Collateral Transactions in the EU Shadow Banking Sector

Name: Collateral Transactions in the EU Shadow Banking Sector
Author: R.A. Spence

Specificaties

Gebonden, 284 blz. | Engels

Wolters Kluwer | 1e druk, 2022

ISBN13: 9789013168242

Rubricering

Hoofdrubriek : Juridisch

Juridisch : Bank- en effectenrecht Europees-internationaal recht

Jongbloed : Bank- en effectenrecht Europees recht

Wolters Kluwer 1e druk, 2022 9789013168242

Onderdeel van serie Recht en Praktijk (compleet)

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Samenvatting

This publication offers a pioneering in-depth analysis of the use of collateral transactions in the EU shadow banking sector. This author examines the topic from both a practical and theoretical standpoint, which yields valuable insights for practitioners, academics, students and generally interested parties.

The Global Financial Crisis and the Covid-19 pandemic offer a vivid reminder that when leveraged financial institutions are forced to deleverage, margin levels rise, and deleveraging occurs. This, in turn, causes market participants to ‘run’ in advance of other market participants, who are motivated to do exactly the same thing. As a result, a vicious cycle emerges where lenders raise margin levels thereby demanding more financial collateral, forcing de-leveraging and more asset fire sales, eventually generating a downward leverage and liquidity spiral. The source of this instability is a recurring phenomenon involving the build-up of leverage that makes the economy particularly vulnerable to financial crises.

Collateral Transactions in the EU Shadow Banking Sector provides a pioneering in-depth analysis of the use of collateral transactions in the EU shadow banking sector. At the cross-section of finance, law and economics, this publication contains an accessible examination of the issue, adopting both a practical and theoretical perspective.

In particular, the author argues for the introduction of more stringent margin measures to tame financial uncertainty by limiting leverage and dampen procyclicality. One plausible way to restrict leverage is to impose minimum margin regulation, which would ex-ante limit the amount of leverage a financial institution can obtain. The author proposes four complementary measures that would ultimately result in a harmonised legal and regulatory margin framework in the EU shadow banking sector.

Specificaties

ISBN13:9789013168242

Taal:Engels

Bindwijze:gebonden

Aantal pagina's:284

Uitgever:Wolters Kluwer

Druk:1

Verschijningsdatum:3-5-2022

Hoofdrubriek:Bank- en effectenrecht, Europees-internationaal recht

ISSN:

Jongbloed:Bank- en effectenrecht, Europees recht

Serie:Recht en Praktijk (compleet)

Inhoudsopgave

ACKNOWLEDGEMENTS V
TABLE OF CONTENTS VII
PREVIOUSLY PUBLISHED WORK XIII
TABLE OF ABBREVIATIONS XV

1 INTRODUCTION 1
1.1 Problem Statement 4
1.2 Research Questions 7
1.3 Methodology 9
1.4 Scope and Limitations of Research 10
1.5 Structure of Research: A Roadmap 11

2 SHADOW BANKING 15
1 Introduction 15
2 Defining Shadow Banking 17
2.1 The Origins of Shadow Banking 17
2.2 The Characteristics of Shadow Banking 17
2.3 Appropriateness of the Term 21
2.4 The Definition Problem 22
2.4.1 A broad definition 23
2.4.2 A narrow definition 24
3 The Rise of Shadow Banking 25
3.1 Introduction 25
3.2 Prudential Regulation 26
3.2.1 Evolution of the Basel Accords 26
3.2.1.1 Basel III 27
3.2.1.2 Basel IV 28
3.2.1.3 Some observations 29
3.3 Profitability 31
3.4 Regulatory Arbitrage 32
3.5 Financial Innovation 33
4 The Global Financial Crisis 34
4.1 Lehman Brothers 34
4.2 Beyond Lehman Brothers 36
4.3 The Need for Regulation 38
4.3.1 Systemic risk and financial stability 39
4.3.2 Market failures 39
4.3.2.1 Negative externalities 40
5 Conclusion 41

3 FINANCIAL COLLATERAL 43
1 Introduction 43
2 Defining Financial Collateral 45
2.1 Collateral 45
2.2 What is Financial Collateral? 46
2.3 Liquidity and Safety 47
2.3.1 Introduction 47
2.3.2 Market liquidity 47
2.3.3 Funding liquidity 48
2.3.4 Liquidity risk 48
2.4 Financial Collateral Securities 49
3 The Financial Collateral Directive 51
3.1 Cash 51
3.2 Financial Instruments 52
3.2.1 The debt and equity dichotomy 53
3.2.2 Other securities which give rise to cash settlement 54
3.3 Credit Claims 55
3.4 Scope of the Financial Collateral Directive 55
3.4.1 Personal scope 56
3.4.2 Material scope 57
3.4.2.1 Types of financial collateral 57
3.4.2.2 Property law 57
3.4.2.3 Possession and control 58
3.5 Conflict of Laws 60
3.6 Shadow Banking and the Financial Collateral Directive 61
4 Collateral Transactions 61
4.1 Repurchase Agreement 62
4.1.1 What is a repurchase agreement? 62
4.2 Securities Lending 63
4.2.1 What is securities lending? 63
4.3 Derivatives 64
4.3.1 What is a derivative? 64
4.4 Margin 66
4.5 Master Agreements 67
5 The Velocity of Financial Collateral 67
5.1 Two Functions of Financial Collateral 69
5.2 The Scarcity of Financial Collateral 70
5.3 Defining the Market Practice of Collateral ‘Velocity’ 71
6 Conclusion 74

4 MARGIN 75
1 Introduction 75
2 What is Margin? 76
3 Haircuts and Initial Margins 78
3.1 Haircut 78
3.2 Initial Margin 80
3.3 Determining Margin at the Point of Trade 81
4 Margining 83
4.1 Repurchase Agreements 84
4.1.1 Margin transfers 84
4.1.2 Repricing and adjustment 85
4.2 Securities Lending 85
4.3 Derivatives 86
5 Leverage 86
5.1 Introduction 86
5.2 Procyclicality and Leverage 87
6 Conclusion 88

5 COLLATERAL TRANSACTIONS IN PRACTICE 89
1 Introduction 89
2 Parties involved 90
2.1 The Significance of Intermediaries 91
3 Repurchase agreements 91
3.1 Structure of the GMRA 92
3.2 Modus Operandi of a Repo 93
3.2.1 Rationale for entering into a repo 94
3.2.1.1 Seller’s perspective 94
3.2.1.2 Buyer’s perspective 95
3.2.2 Types of repo 96
3.3 The Interaction between the GMRA and Market Practice 96
3.3.1 Maturity 96
3.3.2 Financial collateral 97
3.3.3 The significance of the repo rate 98
3.3.4 Margin 99
3.3.4.1 Margin transfers 100
3.3.4.2 Repricing and adjustment 102
3.3.4.3 Substitution 102
3.3.5 Event of Default 102
3.3.6 Property functions of a repo 104
4 Securities lending 105
4.1 Structure of the GMSLA 106
4.2 Modus Operandi of Securities Lending 107
4.2.1 What is securities lending? 107
4.2.2 Maturity 108
4.2.3 Fees, interest and rebates 108
4.2.4 Financial collateral 109
4.2.5 Margin 109
4.2.6 Property aspects of securities lending 110
4.2.7 Event of default 111
4.2.8 The significance of intermediaries 112
4.3 Rationale for Securities Lending 113
4.3.1 The borrower’s perspective 113
4.3.2 Lender’s perspective 114
4.4 Differences between Repo and Securities Lending 114
4.4.1 Scope of collateral 114
4.4.2 Right of recall 114
4.4.3 Type of securities 114
4.4.4 Payment & income 115
4.4.5 Maturity 115
5 Derivatives 115
5.1 Introduction 115
5.2 Evolution of the ISDA Credit Support Annexes 115
5.2.1 2009 G20 Pittsburgh Summit 116
5.2.2 ISDA credit support documentation 117
5.2.3 Structure of the Credit Support Annex 118
5.2.4 Property law functions of the Credit Support Annex 118
5.3 Modus Operandi of the Collateralisation of Derivatives 119
5.3.1 What is a derivative? 119
5.3.2 Setting up a collateralised relationship 121
5.3.2.1 Eligible collateral 122
5.3.2.2 Initial margin 122
5.3.2.3 Variation margin 123
5.3.2.4 Independent amount 124
5.3.2.5 Minimum transfer amount 124
5.3.2.6 Haircut 125
5.3.2.7 Reuse of collateral 126
5.3.2.8 Substitution of collateral 126
5.3.2.9 Event of default 126
5.3.2.10 Intermediaries and Valuation Agent 127
6 Conclusion 128

6 THE ROLE OF DEBT IN THE EU SHADOW BANKING SECTOR 129
1 Introduction 129
2 Debt 130
2.1 What is Debt? 130
2.1.1 Traditional banking sector 131
2.1.2 Shadow banking sector 132
2.1.2.1 Trading at par 134
2.1.2.2 The creation of shadow money 134
2.1.2.3 The role of margin 135
3 Information sensitivities of Debt 136
3.1 Information Insensitive Debt and Safe Assets 136
3.2 Information Sensitive Debt 137
4 Liquidity 137
4.1 Introduction 137
4.2 Market Liquidity and Funding Liquidity 138
4.2.1 Funding liquidity 139
4.2.2 Market liquidity 139
4.3 The Interaction between Market Liquidity and Funding Liquidity 140
5 The Vulnerabilities of Debt 141
5.1 The Two Faces of a Debt Contract 141
5.2 The Leverage and Liquidity Spiral 142
6 Conclusion 145

7 THE REGULATION OF MARGIN IN THE EU SHADOW BANKING SECTOR 147
1 Introduction 147
2 Tracing Post-Crisis Policy Reponses 148
2.1 Derivatives 149
2.1.1 BCBS and IOSCO 149
2.2 Repurchase Agreements and Securities Lending Transactions 151
2.2.1 Financial Stability Board 151
2.2.2 The European Systemic Risk Board 152
2.2.3 The European Securities and Markets Authority 153
2.2.4 From ideas to action – some observations 153
3 Private Law 154
3.1 Introduction 154
3.2 Self-Regulation: Lex Mercatoria 155
3.2.1 Master agreements 157
3.3 Interplay Between the Private Sector and Public Law 158
3.4 Financial Collateral Directive 158
3.4.1 Traditional insolvency law 159
3.4.2 Special insolvency treatment 159
3.4.3 Close-out netting 161
3.4.3.1 Close-out netting: some observations 163
3.4.4 Margining 164
4 Public Law 165
4.1 EMIR: Central Counterparty Clearing 166
4.1.1 Defining ‘clearing’, ‘settlement’ and a ‘CCP’ 167
4.1.2 Modus operandi of central counterparty clearing 167
4.1.3 Variation margin 170
4.1.4 Risk mitigation 171
4.1.5 Default waterfall 171
4.1.5.1 Margin 173
4.1.5.2 Defaulting party: default fund 173
4.1.5.3 Skin-in-the game 174
4.1.5.4 Non-defaulting party: default fund 174
4.1.5.5 Other financial resources 174
4.1.6 Mitigating procyclicality of margin 175
4.2 EMIR: OTC Derivatives 175
4.2.1 Introduction 175
4.2.2 Post Global Financial Crisis reforms 176
4.2.3 Risk mitigation requirements for uncleared OTC derivatives 176
4.2.3.1 Scope of the risk mitigation requirements 177
4.2.4 Collateral eligibility 178
4.2.5 Initial margin 179
4.2.6 Variation margin 182
4.2.7 Haircut 183
4.3 SFTR: Repurchase Agreements and Securities Lending 184
4.3.1 Scope of the SFTR 185
4.3.2 Reporting requirement 186
4.3.2.1 What has to be reported? 187
4.3.3 Disclosure requirement 187
4.3.3.1 Pre-contractual information 187
4.3.4 Collateral reuse requirement 188
4.3.4.1 Benefits of collateral reuse 189
4.3.4.2 Risks of collateral reuse 189
4.3.4.3 The Article 15 information statement 190
4.4 The AIFMD 192
4.4.1 Rationale of the AIFMD 193
4.4.2 Leverage 194
4.4.3 AIFMD: some observations 195
4.5 UCITS 196
4.5.1 Leverage 198
4.5.2 Enforcement 199
5 Conclusion 200

8 HOW SHOULD MARGIN OPERATE IN THE EU SHADOW BANKING SECTOR? 201
1 Introduction 201
2 Recommendation 1: Mandatory Central Counterparty Clearing 203
2.1 Regulatory Shortcomings 204
2.2 The Way Forward 205
3 Recommendation 2: Minimum Margin Floors 206
3.1 Introduction 206
3.2 Rationale for Minimum Margin Floors 206
3.3 Experience from the USA: Regulation T 208
3.4 Some Concerns 209
3.5 The Way Forward 210
4 Recommendation 3: Countercyclical Margin Add-Ons 211
4.1 Introduction 211
4.2 Basel III: Countercyclical Capital Buffer 211
4.3 Shadow Banking: Modus Operandi of Countercyclical Margin Add-Ons 212
4.4 Some Concerns 214
5 Recommendation 4: Margin Ceilings 216
5.1 Introduction 216
5.2 What is a Margin Ceiling? 216
5.3 Some Concerns 216
5.4 The Way Forward 218
6 Piecing the Recommendations Together 218
7 Conclusion 220

9 CONCLUSION 223

Bibliography 231
Curriculum vitae 255