EU’s Shadow Banking Rules Arrive, Intending to Prevent Credit Crunch Rerun

By John Glover | January 12, 2016

A European Union regulation intended to prevent a rerun of the global credit crunch by shining a light on financing arrangements such as repurchase agreements, securities lending and margin loans comes into force on Tuesday.

The EU’s Securities Financing Transactions Regulation will require disclosure to clients and authorities of those activities, and also force intermediaries to obtain consent if they want to use a security as collateral in a trade that involves a change of ownership. The rules will be phased in starting this week, though their full impact won’t be felt for about six months, according to Pauline Ashall, a partner at Linklaters law firm in London.

The rules are part of the bloc’s response to the financial crisis, when so-called shadow banking activities allowed leverage to increase to dangerous levels at hedge funds, insurers, asset managers and other intermediaries, unnoticed by regulators because it took place outside the banking system. While securities financing transactions are key to brokers’ ability to make markets and supply liquidity to their clients, their use in activities including borrowing short-term to fund long-term liabilities creates additional risks for the global financial system.

‘Onerous’ Requirement

“It’s a pretty onerous new requirement and it applies to everyone involved in securities financing transactions, buy side and sell side,” Ashall said. “The impact will be felt by insurers, pension funds, asset managers and so on, and not just by the banks.”

Securities financing transactions include trades such as lending or borrowing stocks, bonds and commodities, as well as repurchase agreement, or repos, and reverse repos. Market makers and speculators use borrowed securities to cover short positions or to settle trades while the practice generates fee income for asset managers. Repos and reverse repos are used to borrow or lend cash securely. The same rule applies when the party taking the collateral gains the right to reuse it, a process known as rehypothecation.

Disclosure to clients and counterparties “isn’t going to be particularly difficult,” Ashall said. “Much more challenging will be the reporting obligation” to regulators. That will “require systems to be built. We still don’t know when that’s coming in but it’s going to require years rather than months.”

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