Collateral reuse could pose financial stability issues, says FSB

The reuse of collateral and rehypothecation of client assets may pose financial stability issues, according the Financial Stability Board (FSB).

Research revealed that in spite of the potential benefits, such as cost reduction associated with long and short positions in equities and other securities, additional issues may arise.

Specifically, the FSB suggests that rehypothecation of client assets may hinder clients from accessing their securities promptly in the event that an intermediary faces insolvency.

As a result issues may also occur, according to the research, when client assets are not appropriately segregated or when a conflict of rights on available securities arises.

Depending on the insolvency regime, this may leave assets still “frozen” in insolvency proceedings.

The regulator also outlines that by using collateral provided by their clients in secured funding transactions, financial intermediaries can use rehypothecation to reduce funding costs to finance clients’ activities which may increase the overall leverage in the financial system.

In addition, intermediaries may also achieve leverage by allowing a given pool of collateral to underlie a larger set of securities financing transactions and to be reused as margin in derivative transactions.

Such a large amount of leverage through collateral reuse may, according to the report, have systemic implications on the market.

The Securities Financing Transaction Regulation (SFTR) had been designed to improve transparency of collateral reuse in the wake of the financial crisis which has seen collateral reuse drop.

Under SFTR firms must obtain written consent and agreement from clients permitting the reuse of collateral.

Furthermore, clients must be made fully aware of the risks that collateral reuse can entail.

The reporting obligations will require firms to build new systems and processes, and this will add to the workloads of asset managers.