New Light on Shadow Banking: The FSB's New Report on Rehypothecation of Client Assets

 Margaret Grottenthaler

The Financial Stability Board has been considering the possible harmonization of rules relating to rehypothecation of client assets in securities financing transactions (such as securities loans, repo and margin loans) for several years. On January 25, 2017, it released a report entitled Transforming Shadow Banking into Resilient Market-based Finance, which summarizes the findings of its Rehypothecation and Re-use Experts Group.

Regulatory Approaches to Shadow Banking

Those of you who want to know more about how this aspect of so-called “shadow banking” works will find the new report very informative. Specifically, it explains:

  • What rehypothecation is;
  • Why it is important to the efficient functioning of lending markets;
  • What systemic risks it poses;
  • How those risks are currently addressed by regulation and market practice; and
  • The possibilities for harmonizing regulatory approaches.

The report ultimately concludes that there is no immediate case for harmonizing regulatory approaches. One interesting section of the discussion is the status update on the implementation of Recommendation 7 of an earlier FSB report, Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos (August 29, 2013). Recommendation 7 had three elements:

  1. Disclosure to clients by financial intermediaries with respect to rehypothecated assets so clients can assess their risks.
  2. Restricting rehypothecation to the intermediary to client-related purposes such as financing long positions or covering short ones, not for the intermediary’s own purposes.
  3. Only allowing entities subject to adequate regulation of liquidity risk to rehypothecate client assets.

With respect to these issues, the Rehypothecation and Re-use Experts Group found that:

  • Most jurisdictions require client consent before assets can be rehypothecated;
  • All jurisdictions have reporting mechanisms to track the status of rehypothecation of client assets;
  • No jurisdiction bans the practice outright;
  • Many jurisdictions’ restrictions vary depending on whether the assets are cash or non-cash;
  • Restrictions are laxer for banks/investment firms than for investment funds; and
  • All jurisdictions require adequate regulation of liquidity risk as a condition.

Approaches in the jurisdictions examined diverged on the second element of Recommendation 7 (not permitting rehypothecation to fund intermediary’s own-account purposes). Even where this element was not implemented, however, its underlying rationale was often satisfied by rules preventing intermediaries from funding a material portion of their own account activities with client assets. The FSB is monitoring implementation of this element of the recommendation.

Ultimately, the FSB concluded that there was no immediate case for harmonizing regulatory approaches. The differences in approaches are deeply rooted in national/regional securities laws, bankruptcy laws and other legal regimes that vary significantly across jurisdictions. Moreover, since the 2007-09 financial crisis, firms and clients have made notable improvements in risk management practices associated with rehypothecation, making the entire issue somewhat less urgent from a regulatory point of view.

Collateral Re-use

The report also addresses collateral re-use. This is the practice of secured parties using collateral provided by the debtor party. It overlaps with rehypothecation inasmuch as the financial intermediary may be a secured party and the debtor may be a client. This practice raises similar issues. The risks are addressed in different ways, such as Basel III Leverage Ratio and liquidity frameworks, and clearing requirements. Successfully implementing the global securities financing data collection and aggregation initiative will be an important step in obtaining a clearer understanding of these activities and allow any residual risks not addressed by the current initiatives to be identified and addressed. 

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