Financial Stability Board reports on the re-hypothecation of client assets and collateral re-use

The Financial Stability Board (“FSB”) have recently published two reports on the re-hypothecation of client assets (defined as any use of client assets by a financial intermediary) and non-cash collateral re-use. The reports broadly conclude that there is no immediate need for the FSB to harmonise its regulatory approach to re-hypothecation, but for collateral re-use there is a need to measure its use for financial stability purposes.

Re-hypothecation and collateral re-use

The advantages of re-hypothecation and collateral re-use are that they increase the availability and reduce the cost of using collateral, and subsequently this leads to a reduction in transaction costs. However, the drawback is that clients may not be able to quickly access their securities in the event that a financial intermediary faces insolvency. This very issue was highlighted during the recent global financial crisis.

Despite this drawback, the FSB believes that it is not necessary for any regulatory approach to be developed as yet, but it encourages firms to implement Recommendation 7 in its Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos:

  • financial intermediaries should provide sufficient disclosure to clients in relation to re-hypothecation of assets so that clients can understand their exposures in the event of a failure of the intermediary;
  • in jurisdictions where client assets may be re-hypothecated for the purpose of financing client long positions and covering short positions, they should not be re-hypothecated for the purpose of financing the own-account activities of the intermediary; and
  • only entities subject to adequate regulation of liquidity risk should be allowed to engage in the re-hypothecation of client assets.

The FSB also requests that authorities should consider monitoring collateral re-use outside of securities and financing transactions.

Non-cash collateral re-use

The advantages of re-using collateral in financial markets are that it increases the availability, and reduces the cost, of collateral and subsequently this leads to a reduction in liquidity costs. However, the drawbacks, as discovered during the global financial crisis, are that it can contribute to a build-up of excessive leverage of individual entities and that there may be a risk of contagion and therefore failure, through inter-connectedness, if collateral re-use is used in long transaction chains.

The FSB felt it necessary to publicly consult on collateral re-use in February 2016 and following that consultation, FSB members have agreed to collect data for the FSB to measure and assess global trends in non-cash collateral re-use. The purpose of the data collection is to measure how much non-cash collateral re-use contributes to the build of leverage and inter-connectedness. The data collected will be forwarded to the FSB for global aggregation from January 2020.

Both reports are part of the FSB’s work to transform shadow banking into resilient market-based finance.

To read the reports in full, please click here.

For any further guidance or information on the above topics, Cleveland & Co, your External In-House Counsel are here to help.

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