Shadow Banks Fault EU Effort to Avert Lehman-Style Contagionby
Securities financing reporting rules drive up costs, ISLA says
ESMA’s Maijoor says pre-crisis supervisors were ‘in the dark’
European Union rules intended to avert the sort of contagion loosed by the collapse of Lehman Brothers Holdings Inc. may end up swamping financial markets in red tape, pushing up costs and potentially draining liquidity, according to industry trade groups.
Reporting requirements in EU regulations on securities financing transactions, which allow firms to use assets such as shares and bonds to secure financing for their activities, will generate reams of detailed information at great cost to companies. And much of it will be of little use to regulators, according to groups including the International Securities Lending Association.
Policy makers say the reporting rules, part of the EU’s efforts to shed light on so-called shadow banks, will benefit investors and allow regulators to identify risks to financial stability. “We were supervising in the dark in the run-up to the financial crisis, and we need to have more data to properly supervise,” Steven Maijoor, head of the EU’s market regulator, said on May 17.
After Lehman filed for bankruptcy, regulators worldwide discovered they had little idea where risk was lurking in largely unregulated shadow banks linked by the chains of securities that are lent, borrowed, and re-lent as collateral. When the system unraveled, players from asset managers and hedge funds to structured investment vehicles and conduits turned out to be linked by those chains of securities, thanks to intermediaries such as Lehman, amplifying and spreading the damage from the collapsed firm.
“During the crisis, regulators realized there wasn’t enough transparency to see the build-up of risk hot spots, or even the early warning signals that hot spots were appearing,” said Andrew Dyson, chief operating officer of ISLA. “That’s fine, but they have to take care. If they put in too much incremental cost, people will exit the market and that will reduce liquidity.”
The main issue is so-called dual-sided reporting, when both borrower and lender report a transaction. EU rules in force since January require counterparties to securities financing transactions to report details to a trade repository “no later than the working day following the conclusion, modification or termination of the transaction.”
The Alternative Investment Management Association, which represents hedge funds, isn’t alone in saying this doesn’t work.
“Dual-sided reporting is a flawed model that has been proven to be both costly and inefficient,” the AIMA wrote in response to technical standards proposed by the European Securities and Markets Authority to make the Securities Financing Transactions Regulation work.
“The extra layer of cost incurred by buy-side participants required to implement systems to facilitate reporting, either on a self-reporting or delegated basis, is unnecessary when their sell-side counterparties have all of the relevant information and are in the strongest position to make accurate and useful reports” to trade repositories, the AIMA wrote.
The industry’s message is starting to hit home with regulators.
ESMA’s Maijoor said there are “possibilities to streamline” reporting under the securities financing rules and related legislation such as the European Market Infrastructure Regulation. These include two-sided reporting.
The securities finance rules make financial firms responsible for reporting on behalf of some non-financial counterparties, for example. ESMA supports this, “and we think a similar approach can be applied for EMIR,” Maijoor said.
“We shouldn’t shy away from measures that can improve this two-sided system, and I would say that relying on one of the sides that takes the responsibility could be a good way forward,” he said.
Jonathan Hill, the EU’s financial-services commissioner, said asset managers and others had raised concerns about “being asked to report the same data in different forms to comply with separate pieces of legislation. So I want to look at whether their reporting burden could be lowered without affecting the quality of what’s reported.”
Tracking collateral chains is also proving tricky in the 5.6 trillion-euro ($6.3 trillion) European market for repurchase agreements. Repo underpins other financial markets, in particular those in bonds and derivatives, because it is the main source of financing for dealers.
Repo is used to raise secured short-term money, with the borrower selling a security, typically a government bond, to the lender. This is accompanied by an agreement to repurchase it on an agreed date at an agreed price and the security that’s sold in effect acts as collateral for the contract to buy it back.
EU securities financing rules place conditions on the reuse of collateral. The receiving counterparty has to inform the provider of collateral of the “risks and consequences” involved in allowing reuse or of concluding a title transfer collateral arrangement. And the provider must give express consent.
“If you’re going to be able to get the collateral when and where needed, it does need to move around,” said David Hiscock, a senior director at the International Capital Market Association in London. Interfering with collateral movement “threatens to undermine the very mechanism that you’re relying upon to help to provide you with financial stability.”
The goal of the regulation is to increase transparency and reduce risks, including those posed by the “complex chains of transactions hidden from market participants and regulators” that increase the chances of a “run on a financial company if there are concerns about its creditworthiness,” according to the European Commission.
Yet these conditions, taken together with reporting requirements, also pose risks, ISLA’s Dyson said. “If you make this prohibitively expensive, people will just exit the market,” he said. “When securities aren’t available to be lent, it has an impact on liquidity. That boosts costs, and in the end, we all pay.”