Summary of the PRA ‘Dear CEO’ letter
The Dear CEO of 5 October is the outcome of a ‘thematic review’ by the UK’s Prudential Regulation Authority (PRA) of fixed-income financing (aka matched-book repo) of developed-country sovereign and liquid credit bonds in the context of the extreme volatility and illiquidity triggered by ‘improbable’ tail events such as the pandemic shock, geopolitical tensions, the tightening of monetary policy and the 2022 gilt market meltdown.
Counterparty credit risk
The improbable tail events cited by the PRA revealed weaknesses in firms’ counterparty risk management and variation margining. Similar weaknesses had been found previously in cash and synthetic equity financing provided by prime brokerages following the Archegos default. While prime brokerages have made progress in strengthening counterparty risk management of hedge fund clients, the PRA believes the same needs to be done in other business lines where leverage is provided to clients through secured or synthetic financing of fixed-income.
The PRA therefore expects firms to formally embed in their risk-monitoring and decision-making, a policy of comprehensive, systematic and regular/frequent/timely stress testing of the counterparty credit risk in matched-books at both individual client and portfolio levels.
Firms will also be expected to improve their ability to identify and control the build-up of concentrated exposures to sovereign and liquid credit bonds. The tools recommended include greater use in calculations of non-standard margin periods of risk (MPoR) – the assumed interval between the last margin call that has been met by a counterparty and its default – and the stricter application of collateral haircuts. In respect of haircuts, the PRA criticised the fact that they were generally driven by market convention and competition, and that collateral risk was primarily managed with counterparty credit and regulatory capital limits. They therefore want firms to have minimum haircut policies formulated by their independent credit risk management functions that are based on appropriate risk criteria, applied to all counterparties and include a formal process for approving exceptions.
Response to LDI Turmoil
Because pooled LDI funds had greater difficulty accessing liquidity in response to sharply increased margin calls during the gilt market melt-down in 2022, the PRA will require firms to tighten onboarding and ongoing client due diligence in order to be able to distinguish mandated from pooled LDI funds.
Also in respect of due diligence, the PRA reiterated concerns raised in their Archegos equity financing thematic review about inadequate disclosure by some fund managers of systematic and timely fund-level credit information (e.g. leverage profile, performance, net asset value, liquidity buffers and underlying strategy) which meant that firms were not always able to make fully-informed, timely counterparty risk decisions during periods of stress. Firms will henceforth be expected to establish and apply formal counterparty disclosure standards for all clients and not just the hedge fund clients of prime brokerage, and to be able to assess the quality of disclosure.
Operational and settlement risk
In the light of issues arising from the intensification of margin calls during stressed periods, the PRA expressed concern about deficiencies in settlement and operational controls.
The Dear CEO letter neatly summarises the basic challenge for repo desks: how to meet targets for the rate of return on balance sheets given the tight margins earned on repo against liquid collateral? The answer is scale. But scale means that sudden and substantial mark-to-market fluctuations in collateral valuations during periods of market stress can trigger such large increases in margin calls as to strain margining and settlements processes. While balance sheet netting can mitigate the problem, it may not be sufficient because of the sheer size of matched-books. Furthermore, balance sheet netting does not work where there are significant maturity mismatches between assets and liabilities in large matched-books.
The PRA therefore will require that firms ensure that their operational processes and margining platforms are sufficiently robust and scalable to cope with extended periods of exceptional margin payment flows. The expected solution is automation.
Firms will also be expected to assess whether there are bottlenecks in clients’ operational processes, including settlement arrangements with third parties such as custodian banks.
Finally, the PRA suggests that firms consider accepting cash margin.
The PRA notes that only a few treasuries assess their ability to monetise multi-currency pools of HQLA in stressed situations where these assets are sourced through internal reverse repos with their matched-book desk, taking account of their size, concentrations of currency and asset-type and, where HQLA balances are not ring-fenced, the maturity risk that might be taken by the matched-book desk when sourcing those assets from the market.
Liquidity risk analysis will therefore be expected to consider whether the potential demand by the treasury to monetise HQLA buffers in a period of stress could be satisfied given the overall maturity profile of the matched-book. The analysis should include the likely run-off rates for repos and reverse repos with key clients of the matched-book desk, as well as additional sources of repo funding such as central banks in different jurisdictions but taking into account and addressing any internal operational frictions or constraints on the mobilisation of collateral across legal entities.
Some firms were observed by the PRA to occasionally run large cross-currency exposures within their matched-books, often combined with material maturity mismatches. While cross-currency basis risk was always subject to granular limits, the wrong-way risk in cross-currency exposures was not generally identified and managed within business units. The concern is that, if repo balances were to rapidly run off in a crisis, could any longer-dated currency swaps used to hedge the cross-currency risk be easily unwound given the scale and maturity mismatches in swap books.
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