In recent years, indeed even in the past year, US regulatory requirements affecting securities finance such as repurchase agreements and securities lending have become more demanding.
These regulatory requirements reflect the efforts of regulators, in the US and globally, to address the perceived causes of the 2008-2009 financial crisis.
Among the more recent regulatory developments, discussed in more detail below, are the US Securities and Exchange Commission’s (SEC) recent reform of money market fund regulations, which affect the utility and attractiveness of money market mutual funds as securities lending investment vehicles.
Another is the SEC’s adoption of beefed-up reporting requirements for mutual funds, including additional detailed requirements for mutual funds that engage in securities lending.
And, finally, the prospective regulations from US banking regulators requiring that financial contracts such as swap contracts, securities lending agreements and repurchase agreements be subject to contractual stays so as to afford regulators time to effect an orderly resolution of an insolvent financial institution.
Since the financial crisis, regulators around the globe – and the US has been no exception – have focused sharply on preventing a recurrence of a global financial meltdown. Concerns about the costs of regulation, and the potential impact of regulation on economic growth, have been secondary.
With the Trump election, however, there are signs that the regulatory wave may have crested. In February of this year, President Trump issued an executive order to begin a process of evaluating whether changes should be made to regulations governing the US financial system.
Although the order was broad and general, and at most represents an initial step in a longer, more detailed process, it articulates core principles, including fostering economic growth and vibrant financial markets through more rigorous regulatory impact analysis; making regulation more efficient, effective and appropriately tailored; and enabling American companies to be competitive with foreign firms in domestic and foreign markets.
The details remain to be seen, but these principles provide a broad roadmap for potential regulatory reform and at minimum reduce the likelihood of new, burdensome regulation.
Money market reform
In October 2016, more stringent regulations of US money market funds became effective.
Among other things, the regulations require that all money market funds, other than retail money market funds and government money market funds, allow their per-share net asset values to float, rather than maintain the $1.00 per share asset value at which money market funds have traditionally transacted purchases and redemptions.
In addition, all money market funds other than government money market funds must (and government money market funds may) impose liquidity fees or impose redemption gates if their weekly liquid assets fall below certain levels.
Weekly liquid assets are defined as those that can be converted to cash within seven days. Historically, money market funds have served as an important vehicle for investment of securities lending collateral.
Moreover, the yield on investment of securities lending collateral has traditionally been a major incentive to engage in securities lending.
However, the possibility of redemption fees or gates makes money market funds, other than government money market funds, much less attractive, since collateral may be required to be returned on very short notice.
Government money market funds may opt out of redemption fees or gates but must invest at least 99.5% of their assets in US government or agency securities, including repurchase agreements collateralized by such securities.
Since government money market funds tend to have significantly lower yields than their ‘prime’ counterparts, the money market fund reforms could affect the attractiveness of securities lending for some market participants.
Other vehicles continue to be available for use as securities lending collateral pools, including short-term bond funds, private (unregistered) funds, separately managed accounts, and, for retirement plan investors, collective investment trusts – none of which are subject to the SEC’s money market fund regulations.
But it remains unclear whether the new money market fund requirements will lessen the attractiveness of securities lending for some market participants.
The new money market fund requirements were adopted by the SEC over the strong objection of many industry participants. And there are now many industry proposals to roll back post financial crisis laws and regulations.
But we have seen little appetite, even among proponents of financial regulatory reform, to undo the recent money market reform regulations.
So the impact of the money market reforms may be felt by the securities lending industry for some time to come.
Enhanced reporting requirements
In the aftermath of the financial crisis, regulators have believed that if they could acquire significantly more data from market participants they might be better able to identify and curtail threats to financial stability.
One area that has been of particular interest to regulators concerns indemnification agreements by securities lending agents, guaranteeing performance by securities borrowers.
The regulators’ concern is that securities lending indemnification agreements represent contingent liabilities which, in the event of widespread defaults by securities borrowers, could threaten the solvency of the lending agents, typically broker-dealers or banks.
Late last year, the SEC adopted new reporting requirements for mutual funds. These requirements will become effective in 2018 and 2019.
While they are only one facet of those new requirements, the reporting requirements for securities lending are significant.
On a monthly basis, mutual funds will be required to identify all borrowers of securities, the value of the securities on loan to each borrower, and the amount and value of each category of non-cash collateral (similar information is required for repurchase agreements and collateral subject thereto).
More securities lending reporting is required annually, including identification of each lending agent and cash collateral manager, whether any borrower defaults have resulted in collateral liquidations, gross and net income from securities lending, and securities lending fees and compensation paid.
The reporting requirements also reflect the regulators’ interest in indemnification arrangements, because they require disclosure of whether lending agents or others have provided indemnification, and whether indemnification rights were exercised.
The new regulations are widely regarded by industry participants as highly burdensome, and they are expected to require mutual funds to invest significantly in technology to accommodate the enhanced reporting requirements.
Unlike in the case of money market reform, some industry organizations are expected to urge the SEC to revisit, pare back or delay these reporting requirements.
Whether any paring back will happen and, if so, whether it will relate to the securities lending disclosure requirements, remains to be seen.
Regulators globally have sought broader restrictions on the exercise of rights by financial contract counterparties that could effectively thwart the ability of regulators to accomplish an orderly resolution of a failing systemically important financial institution (Sifi).
Of particular concern to regulators is the contractual right of a counterparty to a failing Sifi to close out a financial contract, including a securities lending agreement or repurchase agreement, on account of the commencement of a resolution proceeding for the institution before the resolution authority has been able to take steps to resolve the institution.
For example, this could be by effecting a transfer of the institution’s assets to a third party or new financial institution or a bail-in of funded debt and other liabilities of the failing institution to accomplish the institution’s rehabilitation.
Although a resolution regime will typically, by statute or regulation, impose a stay on the termination of a financial contract arising from the commencement of a resolution proceeding, regulators have been concerned that, when the financial contract is governed by foreign law or is with a foreign counterparty, the stay imposed by the resolution regime in the institution’s home jurisdiction may not be enforced in a foreign forum.
As a result, regulators have promulgated rules for Sifis to require their counterparties to agree contractually to the stays imposed by their home resolution regimes and have worked with industry groups, such as the International Swaps and Derivatives Association, to develop so-called stay protocols to which parties to financial contracts would agree.
US banking regulators are supportive of these efforts. In 2016, the US Federal Reserve Board promulgated proposed regulations that would in effect require financial contracts to incorporate the relevant stay protocols.
It is anticipated that other US federal banking agencies will take similar steps.
The stay protocols applicable to US institutions, like many of the stay protocols generally, would in a resolution proceeding under Title II of the Dodd-Frank Act, the so-called Orderly Liquidation Authority, contractually eliminate in a financial contract with a subsidiary of the institution a cross-default to the commencement of a resolution proceeding to which the institution is subject.
It would also defer recourse to a legal ‘guaranty’ or other credit enhancement provided by the institution of the subsidiary’s financial contract obligations so long as during the stay period the credit enhancement is assumed by the transferee of the institution’s assets or is assumed by the institution as part of its rehabilitation.
The stay protocols applicable to US institutions would also provide for the cross-default and credit enhancement-related agreements to apply if the institution were subject to a case under chapter 11 of the US Bankruptcy Code rather than the Orderly Liquidation Authority.
Numerous other regulatory requirements affect securities finance. Among them are enhanced capital requirements and single counterparty credit limits.
It remains unclear whether these requirements will be loosened to any significant extent, but there seems to be a growing recognition that onerous capital requirements inhibit bank lending and, consequently, economic growth.
But other initiatives that affect securities lending are unlikely to be revisited.
For example, T+2 settlement of securities transactions, recently adopted by the SEC, may impose additional demands on securities industry participants, but that initiative had the support of both the Republican and the Democratic SEC Commissioners and is unlikely to be reversed.
Recent regulations have clearly imposed burdens on securities finance activities, but the regulatory wave may have crested. While significant new regulation may well be averted, some recent regulation may be here to stay.
Whether, and to what extent, other recent regulations will be streamlined or rolled back remains to be seen.