The European Commission has proposed new rules to stop the biggest and most complex banks from engaging in the risky activity of proprietary trading. Alongside this proposal, the Commission has adopted accompanying measures aimed at increasing transparency of certain transactions in the shadow banking sector. These measures complement the overarching reforms already undertaken to strengthen the EU financial sector.
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What are securities financing transactions? What are they used for?
Securities financing transactions (SFTs) include a variety of secured transactions that have similar economic effects such as lending or borrowing securities and commodities, repurchase (repo) or reverse repurchase transactions and buy-sell back or sell-buy back transactions. The main SFTs are securities lending and repos.
Securities lending is primarily driven by market demand for specific securities and is used, for instance, for short selling or settlement purposes. In this type of transaction, the lending counterparty lends securities for a fee against a guarantee in the form of financial instruments or cash given by their clients or counterparties.
Repos/reverse repos are generally motivated by the need to borrow or lend cash in a secure way. This practice consists of selling/buying financial instruments against cash, while agreeing in advance to buy/sell back the financial instruments at a predetermined price on a specific future date.
What is shadow banking?
Shadow banking can be defined as a system of credit intermediation that involves entities and activities outside the regular banking system. Shadow banks are not regulated like banks, though their operations are like those of banks, as they:
- Take in funds similar to deposits;
- Lend over long periods and take in deposits that are available immediately (known as maturity and/or liquidity transformation);
- Take on the risk of the borrower not being able to repay; and
- Use borrowed money, directly or indirectly, to buy other assets.
They may include ad hoc entities such as securitisation vehicles or conduits, money market funds, investment funds that provide credit or are leveraged, such as certain hedge funds or private equity funds and financial entities that provide credit or credit guarantees, which are not regulated like banks or certain insurance or reinsurance undertakings that issue or guarantee credit products.
Shadow banking also includes activities, in particular securitisation, securities lending and repurchase transactions, which constitute an important source of finance for financial entities.
What are the main elements of the proposal for a regulation?
The proposal aims to improve the transparency of securities financing transactions (SFTs) mainly in the following three ways:
First, the proposed regulation would require that all transactions are reported to a central database. This would allow supervisors to better identify the links between banks and shadow banking entities and would shed more light on some of their funding operations. As a consequence, supervisors would be able to monitor the exposures to and risks associated with SFTs and, if necessary, take better-targeted and timelier actions.
Second, it would improve transparency towards investors on the practices of investment funds engaged in SFTs and other equivalent financing structures by requiring detailed reporting on these operations, both in the regular reports of funds and in pre-investment documents. This would lead to better-informed investment decisions by investors.
Finally, this proposal would improve the transparency of the rehypothecation (any pre-default use of collateral by the collateral taker for their own purposes) of financial instruments by setting minimum conditions to be met by the parties involved, including written agreement and prior consent. This would ensure that clients or counterparties have to give their consent before rehypothecation can take place and that they make that decision based on clear information on the risks that it might entail.
What are the benefits of the proposal?
Transparency is important in understanding how the market works, what the risks are and what their magnitude is.
In this respect, transparency is important as it provides the information necessary to develop effective and efficient policy tools to prevent systemic risks.
First, the reporting of SFTs to trade repositories would allow supervisors to better identify links between banks and shadow banking entities. It would also shed more light on the funding operations of shadow banking entities. Supervisors and regulators would then be able to monitor the market and, if necessary, design better-targeted and timely actions to address any risks to financial stability that emerge.
Second, transparency in the use of SFTs by investment funds is vital. At present, there is very little information available on the use of these transactions by funds, in particular with regard to securities lending and total return swaps. The disclosures required by the draft Regulation would therefore not only benefit investors, but also enable regulators to access valuable information. This, in turn, would allow them to assess the risk linked to the use of these instruments and propose further measures if necessary.
Finally, the harmonised rules with respect to rehypothecation would limit potential financial stability risks with the removal of uncertainty about the extent to which financial instruments have been rehypothecated.
What is the link to the proposal on structural reform of the European banking sector adopted in the same package of measures?
The Commission’s proposal for structural reform of the European banking sector would ban or put constraints on certain activities of banks. Its effects could, however, be diminished if these activities migrate from regulated banking groups towards the shadow banking sector where there may be less scope for control by supervisors.
The work done by the Financial Stability Board (FSB) has highlighted that the disorderly failure of shadow banking entities can carry systemic risk, both directly and through their interconnectedness with the regular banking system. The FSB has also suggested that, as long as such entities remain subject to a lower level of regulation and supervision than the rest of the financial sector, reinforced banking regulation could drive some banking activities beyond the boundaries of traditional banking and towards shadow banking.
To prevent banks from shifting parts of their activity to the less-regulated shadow banking sector, it is important that any structural separation measure is accompanied by measures improving the transparency of shadow banking. Due to their size and close links with the banking sector, SFTs such as repurchase agreements, securities lending, other equivalent financing structures and rehypothecation are particularly relevant activities to address. SFTs display structural similarities to banking activities as they can lead to maturity and liquidity transformation and increased leverage, including short-term financing of longer-term assets.
Why is there a need to address shadow banking?
The shadow banking sector needs to be better monitored because of its size, its close links to the regulated financial sector and the systemic risks that it may pose. There is also a particular need to prevent the shadow banking system being used for regulatory arbitrage.
In addition to the risks associated with circumventing the rules and the fact that these shadow banking entities/activities can lead to high levels of debt being built up in the financial sector, authorities should monitor this sector for two main reasons:
The first factor is size. The latest studies indicate that the aggregate shadow banking assets are about half the size of the regulated banking system. Despite the fact that shadow banking assets have decreased slightly since 2008, the global figure at the end of 2012 was 53 trillion (1). In terms of geographical distribution, the biggest share is concentrated in the United States (around 19.3 trillion) and in Europe (Eurozone with 16.3 trillion and the United Kingdom with around 6.7 trillion).
The second factor which increases risks is the high level of interconnectedness between the shadow banking system and the regulated sector, particularly the banking system. Any weakness that is mismanaged or the destabilisation of an important factor in the shadow banking system could trigger a wave of contagion that would affect the sectors subject to the highest prudential standards.
How is the Commission addressing the risks inherent to shadow banking?
The Commission has already implemented, or is in the process of implementing, a number of measures to provide a better framework for these risks, such as harmonised rules applying to hedge fund activity (2) and reinforcing the relationship between banks and unregulated actors. (3)
In September 2013, the Commission adopted a Communication in which it set out its roadmap and its priorities in the shadow banking area. At the same time, the Commission adopted a proposal for a regulation on Money Market Funds.
As indicated in the shadow banking communication, the Commission is taking a proportionate approach by focusing on activities and entities that pose a high level of systemic risk to the economic and financial sector. Increasing transparency and reducing risks associated with SFTs have been identified as two of the main priorities.
The proposed regulation on the reporting and transparency of SFTs addresses these two priorities. The establishment of reporting obligations to trade repositories, the new disclosure requirements for investments funds and rehypothecation would enhance the transparency of securities financing markets. It would allow supervisors to access detailed, reliable and comprehensive data to monitor risks originating in shadow banking and to intervene when necessary.
Why now? Should the Commission not wait until the reform of the regulated financial sector is fully implemented?
The financial crisis, especially in 2007 and 2008, highlighted the need to improve regulation and monitoring outside the regulated banking sector, because the volume of transactions carried out outside the core banking sector had increased enormously and the risks created could be systemic.
The Commission has been working on measures in this field since 2010 and it is important to act now. The measures that would be put in place respond to the risks identified in the past, but are also pro-active in order to make sure that new activities or techniques do not create systemic risk. The measures announced are also fully compatible with other measures taken.
The European Parliament also adopted an own initiative report on shadow banking in November 2012.
Why is additional regulation necessary in view of the ongoing extensive reform of the financial sector?
The Commission has undertaken the biggest ever reform of financial services regulation with the aim of restoring sustainable health and stability to the sector. The approach consists of tackling all financial risks and ensuring that the benefits achieved by strengthening certain actors and markets are not diminished by financial risks migrating to less regulated sectors. Room for regulatory arbitrage should be avoided in all cases. Therefore, it is necessary to strengthen regulation, also outside the regulated banking sector.
What preparatory work has been done before coming up with this draft regulation?
The preparation of this proposal has involved collecting information and views from a wide range of stakeholders over the last two years. In particular, it takes into account:
- The input received as part of the Commission consultation on the Green Paper on shadow banking and during a public conference as well as the policy conclusions set out in the Commission Communication on Shadow Banking;
- A public consultation in 2012 on various issues concerning Undertakings for Collective Investment in Transferable Securities (UCITS), including transparency requirements;
- The results and responses to a public consultation in 2012 by the Financial Stability Board on the problems identified in securities financing markets, including the lack of transparency. (4)
- The European Parliament’s own initiative report on shadow banking which highlighted the importance of appropriate measures in this area.
- Discussions with Member State experts.
Is the proposal consistent with the Financial Stability Board Recommendations?
Financial markets are global, hence systemic risks created by shadow banking entities and activities need to be tackled in an internationally coordinated manner. The Commission is therefore following very closely the work of the Financial Stability Board (FSB), which is in charge of identifying risks and developing recommendations to address those risks.
In August 2013, the FSB adopted 11 Recommendations to address the risks inherent to securities lending and repurchase agreements. The proposed Regulation is in line with four of these Recommendations (Numbers 1, 2, 5 and 7) related to the transparency of the securities financing markets, disclosure to investors and rehypothecation. The other FSB Recommendations, which are not the subject of this proposal, address risks inherent to the regulatory or structural aspects of securities financing markets such as cash collateral reinvestment, collateral valuation and management, central clearing and bankruptcy law treatment.
This draft Regulation focuses on improving the transparency of SFTs because it is important in understanding how the market works, what the risks are and what their magnitude is. In this respect, transparency is an important step as it provides the information necessary to develop effective and efficient policy tools in the areas already identified by the FSB.
The proposed Regulation is consistent with the work of the FSB. In particular:
- It provides for highly granular and frequent reporting of securities financing transactions to trade repositories. (Recommendations 1 and 2).
- It provides for enhanced disclosure of the use of securities financing transaction to fund investors (Recommendations 5).
- It provides for rules on rehypothecation improving the disclosure to clients and counterparties (Recommendation 7).
Elements of the proposal specific to reporting to trade repositories
Who would be required to report securities financing transactions to trade repositories?
Any EU financial or non-financial entity would be required to report – banks, brokers, funds, insurance companies, pension funds, other financing companies and non-financial companies.
The European System of Central Banks, the Bank for International Settlements and public bodies managing public debt would be exempt from reporting in order not to jeopardise their discretionary policies.
Who would have access to the data collected by trade repositories?
Supervisors and regulators responsible for financial stability and securities markets would have access to the data. These include the European Securities and Markets Authority (ESMA), the European System of Central Banks, the European Systemic Risk Board, the European Banking Authority, the European Insurance and Occupational Pensions Authority and the relevant national authorities.
How would this reporting work in practice?
The reporting of securities financing transactions would be based on the existing reporting framework for derivative contracts established by the European Market Infrastructure Regulation (MEMO/12/232) and would work in a similar way, i.e. a counterparty to an SFT would have to report the details of this transaction to a trade repository. ESMA would supervise this reporting framework and would develop specific technical standards on reporting procedures, access to data procedures and registration procedures for trade repositories.
Elements of the proposal specific to reporting to fund investors
What kind of risks do SFTs create for fund investors?
SFTs are used by fund managers to earn additional returns or to secure additional funding. For example, repo transactions are often used to raise cash for additional investments. At the same time, SFTs create new risks, such as counterparty risk and liquidity risks that materialise if the counterparty to the transaction defaults. Generally, only a part of the additional earnings is attributed to the fund, but the entire counterparty risk is borne by the fund’s investors. Therefore, the use of SFTs may lead to a significant alteration of the risk-reward profile of the fund. Moreover, managers’ motivation to use SFTs may not necessarily be aligned with the interests of the investors. For instance, revenues might not be fully shared with fund investors.
How would the new disclosure requirements help investors?
The proposed disclosure requirements would provide investors with all relevant data regarding the use of SFTs by the fund. The idea is not to overload investors with every detail on each transaction the manager performs, but to provide information on SFT transactions in a concise and aggregate manner. This would allow investors to understand the risks and returns directly linked to the use of SFT transactions. This would also enable investors to assess the level of risk of the (potential) fund investment and make it easier to make comparisons between different fund investments. Furthermore, as managers would be obliged to disclose the information, they may have more incentive to act in the interests of investors.
Elements of the proposal specific to rehypothecation
What is rehypothecation?
Rehypothecation is mainly employed by financial companies (e.g. banks, dealers, brokers). It allows them to use for their own purposes financial instruments that have been given to them by their clients or counterparties as collateral, especially to borrow money in the wholesale markets. (Example: a hedge fund posts financial instruments as collateral with its prime broker, which then uses these instruments for its own transactions. The hedge fund is usually compensated for this by lower borrowing costs or fees).
What are the risks of rehypothecation?
Rehypothecation has several risks:
- When rehypothecation takes place, the ownership of the financial instruments is replaced with a contractual claim to the return of equivalent financial instruments. In practice, this is akin to an unsecured obligation.
- Rehypothecation allows for the same financial instruments to create multiple obligations that interconnect different actors within the market. These obligations amount to a multiple of the value of the rehypothecated financial instruments, creating concerns for financial stability because of amplified leverage and procyclicality.
- Rehypothecation forms complex chains of transactions hidden from market participants and regulators. This increases the possibility of a run on a financial company if there are concerns about its creditworthiness.
The uncertainty about the extent to which financial instrument have been rehypothecated can create financial stability risks. This would be especially relevant where clients or counterparties have insufficient visibility over the risks and the use of financial instruments.
What specific rules on rehypothecation would this draft Regulation introduce?
The draft Regulation would harmonise requirements on rehypothecation in the EU. It sets out four conditions to be fulfilled:
1. The client or the counterparty would need to give its consent for its assets to be rehypothecated.
2. The entity wishing to engage in rehypothecation would have to disclose the potential risks, for example those in the event of default.
3. There would have to be a written agreement.
4. The financial instruments would have to be transferred to the account of the entity that uses them for its own purposes (i.e. the rehypothecation could not take place on the client’s or counterparty’s own account).
Stricter rules could be allowed at national level or in sectoral EU legislation.
What is the scope of the proposed rules on rehypothecation?
The rules would apply to all EU entities as well as to those third country entities that rehypothecate financial instruments provided by an EU entity. The rules would also cover any collateral arrangement under the Financial Collateral Directive i.e. title transfer collateral arrangement or security interest collateral arrangement.
Notes
1 : Global Shadow Banking Monitoring Report 2013, 14 November 2013, Financial Stability Board.
2 : Alternative Investment Fund Managers Directive (AIFMD).
3 : For instance, the provisions related to securitisation exposures in the revised Capital Requirements Directives.
4 : 49 responses were received from trade associations, intermediaries, asset managers, market infrastructures and public authorities.
