A recent FT article claimed that sources within the financial services industry reported blocked “liquidity swap” transactions – which may include stock (securities) lending, repo transactions or sale plus total return swap - however, an FSA spokesman denied being aware of any blocked transactions since actions on guidance are still being put in place and the UK regulator continues to consult the industry on proposals, at the same time it is the FSA’s practice to not comment on supervisory actions with firms.
In stock lending, gilts, or UK government bonds, are lent by an insurer for a significant period in return for a fee and collateral. Legal ownership of the gilt passes to the borrowing bank counterparty - in the event of the bank counterparty defaulting, the insurer has recourse to the collateral.
“If structured and operated correctly, valuation, margining and over-collateralisation should protect the insurer against loss in the event of a ‘fire-sale’ of the collateral. To the extent there is insufficient collateral the insurer will have an unsecured claim against the bank counterparty,” the FSA writes in its guidance consultation.
The main areas of concern for the FSA are in the mechanics of risk management within organisations participating in liquidity transformation – seemingly trading up asset-backed securities (ABS) as this structured product is mentioned in the guidance consultation - and what the potential impact might be on the wider economy if the practice becomes more common.
This is quite likely to become a reality, as most industry experts across the banking, insurance and pension fund industries are expecting the collateral upgrade trade to become a major driver of securities lending activity since global regulations pushing OTC transactions on exchange will substantially increase the demand for high quality collateral to post to a CCP against derivatives trades.
Irving Henry, director of Prudential Capital and Risk at the British Bankers’ Association (BBA), says that the FSA proposals are in their infancy but that the regulator needs to spend more time looking at a wider variety of transactions and become more comfortable with the way that different market participants approach the practice.
“There was very much a feeling [during the consultation] that insurance companies need to be protected from banks and whether the governance of risk at the insurance companies was up to scratch,” he says. “But [insurance companies] felt better able to hang on to these types of [riskier] assets because they tend to be long investors and they are trying to get some additional yield which they are not able to do holding a shedload of gilts.”
Gilts fit better with banks which need the immediate liquidity, while insurance companies feel able to sit out stresses by holding onto the assets for a longer period of time, he adds.
Another sticking point for the FSA for liquidity swaps was on the issue of intragroup transactions, meaning that the insurance company and bank are part of the same Group. Henry explains that currently, those transactions are subject to regulatory scrutiny to ensure risks are captured properly but also tax authorities and auditors require transactions are done on an arms length and transparent basis.
Meanwhile, disclosures on stock lending in mutual funds is also a reported activity, something commonly understood by mutual fund trustees.
“There is something to be said about treating customers fairly and that the churning of a portfolio ought to be disclosed more widely than it is and there ought to be a better spread of the fees earned from such transactions because they accrue to the manager rather than to the investors,” Henry says. “But it would have been helpful if the FSA could have spent a bit more time talking to participants and given us some clear conclusions based on a pool of transactions…so we can start thinking about how this plays into financial stability.”
Apart from banks feeling pressured by Basel III and the capital requirement directive CRD IV, the insurance fund industry is facing regulations under Solvency II, which could make these transactions "uneconomic" according to the FSA.
“These rules are being developed in isolation and that silo [mentality] leads to issues not being addressed, because they fall through the gaps, but also unintended consequences,” Henry says, adding that if banks cannot swap riskier pools of assets with pension funds and insurance companies, it is not clear where those assets will go to relieve pressure on balance sheets.