The Bank of England’s Securities Lending Committee reflected at its recent quarterly meeting on what lessons can be learned from the GameStop and Archegos events, continuing a dialogue that began at its previous meeting in February.
The committee noted that some prime brokers have accepted reduced income and have been willing to accept less liquid collateral or lower collateral margins, competing for market share in the hedge fund industry.
It questioned, in these circumstances, whether adequate levels of haircut and margin were applied and whether the guarantees provided by the commercial counterparties were sufficiently diversified.
Reflecting on the developments of GameStop and Archegos, he pointed out, unsurprisingly, that the speed with which prime brokers were able to liquidate their positions during the Archegos event had a major impact on the level of losses they have suffered.
A number of prime brokers lost money when they were forced to liquidate positions from Archegos Capital after failing to respond to margin calls. Industry sources suggest the sale of Archegos-related shares resulted in losses for Credit Suisse of more than $ 3 billion, with Nomura and Morgan Stanley also substantially out of pocket.
“Speed to market was seen as an important factor that has impacted the liquidity of collateral held and is expected to have implications for how lenders perceive pledge collateral risk in relation to the transfer of ownership. “, he indicates.
Learning from these events, the Committee noted that for certain types of transactions (e.g. financing leveraged equity positions), the only effective hedging mechanism for lenders may be to charge more. guarantees. Industry standard haircuts are insufficient for this type of risk, he suggested, where the average shortfall for liquidating Archegos collateral was around 28%.
For prime brokers, he warned that low margin trading does not provide effective compensation for tail risk, where overall industry losses related to Archegos totaled over $ 10 billion.
Discussions considered the possibility of setting appropriate haircut levels under conditions of market stress in different jurisdictions. For end-of-day price-based valuations in UK markets, for example, large movements in US prices, while US markets are still trading, can result in insufficient hedging of UK loans.
Members focused on the potential benefits of CCP clearing which they believe will provide both standard and real-time valuations and margins, although this does little to address the time gap issues.
The Committee also underlined the need to monitor the risks presented by the concentration of collateral. “In a situation like Archegos, it can be difficult to see how important exposure to a company can be,” say the minutes of the meeting. One proposed solution was for tripartite agents to set limits on collateral rather than specific limits for each counterparty.
Reflecting on the dynamics of financial securities markets in the first quarter of 2021, the Committee noted that a general compression of spreads in financial markets has contributed to stronger securities lending balances as asset owners seek additional returns. GC lending rates contracted amid low interest rates.
“Spreads are more generally thin and the Committee noted that the securities lending market as a whole is compressed in terms of rates and income,” he said.
Commenting on the application of ESG principles to securities lending activities, the Committee noted that much remains to be done to establish effective market infrastructure and practices, in particular to promote the standardization of ESG collateral listings.
Members indicated that there are currently only two ESG indices and that this lack of choice can be problematic when applying an ESG overlay to an investment portfolio. It is currently difficult to modify the schedules of guarantees as this has to be done for each individual relationship rather than at the tripartite level.
Overall, the Committee proposed that there is a need for a common approach to ESG guarantee schedules and that it would be beneficial for tripartite agents to play a central role in this standardization initiative.
The UK Money Markets Code was released on April 21, 2021 and the Bank of England highlighted the role of its Securities Lending Committee in upgrading the securities lending provisions of the code, including updates on ESG, diversity and inclusion, remote working and “the electronization 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.