BoE warns on securities lending contagion risk
19 September 2011 London
Image: Shutterstock
The Bank of England (BoE) has issued a warning on the potential contagion risk associated with securities lending transactions in its latest quarterly bulletin.
As a financial transaction, securities lending results in chains of counterparty exposures which increase interconnections within the financial system, writes BoE, adding that during episodes of stress, interconnectedness can cause contagion when problems at one or more institutions are
transmitted across networks, impacting counterparties and their customers.
Lehman Brothers, for example, was a large borrower in the securities lending market and often borrowed securities on behalf of clients, such as hedge funds.
"When Lehman failed, most beneficial owners were able to liquidate their collateral and replace their lost securities. But a small number of beneficial owners struggled to liquidate their collateral and made losses," writes BoE.
Meanwhile, hedge funds that had borrowed securities via Lehman found it difficult to reclaim the collateral that they had pledged to Lehman in order to borrow securities. This was partly due to rehypothecation of collateral by Lehman - a practice that involves using collateral posted by their clients as collateral for other purposes.
"Since the onset of the financial crisis, market participants have sought to address some of the concerns around securities lending. New regulation on institutions involved in securities lending may also address some of the risks, particularly counterparty credit risks. New market infrastructure may also help," writes BoE.
The advent of CCPs "should lead to more continuous and predictable changes in margin requirements" and reduce the likelihood of sudden collateral calls on borrowers.
"Provided CCPs are highly robust, they can potentially provide benefits to the securities lending market. By acting as a secure node within a network of financial institutions, they can reduce
system-wide counterparty credit risk," writes BoE.
However, the central bank also notes that the net impact of new regulations on the securities lending market are difficult to estimate but could be significant.
Higher capital requirements in Basel III regulation could result in higher costs to Banks for securities lending transactions. In turn, this could increase the cost of services such as market-making or collateral upgrade trading for bank funding purposes.
"Higher capital requirements for banks and insurers should make participants more able to withstand negative shocks and reduce the risks that arise from interconnections. But it could also reduce the
supply of — and demand for — securities loans, diminishing some of the benefits to the functioning of the financial system associated with securities lending," writes BoE.
Such benefits include increased liquidity which helps markets operate more smoothly and efficiently, in turn leading to better price discovery and reduced volatility.
As a financial transaction, securities lending results in chains of counterparty exposures which increase interconnections within the financial system, writes BoE, adding that during episodes of stress, interconnectedness can cause contagion when problems at one or more institutions are
transmitted across networks, impacting counterparties and their customers.
Lehman Brothers, for example, was a large borrower in the securities lending market and often borrowed securities on behalf of clients, such as hedge funds.
"When Lehman failed, most beneficial owners were able to liquidate their collateral and replace their lost securities. But a small number of beneficial owners struggled to liquidate their collateral and made losses," writes BoE.
Meanwhile, hedge funds that had borrowed securities via Lehman found it difficult to reclaim the collateral that they had pledged to Lehman in order to borrow securities. This was partly due to rehypothecation of collateral by Lehman - a practice that involves using collateral posted by their clients as collateral for other purposes.
"Since the onset of the financial crisis, market participants have sought to address some of the concerns around securities lending. New regulation on institutions involved in securities lending may also address some of the risks, particularly counterparty credit risks. New market infrastructure may also help," writes BoE.
The advent of CCPs "should lead to more continuous and predictable changes in margin requirements" and reduce the likelihood of sudden collateral calls on borrowers.
"Provided CCPs are highly robust, they can potentially provide benefits to the securities lending market. By acting as a secure node within a network of financial institutions, they can reduce
system-wide counterparty credit risk," writes BoE.
However, the central bank also notes that the net impact of new regulations on the securities lending market are difficult to estimate but could be significant.
Higher capital requirements in Basel III regulation could result in higher costs to Banks for securities lending transactions. In turn, this could increase the cost of services such as market-making or collateral upgrade trading for bank funding purposes.
"Higher capital requirements for banks and insurers should make participants more able to withstand negative shocks and reduce the risks that arise from interconnections. But it could also reduce the
supply of — and demand for — securities loans, diminishing some of the benefits to the functioning of the financial system associated with securities lending," writes BoE.
Such benefits include increased liquidity which helps markets operate more smoothly and efficiently, in turn leading to better price discovery and reduced volatility.
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