On February 28, ISDA responded to the Financial Stability Board’s (FSB) consultation on leverage in the non-bank financial intermediation (NBFI) sector.

In the response, ISDA makes the following points:

• Due to the diverse nature of the NBFI sector (in terms of business models, risk profiles, market activity, etc), and the fact that many NBFIs and other non-bank market participants are already subject to financial and/or market regulation within their home jurisdictions, through local rules and international standards, overly prescriptive regulatory recommendations for all such firms across all geographies and market sectors could be inappropriate.

• The ways in which the use of leverage in the NBFI sector would create financial stability risks deserve further examination. ISDA has some initial points regarding the two channels of risk transmission defined by the FSB in the report – the counterparty channel and the position liquidation channel – which would merit further discussion among standard setters and authorities.

• The report acknowledges the potential impact of proposed measures on the cost of hedging, market liquidity and liquidity needs in time of stress and ISDA welcomes the FSB’s statement on the need “to balance risk mitigation with avoiding restrictions on beneficial aspects of NBFI leverage”. ISDA believes the FSB should undertake a deeper analysis of the impact of the proposed measures on these aspects. In some cases, the impact of the proposed measures could nullify any of the reduction of financial stability risk arising from leverage.

• The FSB should account for how the use of derivatives and secured financing, which the FSB characterizes as leverage-inducing activities, support key functions performed by financial markets, including: financing, hedging, price discovery, and market stabilization through countercyclical behaviors. In addition, as acknowledged by the FSB, “the use of leverage, including in NBFI, may in some cases allow entities to meet short-term cashflow needs without having to engage in asset sales.”

Therefore, instead of immediately imposing entity- or activity-based measures, ISDA would encourage authorities to first:

• Analyze system-wide dynamics. As explained in a recent ISDA whitepaper, in the case of derivatives, for instance, much of the information required to see and identify the build-up of exposures and risks is available in the trade repository data that is reported to regulators. By publishing analyses on system-wide dynamics utilizing this data, authorities would foster market participants’ awareness of risks and vulnerabilities building at the system level in a constructive manner, allowing market participants to mitigate risks on a self-initiative basis, following the strategy that is most suited to the specifics of their activity.

• Address the remaining risks that may crystallize through the position liquidation channel, by (i) ensuring market participants can rely on deep and liquid repo markets under stress; (ii) easing the pressure arising from collateral demands, to reduce the need for sudden deleveraging; (iii) improving the transparency of CCPs’ margining practices to help with liquidity preparedness; and (iv) facilitating bank intermediation capacity, which also supports repo market resilience.

The response to the FSB can be found below.