FSB aims to put 'guard rails' around leveraged trading
The Financial Stability Board has reiterated its mission to place “guard rails” around leveraged trading activity among financial institutions outside the banking system, given the potential destabilising effect that a swift unwinding of positions by hedge funds and other firms could have across financial markets and the real economy.
The comments from the FSB, the international watchdog for regulators from the 20 leading economies, come in the wake of a series of episodes of financial market stress in recent years that policymakers said were exacerbated by excessive leverage. Those include the fallout from the collapse of Bill Hwang's Archegos Capital Management in March 2021, which caused about US$10bn in bank losses, and the "dash for cash" by UK pension funds during the Gilt market meltdown in September 2022.
“Now is the time to start putting guard rails around leveraged trading. As our financial markets continue to get bigger relative to the size of the real economy, and more complex, they become relentlessly less stable and there comes a point when we all need to recognise that there is a need for proportionate containment,” Martin Moloney, deputy secretary general at the FSB, told ISDA's annual general meeting in Amsterdam on Wednesday.
“Leverage is now widely used, both to control risk and to intensify it,” he said.
Moloney’s comments come in the aftermath of the publication of the FSB’s consultation paper in December on leverage in non-bank financial intermediation. The paper made several policy recommendations to enhance the ability of authorities to monitor and mitigate potential market vulnerabilities from non-bank leverage, and to contain leverage “where it may create risks to financial stability”.
While the FSB won’t formally respond to feedback it receives from the paper until its final report is published in July, Moloney confirmed that it won't just be highly leveraged hedge funds that come under scrutiny.
“A build-up of leverage by a large number of small entities is as potentially threatening to financial stability as leverage positions taken by large entities,” he said. “Our focus is not on hedge funds; it’s on a particular kind of trading, irrespective of who does it.”
Sarah Breeden, deputy governor for financial stability at the Bank of England, also highlighted the FSB's work on leverage among non-bank financial institutions in a speech earlier on Wednesday.
“Broader reforms to address the risks from [non-bank financial institutional] leverage and improve resilience in core markets are a necessary part of ensuring financial stability,” Breeden told the AGM.
She pointed to the experience of the Gilts crisis in September 2022 that exposed vulnerabilities in repo markets and "the potential for dysfunction to threaten financial stability and the real economy".
She said the Bank of England will publish a discussion paper later this year to consult the industry on possible reforms to market structure "to enhance Gilt repo market resilience".
Breeden discussed the importance of sound margining practices in reducing risks in the financial system. "We should work with our international partners to ensure margining practices, in centrally and non-centrally cleared markets, are robust and do not lead to excessive pro-cyclicality or facilitate excessive leverage in the system," she said.