EU Said to Weigh Curbs on Collateral Asset Reuse in ReposJim Brunsden and John Glover
Banks and brokers may face European Union curbs on the number of times a single asset can be passed on as collateral in repurchase agreements and other secured trades, according to a person familiar with the plans.
The EU is weighing whether it should limit the length of transaction chains in which traders who receive collateral in turn use the same securities to back separate trades, according to the person, who asked not to be named because the proposals aren’t public. It is also planning measures to make the chains easier to monitor by regulators.
Repurchase agreements, or repos, are one of the targets of the possible EU rules, as authorities seek to extend regulations beyond traditional banking activities to cover other sources of risk taking.
The 2008 collapse of Lehman Brothers Holdings Inc. unleashed turmoil in financial markets, driven in part by uncertainty over who owned cash and other assets used to back derivatives trades with the bank. Litigation over the collateral has continued ever since, including a dispute between Lehman and Intel Corp. over $1 billion in cash the bank provided to the world’s largest chip maker as part of a swap agreement.
The handing over of collateral is an integral part of repos -- one of the activities under review by global regulators as part of their efforts to regulate shadow banking. Banks use repos to help finance investments in Treasuries, corporate bonds and mortgage-backed securities.
The possible commission plan would “make it more difficult to get leverage in secondary markets and that in turn will make it harder to iron out pricing anomalies,” said Peter Chatwell, an interest-rate strategist at Credit Agricole Corporate & Investment Bank in London. “That may make it more difficult to manage issuers’ redemption and coupon profiles. Ultimately, it makes for a less efficient market.”
In an efficient market, if a trader sees a bond that is expensive relative to the issuer’s other bonds, he or she uses repo to borrow the note and then sells it, while buying the cheaper debt. The transactions help close the gap between the “cheap” and “expensive” bonds.
“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 a document prepared by European Commission officials in May and obtained by Bloomberg News. “This has consequences for transparency and financial stability.”
Banks are facing a growing list of demands from regulators to seek out highly liquid assets as authorities move to bolster the resilience of the financial system.
Re-use of collateral is one way that lenders can satisfy the tougher rules, amid warnings from banks that there may not be enough highly liquid securities available to satisfy accumulating requirements from supervisors.
Lenders including UBS AG and HSBC Holdings Plc have warned that plans by global regulators in the Basel Committee on Banking Supervision to set minimum collateral requirements for non-centrally cleared swaps trades will prompt a global liquidity squeeze as banks struggle to locate enough securities to satisfy the standards.
While Basel regulators early this year proposed changes to the draft standards, including some scope for re-using collateral, and a longer phase-in time, lenders have said this doesn’t go far enough to resolve their concerns.
There are signs already that the repo market is shrinking in response to moves by regulators.
The U.S. repo market shrank to $4.6 trillion daily outstanding last month, down 35 percent from a peak of $7.02 trillion in the first quarter of 2008, based on Federal Reserve data compiled from its 21 primary dealers.
The repo market is also shrinking as the U.S. Fed scoops up Treasuries through its monthly bond purchases. The central bank owns about 17 percent of the market.
Money-market funds such as those used by individuals to park cash and savings, are a major provider of repo financing. In one example of a repo agreement, a money-market fund may lend cash to a dealer overnight, with government securities serving as collateral for the loan.
The potential consequences of a fall in market liquidity are higher borrowing costs for governments, companies and consumers.
The EU measures may be included in a draft law on securities trading that regulators intend to publish by the end of the year.
The commission may give some details on the proposals in a paper on shadow banking on Sept. 4. The report will be published in tandem with a draft law to force money-market funds to hold minimum levels of liquid assets, and in some cases, additional cash reserves, the person said.
Shadow banking is a term used by regulators to define activities that fall outside the scope of most financial regulation, and which they believe could be a source of systemic risk.
The commission will draw on international discussions on how the “regulatory framework for securities lending and repos could be improved” in drawing up its proposal, Michel Barnier, the EU’s financial-services chief, said in an Aug. 7 response to a parliamentary question.
“Work in this area is extremely complex and technical and touches upon many areas of national law,” he said, adding that he is seeking to present proposals by the end of 2013.
“The entire shadow bank sector is not yet properly regulated,” Chantal Hughes, a spokeswoman for Barnier, said in an e-mail. “We must ensure that risks are not accumulating” in this part of the financial system, she said.
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 ($7.5 trillion) according to survey data published by the International Capital Market Association.