May 24 (Bloomberg) -- Banks and brokers face a clampdown on using assets they hold for clients as collateral for their own trades as part of European Union moves to bolster market stability and rein in shadow banking.
The European Commission is weighing whether firms should have to obtain formal consent from their clients before being allowed to reuse assets to back other trades, according to a document obtained by Bloomberg News. The consent would be enshrined in a “contractual agreement” between the parties.
The handing over of collateral is an integral part of repurchase agreements, or repos -- one of the activities under review by global regulators as part of their efforts to regulate shadow banking. The reuse of clients’ assets poses a potential threat to financial stability should one of a chain of firms that handled the securities go bankrupt, according to the document prepared by commission officials and dated May 15. Uncertainty about who holds an asset can fuel panic in times of market stress, according to the paper.
“Complex” chains of collateral can make it difficult for investors to “identify who owns what, where risk is concentrated and who is exposed to whom,” according to the document. “This has consequences for transparency and financial stability.”
Under the plans being weighed by the commission, banks and brokers holding securities for clients wouldn’t be allowed to reuse the assets for trading on their own account -- speculation on the markets aimed solely at boosting their own revenues, according to the document.
The EU market for repo trades, contracts in which one investor agrees to sell a security and then buy it back at a future date at a fixed price, is worth more than 5.6 trillion euros ($7.2 trillion) according to the most recent survey published by the International Capital Market Association.
Repos are a major source of short-term finance for banks, allowing them to use securities as collateral for short-term loans from investors such as other banks or money-market mutual funds.
The Financial Stability Board has estimated that the global shadow-banking system was worth $67 trillion in 2011, with EU-based activities accounting for about $31 trillion.
Shadow banking is a term used by regulators to define activities that fall outside the scope of most banking and market regulation, and which they believe could be a source of systemic risk. The FSB has identified repos, securities lending agreements and securitization as examples of shadow banking activities.
Evolutions in how markets function mean there is a need for EU rules, according to the document.
“Securities are credited to accounts reflecting a virtual rather than physical nature and EU laws covering securities have not kept pace with market innovation,” according to the document.
The commission is concerned that “legal gaps and inconsistencies” are hampering transparency over the ownership of securities “and can create legal risks in cross-border securities holding and dispositions,” according to the document.
Chantal Hughes, a spokeswoman for Michel Barnier, the EU’s financial services chief, declined to immediately comment on the document.
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