Fixed Income – the PRA requires action.
The fallout from the collapse of Archegos Capital in 2021 and the Liability Driven Investment (‘LDI’) crisis of last autumn rolls on with much of the recent focus on remedial work around the LDI liquidity problems.
In a recent ‘Dear Chief Risk Officer’ (‘CRO’) letter from the PRA to firms involved in the PRA’s planned thematic review of firms’ matched book repo businesses, the PRA explained that they had widened the review to cover lessons learned from the large fluctuations seen in gilt prices in September and October 2022, which particularly impacted LDI firms.
The PRA found a number of shortcomings in firms’ risk management counterparty risk management processes and margining arrangements that needed remediating. Many of the findings were consistent with those they had previously raised in their Dear CEO letter of 2021 relating to cash prime brokerage business and synthetic equity funding financing following the default of Archegos, which was set out in their letter of 10thDecember 2021 and which we covered extensively in our article – ‘Global Equity Finance Business – the PRA/FCA require action’ in the same month.
As demonstrated by firms’ experiences in the gilt market stress event the PRA observed that there is still some way to go in applying these lessons to fixed income financing business. The PRA emphasised that firms should extend enhanced credit due diligence principles, client disclosure standards and counterparty risk management controls beyond those that were introduced for hedge fund clients in equity financing to all client types in all secured financing and other relevant trading business.
The PRA review also covered the settlement and operational controls of fixed income firms, together with general liquidity risk management practices. The PRA observed that working on tight profit margins led to the substantial gross exposure positions leading to material counterparty credit risks from mark-to-market fluctuations in collateral valuations during periods of market stress. This placed strains on firms’ margining and settlements processes. Liquidity risks can also arise if firms are unable to monetise multi-currency secured financing collateral pools in stressed market conditions.
Firms should conduct appropriate liquidity risk analysis in this area, particularly where internal treasury functions’ liquidity pools access third-party sources of secured financing collateral in multiple currencies indirectly through their matched books.
Of course, it can be questioned as to why the overall counterparty macro liquidity market exposures were not picked up by policymakers and regulators and some regulators themselves have voiced concerns about whether they can see and monitor risk exposure at counterparties in their jurisdictions. These concerns come amid and despite prescriptive requirements to report derivatives transactions to trade repositories in major jurisdictions.
In response ISDA has published a paper, ‘Hidden in Plain Sight’ highlighting the relevant data that is available, discusses its values, explains the hurdles policymakers face in effectively using it and suggests steps policymakers might take to address and overcome these challenges to improve the usefulness and functionality of the data they currently receive.
ISDA believes that much of the information, required to see and identify the build-up of derivatives exposures and risks, is available in the trade repository data that is already reported to regulators, but that it may well be ‘hidden in plain sight’, not easily understood, not readily functional, not easily shared by regulators and therefore not as useful as it might otherwise be.
In their paper ISDA raise three questions:
· What information on derivatives trades and exposures is currently available to policy makers through trade repositories?
· How can this information be efficiently and effectively used by policymakers to address their risk exposure concerns? and,
· How can derivatives trade and risk data be shared by regulators that receive it with other policymakers within and across jurisdictions, to provide a more holistic view?
The paper is available on ISDA’s website (www.ISDA.org) and is worthwhile reading for policymakers and regulators and anyone who wants to gain a better understanding of how trade repository data might be better used to prevent stress events such as Archegos and the LDI liquidity problem in future.
But, returning to the PRA’s ‘Dear CRO letter’. The PRA has added an Appendix to their letter in which they have detailed their observations from their thematic review and their expectations of practices that firms should benchmark and incorporate in their own risk management controls of these activities.
These are covered in three principal areas that need to be addressed:
• Counterparty risk management controls including:
o Counterparty risk stress testing
o Counterparty risk concentrations
o The Margin Period of Risk
o Collateral haircuts
o Onboarding and ongoing client due diligence and,
o Fund Manager disclosures where relevant
• Operations and settlement processes including:
o Operational constraints
o Margining processes
o Alternative collateral arrangements and,
o Critical operational processes and client due diligence
• Liquidity Management Controls including:
o Treasury Liquidity Pool collateral monetisation and,
o Cross-currency exposure risk appetite
The PRA has given CROs to whom the letter was specifically addressed until 8th December to share the letter with their Board Risk Committee, to confirm that they have done so, have carried out the benchmarking tests against the PRA’s observations and then shared the analysis with their supervisor along with any remediation plans and timelines to address any weaknesses.
While the letter is addressed to the CRO’s of specific firms involved in the review the PRA has published the letter so that all firms can learn from the observations and expectations highlighted by the review. It is worthwhile for all CRO’s to analyse it to see if any parts apply directly or indirectly to their own business and risk management controls and to, at a minimum, make their Board Risk Committees aware of its existence. As we know in today’s regulatory environment of personal responsibility, the regulator’s questioning starts at the top and it doesn't reflect well if Boards and senior management are unaware of the issues being currently raised by the regulators.
FMCR has considerable first and second line of defence experience at major firms of dealing in the complex derivatives market and in Treasury management and we are pleased to discuss how we can assist firms in addressing the issues raised by the PRA in their letter.
In the first instance please contact us at contact@fmcr.com.