Brokers face restrictions on using clients' assets as collateral for other trades, as partof a push by global regulators to prevent the securities lendingmarket from sparking chain reactions that could cause a crisis.

Under recommendations published today by the Financial StabilityBoard (FSB), brokers wouldn't be allowed to tap client assets fortheir own trading, and they would have to provide “sufficientdisclosure” of plans to use the securities as collateral in othertransactions. They would also have to meet minimum standards inmanaging liquidity risks.

Regulators are seeking to rein in how traders use collateral ina bid to prevent any repeat of the turmoil that followed the 2008collapse of Lehman Brothers Holdings Inc., which was driven in partby confusion over who was owed what on outstanding trades. TheEuropean Union may seek to curb the number of times a single assetcan be passed on as collateral in trades, a person familiar withthe plans said last week.

“More safeguards” are needed for client assets, the FSB, whichbrings together regulators and central bankers from the Group of 20nations, said in today's proposals. Recycling the securities ascollateral, a process known as re-hypothecation, “can createfinancial stability risks, especially if clients are uncertainabout the extent to which their assets have been re-hypothecated orabout the treatment in case of bankruptcy.”

Securities lending agreements are trades in which one partytemporarily hands over a security to someone else in exchange forcash or other assets, and they are similar in many respects torepurchase agreements, or repos. Both markets are part of a $67trillion shadow banking system that became a target for tougherrules following the collapse of Lehman.

Failure of a large player “may lead to sharp price falls thatcreate mark-to-market losses for all holders of these securities.These losses can in turn lead to fresh rounds of fire sales byother firms, thereby creating an asset valuation spiral,” the FSBsaid.

Securities lending transactions and repos “play crucial roles insupporting price discovery and secondary market liquidity for avariety of securities,” the FSB said. The goal behind itsrecommendations is to prevent excessive leverage, and to “mitigatethe risk that large forced sales of collateral in one marketsegment” spreads chaos throughout the broader financial system, itsaid.

Non-Banks

In addition to curbs on client-asset use, the FSB is calling forpension funds, insurers, and other non-banks active in thesemarkets to face tougher rules, including liquidity requirements,when they reinvest cash collateral.

The FSB said that it would monitor implementation of therecommendations and report back to G-20 leaders in November2014.

The plans stipulate that a minimum portion of cash collateralshould be kept in short-term deposits, held in liquid assets suchas “high-quality” government debt, or used for short-termtransactions that can be readily converted into cash.

The FSB also published draft rules on the minimum costsnon-banks should face when engaging in trades without usingclearinghouses. The purpose of this rule is to make sure firmscan't get too much cash in exchange for low-quality collateral, theFSB said.

Regulators must ensure that firms don't overreach in using thesemarkets for short-term financing of long-term assets, some of whichmight become illiquid or lose value, the FSB said.

These trades can involve “maturity and liquidity transformation”that can present risks to the wider market if left unchecked, itsaid.

The FSB said it would seek views on this part of therecommendations and complete work on them by spring 2014.

The FSB published today's report as part of a package ofmeasures designed to oversee so-called shadow banking activitiesthat allow banks to shift business off their balance sheets, aswell as those which allow investors to bypass lenders and thefunctions they traditionally fulfill on the markets.

In addition to repos and securities lending agreements, the termalso covers activities such as investments in money-market fundsand securitization.

The FSB has been tasked by the Group of 20 nations with drawingup international rules to prevent shadow banking from sowing theseeds of the next crisis. Some measures, such as those formoney-market funds, have already been published by standardsetters.

Other parts of the FSB plans involve boosting companies'disclosure of their repo and securities lending activities, andrequiring them to do more internal stress testing of potentiallosses on these trades.

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