The FT suggests that collateral transformations amount to regulatory arbitrage

In a strongly worded article, the Financial Times yesterday came out swinging against collateral transformations. This was a surprise attack against a practice that certainly carries some risk, but is far from the backhanded and devious business that the author implies. What’s going on here?

In “Regulators’ boost for securities lending has risky implications,” FT’s Financial Editor Patrick Jenkins said that transformations are “yet another example of the backdoor transfer of risk out of banks and into other parts of the financial system — namely the lightly regulated realm of shadow banking — which we may one day come to rue.” His particular focus is lending government debt in exchange for equities. There’s some right stuff in this article and some wrong stuff. Let’s start with the title.

We at Finadium have proven pretty conclusively that regulator are not only NOT boosting securities lending, but that they have strongly disadvantaged it. We have found this in our consulting work, in the recent report, “Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact” (free courtesy of State Street), and in an upcoming December report on the regulatory costs of OTC derivatives vs. securities loans. Given its otherwise relatively smooth functioning, the regulatory attack on securities lending seems really out of place. We even sent the FT the Real World Impact paper, which shows in great detail how securities lending benefits investors by aiding in market liquidity and the elbow to the gut that regulators are delivering to it. Clearly the FT have another view of the world in mind.

Jenkins describes the core reason for collateral transformations accurately: to gain HQLA for capital purposes, to reduce equities that are not HQLA, and as collateral for OTC derivatives. Of these, we will argue that the biggest reason for collateral transformations is HQLA-related; few market participants really need collateral for OTC derivatives collateral quite yet. At the same time, commenters on the FT’s site note that the balance sheet benefits may be hard to come by.

Jenkins’s analysis is based on an idea that banks are hiding their true capital positions through collateral transformations. He writes about window dressing, “That premise is worth keeping in mind when considering the booming business of securities lending, the practice among financial institutions of swapping shares, bonds and cash with one another. What are they trying to hide?”

He also thinks that this adds more risk to financial markets including asset managers: BlackRock is painted as a bad actor in this story too by lending out bonds in exchange for equities.

It seems that the vitriol behind this article is a lack of evident transparency (hence the Shadow Banking reference). But, we must disagree: all of this business is not so mysterious. Collateral holdings are pretty easily tracked, show up in market data and are now reported in bank financials. New SFT Trade Repositories will only increase the amount of sunlight on the industry, and for regulators, on specific firms.

The article is accurate in that collateral transformations add risk to the market by extending the number of actors in a chain of financing transactions that could be impacted by a market downturn. At the same time, this is the business of finance. You can’t have a functioning financial sector without credit and risk exposure. It doesn’t matter if its bilateral or on a CCP, retail or institutional, or between banks or buy-side to buy-side: you must have counterparty and/or market exposure for the machine to operate.

Its really too bad that a major publication like the FT would make such a sharp attack at a market practice that supports liquidity and enables banks to meet their regulatory requirements. Not only is this not regulatory arbitrage, it is pretty reasonable activity in the face of what we have come to see as the excessive regulation that has focused on securities finance in particular.

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