On the 29th of January, the European Commission released its proposal for the establishment of a central database for Secured Financing Transactions (SLTs). The Commission goes to considerable lengths to explain that this initiative is a key component of its efforts to ensure that financial institutions do not shift business from the regulated banking industry to the so called shadow banking industry, hence engaging in regulatory arbitrage.
Using the broad definition of repo and securities lending, it covers equities as well as fixed income securities and specifically includes commodities within its scope. It covers all market participants including dealers, agent lenders, banks, insurance companies and investment managers. The proposal includes various measures which the commission feels are necessary to address the risks of rehypothecation. Although generally referred to as a repo repository, the proposal also includes securities lending transactions as well as total return swaps, collateral swaps and buy-sell transactions.
The proposal aims to increase transparency in three ways:
1) It would require all transaction to be reported to a central database. “This would allow supervisors to better identify links between shadow banking entities and would shed more light on their funding operations.” The text specifically mentions the EBA, EIOPA and the ESCB as the regulators who would have access to this data.
2) “It would improve transparency towards investors on the practices of investment funds engaged in SFTs and other equivalent financing structures by requiring detailed reporting of these operations.” The initiative specifically directs UCITS and AIFM to require fund managers to disclose of their use of SFTs.
3) “This proposal would improve transparency of the rehypothecation (any pre-default use of collateral by collateral taker for their purposes) of financial instruments by setting minimum conditions to be met by the parties involved.”
The Commission’s expressed fears around regulatory arbitrage may be somewhat overblown. The repo and securities lending markets are integral of the global securities markets. While they may exist away from the highly regulated banking industry they are none the less highly structured and operate with established legal president and are subject to regulation at many levels. More importantly, there are few opportunities to substitute SLTs for other traditional banking tools. By definition, in order to engage in a SLT the institution in question would have to own securities and it has always been more efficient to fund those securities in the SLT market than in the traditional banking market. But while it is unlikely that the lack of a trade repository would result in a significant migration of borrowing from the traditional banking sector to the shadow banking sector it is certainly prudent for the group of regulators named in this document to attempt to assemble a complete and timely picture of this multi trillion Euro market.
On the subject of disclosure of SLTs by investment managers, there is certainly little harm in requiring an explicit statement of a fund’s securities lending policies (in the case of non-leveraged funds) and leverage parameters (in the case of hedge funds).
The Commission expresses two concerns on rehypothecation. One is the question of the risks associated with dealers that have control over client assets such as a prime brokerage or clearing relationship. The second is a question of the impact of the ‘on lending’ of securities on SLTs. The two differ significantly and probably should be addressed separately. In the case of the former, there certainly is a reason to address the risks of a clearer or prime broker using client assets beyond the level which is required to support that client’s need for leverage.
As for the question of the ‘on lending’ of securities received in a securities lending or repo transaction, the borrowing of specific securities always is done to fulfill a delivery requirement. By definition the security will be rehypothecated. In addition, dealer reverses which fund clients positions and collateral transformation trades will also always result in the on delivery of collateral. The only area of the repo/securities lending market which does not require rehypothecation in a pre-default scenario is the cash investment portion of the market, both bilateral and tri-party. While a security may be ‘on lent’ the risk of default remains between the two parties to the trade. The Commission is certainly correct to concern itself with excess leverage and the pro-cyclicality of SLTs but the rehypothecation of securities received on a majority of SLT’s is a necessary and well understood market practice.
There are two aspects of this proposal that have important implications for the marketplace. First, the Commission suggests that the creation of a central repository may be best carried out by institutions or service providers that are already in this space. Second, the proposal does not suggest that there should be one securities repository. In fact it goes to great lengths to spell out the requirements for any institution that wants to provide this service. This will certainly create issues around to summation of data for the various regulators. While a multi repository structure may create competition it does leave open the question of how an individual firm may choose to report its trades. Will they choose one provider and channel all of their transactions through that provider or will they report their transactions on a piecemeal basis depending on their specific trading venue or depository? The key challenge may be insuring that the various regulators get a complete picture of the market.
The proposal is available here.