The Bank of England’s Securities Lending Committee reflected, in its recent quarterly meeting, on lessons that can be learnt from the GameStop and Archegos events, continuing a dialogue that commenced in its previous meeting held in February.
The Committee highlighted that some prime brokers have accepted reduced revenues, and have been willing to accept less liquid collateral or lower collateral margins, in competition to win market share in the hedge fund business.
It questioned, in these circumstances, whether adequate haircut and margin levels were being applied and whether collateral delivered by trade counterparties was adequately diversified.
Reflecting on the GameStop and Archegos developments, it highlighted, not unsurprisingly, that the speed with which prime brokers were able to liquidate their positions in the Archegos event had a major impact on the level of losses they sustained.
A number of prime brokers lost money when they were forced to liquidate Archegos Capital’s positions after it failed to meet margin calls. Industry sources suggest that sale of stock linked with Archegos resulted in losses for Credit Suisse of more than US$3 billion, with Nomura and Morgan Stanley also substantially out of pocket.
“Speed to market was felt to be a large factor that impacted the liquidity of collateral held and should have implications for how lenders view the risk of pledge collateral versus title transfer,” it says.
In drawing lessons from these events, the Committee indicated that, for certain types of trade (for example funding leveraged equity positions), the only effective hedging mechanism for lenders may be to demand more collateral. Industry standard haircuts are insufficient for this type of risk, it suggested, where the mean shortfall for liquidating Archegos collateral was about 28 per cent.
For prime brokers, it warned that low margin trading does not provide effective compensation for tail risk, where aggregate industry losses linked to Archegos totalled more than US$10 billion.
Deliberations reflected on whether it is possible to set appropriate haircut levels in conditions of market stress across different jurisdictions. For valuations based on end of day prices in UK markets, for example, large movements in US prices, while US markets are still trading, may result in UK loans being inadequately collateralised.
Members focused on the potential benefits offered by central counterparty clearing which, they proposed, will provide standard and real-time valuations and margining, although this would do little to resolve concerns relating to time differentials.
The Committee also emphasised the need to monitor risks presented by collateral concentration. “In a situation like Archegos it can be difficult to see how large exposure to one firm can be,” said the minutes of the meeting. One proposed solution was for tri-party agents to establish limits on collateral holdings rather than just counterparty-specific limits.
Reflecting on the dynamics of securities finance markets during Q1 2021, the Committee highlighted that a general squeeze on spreads in financial markets has contributed to stronger securities lending balances as asset owners seek out additional returns. GC lending rates have contracted against the backdrop of low interest rates.
“Spreads more generally are thin and the Committee noted the securities lending market as a whole is being squeezed in terms of rates and revenue,” it says.
Commenting on application of ESG principles to securities lending activity, the Committee indicated that there is still much work needed to establish effective infrastructure and market practice — particularly in promoting standardisation in ESG collateral schedules.
Members indicated that there are currently only two ESG indices and this lack of choice can be problematic when applying an ESG overlay to an investment portfolio. It is currently difficult to amend collateral schedules since this needs to be done for each individual relationship rather than at tri-party level.
On balance, the Committee proposed there is a need for a common approach to ESG collateral schedules and it would be advantageous if tri-party agents play a central role in this standardisation initiative.
The UK Money Markets Code was released on 21 April 2021 and the Bank of England highlighted the role of its Securities Lending Committee in upgrading the securities lending provisions in the Code, including updates on ESG, diversity and inclusion, remote working and “electronification of markets”.
Significantly, the Committee invited a number of new members to its May 2021 meeting as part of efforts to make this forum more inclusive and diverse.
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