The International Securities Lending Association (ISLA) has responded to the European Commissions (EC) shadow banking green paper.
Industry participants were given an extension, from June 1 until today, to respond the regulation, which is designed to address issues of financial sector regulation that warranted attention.
In its green paper, the EC identified securities lending and repurchase agreements as a central issue of concern as these activities can be used rapidly to increase leverage and are a key source of funds used by some shadow banking entities. The specific issues to be addressed could include: prudent collateral management; reinvestment practices of cash received against collateralized securities; re-use of collateral (rehypothecation); ways to improve transparency both in the markets and for supervisory authorities, and, the role of market infrastructure. The green paper dovetails with work carried out by the Financial Stability Board (FSB), which in October 2011 released a report on strengthening oversight and regulation of shadow banking.
Responding to the ECs concerns in a letter, ISLA Chief Executive Kevin McNulty said it is in all stakeholders interests to ensure that the market is sufficiently transparent and has appropriate regulation to allay concerns about non-bank credit activity.
Whilst the Green Paper does not propose any policy options at this stage, some commentators and policymakers have suggested certain specific proposals on this topic. We have concerns about some of these proposals. For example regulating minimum haircut levels for securities lending activity or mandating that securities lending transactions be centrally cleared would not be proportionate proposals. We do not believe that these would address any material systemic risks, but they are likely to materially reduce the benefits that securities lending provides. Alternative options such as increased transparency to regulators around counterparty exposures between market participants would likely be a more effective way of achieving the policy goals being considered. We have not set our arguments at length on these very specific matters but would be happy to engage with the Commission as appropriate in the future.
We therefore strongly support more discussions between regulators and the industry about how transparency can be improved. Whilst securities lending markets are sometimes referred to as opaque, much has developed in this area over the past decade and there is a high degree of transparency available to market participants, beneficial owners and interested parties.
The ISLA response dealt with the following questions put forward by the EC in its green paper:
-Do you agree with the definition of shadow banking? ISLA said it broadly agrees with the definition of shadow banking but emphasized that, in the context of securities lending it is more appropriate to focus on the activity rather than the entities that may engage in it.
FSB suggests that authorities should narrow the focus for policy purposes to the subset of nonbank credit intermediation where there are (i) developments that increase systemic risk (in particular maturity/liquidity transformation, imperfect credit risk transfer and/or leverage), and/or (ii) indications of regulatory arbitrage that is undermining the benefits of financial regulation. We would agree with this approach and would note that not all securities lending activity incorporates these features.
-What are the Risks and Benefits relating to Shadow Banking? ISLA noted that securities lending provides substantial benefits to the wider capital markets, enabling higher levels of settlement efficiency and increased liquidity. Without securities lending it would be more expensive and more difficult for investment firms to make markets in a wide range of securities, and more difficult for investors to hedge investment positions or engage in trading strategies such as arbitrage.
The green paper also asks whether market participants agree with the description of channels through which shadow banking activities are creating new risks or transferring them to other parts of the financial system. ISLA said that concerning securities lending specifically, before considering policy options it believes that further analysis is required to ensure the concerns are justified and need to be addressed and that any measures proposed do not detract from the benefits that securities lending provides.
Commenting on whether deposit-like funding structures may lead to runs (sudden and massive withdrawals of funds), ISLA said: Whilst many forms of funding structures may be subject to the risk of runs, we do not believe that this was the experience in the securities lending market through the crisis. A number of institutional investors did withdraw from the market during that period but the vast majority continued to lend their assets and took comfort from the bilateral and fully collateralized nature of the business.
On the build-up of high, hidden leverage, ISLA said it believes that a number of current regulatory initiatives (such as AIFMD and CRD IV) will serve to reduce perceived systemic risk concerns through restrictions on leverage or the application of liquidity management provisions.
We note the use of the word hidden in the description of this risk. In terms of securities lending we believe that there is scope for the development of more considered and consistent transparency measures designed to allay concerns about the operation of this market.
On the circumvention of rules and regulatory arbitrage, ISLA said it strongly supports the development of a regulatory framework that reduces the possibilities of regulatory arbitrage.
On disorderly failures affecting banking systems, ISLA suggested that fact that prime brokers, who are required to set aside regulatory capital for any securities lending exposures could offset the impact of these potential failures.
– What are the challenges for supervisory and regulatory authorities? ISLA generally welcomed stricter monitoring and regulation for shadow banking: We are keen to work with the policymakers and regulators in this area and are in the process of considering what options we believe may best suit their needs. We strongly support a global approach to this issue such that there are no significant differences in the reporting obligations of market participants in the major markets of the world.
Typically beneficial owners or their legal representatives have access to transaction level data for their own lending programs, which show at a minimum the percentage on loan per security, the collateral received, the fees or rebates associated with such transactions and any cash collateral reinvestment portfolio holdings.
Many market participants also provide daily transaction level data to industry data companies who aggregate this data and produce comprehensive reporting and analysis. This data is used by lenders, lending agents and borrowers to assess market conditions and benchmark the performance of their programs. Whilst there are few regulatory requirements around the world to report securities lending data, we believe that the majority of securities lending transactions are already being reported to one or more of the existing data aggregators.
Commenting on measures that could be envisaged to ensure international consistency in the treatment of shadow banking and avoid global regulatory arbitrage, ISLA replied that An overly prescriptive regime in Europe is likely to drive business to other regions in the world. The FSBs Workstream on Securities Lending and Repo is committed to publishing policy recommendations by the end of 2012 and we would encourage the Commission to develop its policy thinking in this area through its participation in this group.
– What regulatory measures apply to shadow banking in the EU? Providing its view on current measures already taken at the EU level to deal with shadow banking issues, ISLA said that given the amount of regulatory change either recently implemented or in the process of being introduced (UCITS, AIFMD and CRD IV), it believe it would be prudent to understand the overall impact these have in addressing concerns before overlaying further regulations.
– On banking regulation, ISLA notes the statement that these activities can be used to rapidly increase leverage it believes it is better to consider ways of addressing this directly, rather than indirectly through the regulation of the securities finance market.
In respect of bankruptcy laws, it said, the Global Master Securities Lending Agreement is widely used and developments in this area should not unduly conflict with the operation of this agreement. Global consistency and clarity are important to reduce the risk of lenders re-assessing their participation in the activity, particularly in times of stress.
(JDC)