ESMA unable to quantify haircut market risk
23 March 2017 Paris
Image: Shutterstock
The use of haircuts in EU securities finance markets can “contribute to procyclicality and financial instability by reinforcing asset price movements”, according to the European Securities Markets Authority (ESMA).
In a report on the risks faced by the EU financial markets, haircuts in securities finance transactions markets was flagged as a potential vulnerability to financial stability.
ESMA said: “Haircuts are helpful risk management tools, but haircut levels are also part of the negotiation between counterparties trading bilaterally.”
“Haircuts may thus change over time to reflect the evolution of market conditions, and can contribute to procyclicality and financial instability by reinforcing asset price movements.”
The EU regulator also warned that “the data available on haircuts is sparse and little is known of current market practices”.
The lack of transparency will remain until the reporting obligation under the Securities Financing Transactions Regulation (SFTR) begins in the course of 2018.
“Until SFTR data becomes available, the implementation and calibration of policy instruments run the danger of being based on partial or inconclusive empirical evidence.”
“This would increase the risk of unintended consequences and could reduce the probability of achieving financial stability objectives in the context of haircuts.”
The methodologies for calculating haircuts can be qualitative, quantitative or a combination of the two.
According to ESMA, quantitative methodologies tend to be used more frequently in repo markets, possibly reflecting the relative importance of banking counterparties.
Quantitative methodologies sometimes involve back-testing or regular stress-testing using different scenarios.
Collateral and counterparty analysis are the two key components used to determine haircuts. Counterparty credit risk plays a role prior to the transaction, in deciding whether or not to trade, and during negotiation on the terms of the trade.
In a report on the risks faced by the EU financial markets, haircuts in securities finance transactions markets was flagged as a potential vulnerability to financial stability.
ESMA said: “Haircuts are helpful risk management tools, but haircut levels are also part of the negotiation between counterparties trading bilaterally.”
“Haircuts may thus change over time to reflect the evolution of market conditions, and can contribute to procyclicality and financial instability by reinforcing asset price movements.”
The EU regulator also warned that “the data available on haircuts is sparse and little is known of current market practices”.
The lack of transparency will remain until the reporting obligation under the Securities Financing Transactions Regulation (SFTR) begins in the course of 2018.
“Until SFTR data becomes available, the implementation and calibration of policy instruments run the danger of being based on partial or inconclusive empirical evidence.”
“This would increase the risk of unintended consequences and could reduce the probability of achieving financial stability objectives in the context of haircuts.”
The methodologies for calculating haircuts can be qualitative, quantitative or a combination of the two.
According to ESMA, quantitative methodologies tend to be used more frequently in repo markets, possibly reflecting the relative importance of banking counterparties.
Quantitative methodologies sometimes involve back-testing or regular stress-testing using different scenarios.
Collateral and counterparty analysis are the two key components used to determine haircuts. Counterparty credit risk plays a role prior to the transaction, in deciding whether or not to trade, and during negotiation on the terms of the trade.
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