Securities financing transactions (SFTs) are a broad category of financial transactions that allow investors and firms to use assets, such as shares or bonds, to secure funding for their activities. SFTs can be used for a variety of purposes, such as short selling, hedging, liquidity transformation, and margin lending. It can also be used for extra returns and optimizing liquidity management and improving the balance sheet of market participants.
Under Basel IV, there are changes regarding the treatment of SFT. The question here is: what will be the impact and how will this change the future of the SFT industry? First, we will discuss the types of SFT and touch upon the benefits and risks. We will review the impact of Basel IV and the SFT regulations and the implications as well as the future of the industry.
What are the main types of SFTs
- A short description of the main types of SFT’s that exist:
Repurchase agreements (repos): In a repo, one party (the repo seller) sells securities to another party (the repo buyer) with an agreement to repurchase the securities at a later date at a pre-agreed price. The repo buyer provides cash to the repo seller in exchange for the securities, and the repo seller earns interest on the cash. - Securities lending: In a securities lending transaction, one party (the lender) agrees to lend securities to another party (the borrower) for a fee. The borrower uses the securities as collateral for a loan, and the lender earns interest on the loan.
Buy-sell backs and sell-buy backs: In a buy-sell back, one party (the buyer) agrees to buy securities from another party (the seller) at a fixed price on a future date. In a sell-buy back, the transaction is reversed. - Margin lending: In a margin lending transaction, a broker lends cash to a client who is buying securities on margin. The client provides the broker with securities as collateral for the loan, and the broker earns interest on the loan.
SFT Benefits and Risks
Benefits
One of the primary benefits of SFTs is their ability to provide short-term liquidity. By participating in these transactions, financial institutions can temporarily unlock the value of their securities holdings without the need to outright sell them. This is especially valuable for institutional investors, banks, hedge fund and broker dealers, as it allows them to access funds for operational needs, investment opportunities, and regulatory requirements.
Operational needs are for example the fulfilment of the margin requirements, covering short selling, and liquidity and balance sheet management. SFTs also add return to the portfolio of assets by lending the assets for an open or fixed term (term trades) to a counterparty.
SFTs are addressed by regulatory requirements through the LCR and NSFR. These regulations require financial institutions to have an inventory of high liquidity assets to cover their obligations.
Additionally, SFTs contribute to market efficiency by facilitating the smooth flow of securities between market participants. These transactions aid in redistributing securities from entities with excess holdings to those seeking them, thereby promoting equilibrium in supply and demand. This equilibrium is crucial for maintaining stable financial markets and supporting various trading and investment strategies. So, in a sense, SFT products are 'the lubricant' of the financial markets.
Risk
SFTs can also be used to create leverage and amplify risk. This was evident during the financial crisis of 2008, when SFTs played a role in the collapse of the shadow banking system. Below are some other risks associated with SFTs. These risks include:
- Credit risk: The counterparty to an SFT could default on its obligations. This could result in a loss for the party that lent cash or securities.
- Liquidity risk: Liquidity can dry up due to stressed market conditions. This will make it challanging for market participants to unwind their positions.
- Operational risk: The risk of errors or fraud in the processing of SFTs. This could result in losses for market participants.
Systemic risks can arise if the interconnectedness of SFTs exposes the broader financial system to vulnerabilities. The 2008 financial crisis highlighted how excessive reliance on SFTs and their lack of transparency contributed to systemic instability. This led to regulatory initiatives aimed at increasing transparency, mitigating risks, and improving the overall stability of the financial system.
Despite the risks, SFTs are a valuable tool for market participants. They can be used to raise cash, hedge risk, and manage both liquidity and the balance sheet. Market participants should carefully consider the risks before entering into an SFT. They should also make sure that they understand the terms and conditions of the transaction.
BASEL IV implications
The new Basel IV regulation impacts SFTs, the most important are:
- Increased capital requirements: The Basel IV regulations will increase the capital requirements for SFTs for market participants by the output floor and the impact of the unrated counterparty exposure under the standardised approach.
- More conservative haircuts: The Basel IV regulations will require banks to use more conservative haircuts when valuing collateral in SFTs. The determination of haircuts to be used is prescribed by the supervisory authority. In particular for equities the haircuts will be increased and for debt new maturity bands will be added.
- Increased transparency: The Basel IV regulations will require banks to provide more disclosure about their SFTs. This is to improve the transparency of the SFT market and to make it easier for regulators to monitor the risks associated with SFTs.
As mentioned in previous articles the output floor in combination with the fact that in the standardized approach, lending to all unrated corporates (above SME size) under Basel IV will attract a 100% risk weight when calculating a bank's risk-weighted assets, regardless of the real credit quality of the corporate, will increase the capital requirements.
SFT reporting and Transparency
The EU Securities Financing Transaction Regulation (SFTR) went into force in tranches from January 2016 with a complex reporting obligation for SFTs required since 2020. The main goal is to encourage transparency in SFTs in Europe through extensive reporting requirements for SFTs to Trade Repositories (TR). This regulation applies to any financial or non-financial institution in the EU. Note that the penalty in the event of a reporting breach could amount to up to €5 million, or 10% of annual turnover. The SFTR has great similarities with the EMIR and Mifid II regulations.
To cope with this complexity, it is necessary to rally significant resources, whether human or technical, to ensure efficient connectivity with data providers and to set up a robust and high-quality production chain. As a result, many management companies and institutional investors are likely to outsource this complex reporting obligation with a third party.
Central Clearing Counterpart (CCP) for SFTs: The Future?
The development of a viable Central Clearing Counterpart (CCP) for SFTs has been a long time in the making and a regular topic for discussion at industry events over many years. The objective of reducing the cost of capital for the borrowers is the primary driver behind these initiatives (output floor and unrated counterparty). There are a number of competing offers available or under development. Esiting offerings are mainly focused on repo with new offerings for securities lending foreseen in the near future.
The impetus brought on by the rising expense and scarcity of capital has encouraged these specialised solutions. The CCP impacts credit and systemic risk since it is the legal counterparty to all transactions. Banks enjoy the advantage of borrowing at lower capital costs through the lower risk weight of the CCP, which has an indirect advantage for other market participants.
Other benefits of using CCP for SFTs are:
- Netting: single counterparty exposure which optimizes the balance sheet and leverage (thus capital management).
- Operational efficiencies: settlement efficiency, the elimination of agent lender disclosures, and improved practices around fee management, corporate actions, and post-trade lifecycle processing.
- Standardisation: regarding the products, documentation and processes.
The implementation of Basel IV rules in combination with SFTR has the potential to see more clearing of the SFT in the near future by reducing risk and enhancing capital, liquidity, operational management and transparency in general.
Conclusion
Overall, the Basel IV regulations will have a significant impact on SFTs. The new regulations will make it more expensive for investors and firms to use SFTs and could reduce liquidity in the securities markets. However, the new regulations are also designed to make SFTs safer and reduce the risks associated with them. SFTs remain the cornerstone for efficient markets and solutions have evolved since the financial crisis by new legislation including LCR/NSFR/Leverage and Basel IV and SFTR. It remains to be seen how the new regulations will play out in practice, but they are likely to have a major impact on the SFT market and potentially push the industry to clearing of SFTs.
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