy tool for managing such risks,” the ERCC wrote.