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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Towards the end of every year, we get a phenomenon that might be known as the “December Document Dump”.
There’s nothing particularly sinister or unusual about it — it’s just a reflection of the fact that lots of official organisations have annual work plans combined with difficult tasks. The people who work for them naturally want to get the desk clear and their objectives ticked off so that they can start on new projects after the holidays.
It does mean, though, that sometimes things come out which aren’t properly appreciated. Potentially really quite radical proposals can slip by unnoticed until someone looks at them later on and goes crazy.
As a possible example of this phenomenon, consider the Financial Stability Board’s consultation report on “Leverage In Non-Financial Intermediation”, which came out in the week before Christmas.
It’s the latest in a series of publications from the global club of regulators that address issues related to “Non-Bank Financial Intermediaries”. These are the things that used to be called “shadow banks” until it was decided that this didn’t sound boring enough.
The consultation in question is actually about a quite intrinsically interesting subject. It might fairly be called the “post-Archegos report”, although it points out that the UK’s Liability Driven Investment crisis and the 2022 nickel market squeeze also demonstrate the problems that can arise when big institutions take leveraged positions in crowded trades.
As the report puts it:
. . . The build-up of leverage can pose significant risks to financial stability, if not properly managed. The propagation of shocks through leverage occurs primarily via two channels: the position liquidation channel and the counterparty channel. The position liquidation channel operates when leverage leads to large or unexpected liquidity demands from collateral or margin calls, prompting leveraged entities to sell assets to raise funds. Deleveraging and asset sales can happen also when investors aim to maintain a target level of leverage on their balance sheet or seek to have a stable value-at-risk in their portfolio. Ensuing asset sales, especially under stressed market conditions, can depress asset prices further, causing a feedback loop of additional liquidity demands and sales across market participants exposed to the same asset class.
But how to prevent this? The Financial Stability Board is a sort of meta-meta-regulator. It doesn’t make any rules itself; it’s a place where broad “principles” get agreed between all sorts of different global bodies, which then go out and set “standards” addressed to national regulators, which will hopefully at some point get turned into actual rules to be enforced by the people who tick boxes.
This means that it’s tricky for it to set any direct limits on leverage, particularly when some of the entities that the FSB is really worried about are quite far outside the usual scope of regulation. Archegos, after all, was a family office with no outside investors — it has historically been considered none of the regulators’ business if a very rich person decides to do something silly with their money.
One of the approaches suggested by the FSB is to work through prime brokerages (“leverage providers” in the language of the report) that facilitate most of the problematic stuff.
But of course, the banks can only help if they know what’s going on. And in the case of Archegos, the main reason that Bill Hwang was allowed to build up such gargantuan risks was that he had multiple brokers, none of whom knew that he was holding the exact same positions with each.
And so, we get a proposal that part of the solution is “private disclosure”:
Recommendation 7: Authorities, in cooperation with SSBs, should review the adequacy of existing private disclosure practices between leveraged non-bank financial entities and leverage providers, including the level of granularity, frequency, and timeliness of such practices. Where appropriate, they should consider developing mechanisms and/or minimum standards to enhance the effectiveness of these disclosure practices.
OK, what does that mean?
Authorities should consider applying the following principles:
■ Specific types of information and data disclosed should take account of the strategies, products and markets in which the client is active, to ensure that the information provided is relevant and effective for the purpose of the leverage provider’s risk management.
■ Clients should provide aggregate information on their exposures across all entities or vehicles that are managed under a common strategy or decision-making process, to capture the impact of a coordinated liquidation across the client’s full range of related investment products or vehicles.
OK, what does that mean?
It’s not completely clear — one of the things about being a meta-meta regulator is that you have to state everything in very general terms. But it very much looks like the FSB is recommending that big investors ought to be required to give all their “leverage providers” full disclosure of all their positions, so that the prime brokers can manage their risks properly and can aggregate their information to be aware of crowded trades.
It all sounds pretty innocuous when you put it that way. Who could object to transparency? In fact, this is potentially a regulatory hand grenade that’s been dropped into the trenches of the hedge fund industry.
Basically, there are very good reasons why large funds tend to have multiple prime brokers, and to ensure that nobody has a complete view of their positions. That sort of information (particularly if it’s “granular” and “timely”) is extremely valuable to counterparties.
Even ignoring any potential for literal front-running, it’s just extremely useful to know how the market is positioned, which trades might be crowded and where the “strong hands” and “weak hands” are in terms of who’s got spare borrowing capacity and who’s maxed out.
In general, information is power and power is money in financial markets. If this consultation exercise ends up with a requirement for big funds to show their cards to their prime brokerages, then that will not only make a big prime brokerage operation an incredible competitive advantage, it will also hugely tilt the playing field in the favour of the sellside versus the buyside.
