Non-bank access to liquidity: the path ahead is clear

1. The resiliency and preparedness of the non-bank financial intermediation (NBFI^[1]) sector to stress events is key for financial stability. 
2. Clearing Houses have developed adapted models to facilitate NBFI access to the cleared markets’ liquidity, a useful tool for their liquidity transformation needs.
3. We call on policymakers to integrate Sponsored clearing as a solution to support NBFI liquidity preparedness and adapt regulatory regimes to facilitate the take up of those models.  

Market stresses such as those caused by the Covid pandemic in March 2020 and the UK ‘mini budget’ in September 2022 put increased pressure on the NBFI sector’s access to liquidity, resulting in large liquidation of assets (sometimes at a stressed price). The NBFI sector represents around €212 trillion globally and over half of all financial assets in the EU^[2]. Its resiliency and preparedness for similar events is therefore key for financial stability.

One of the vulnerabilities identified in the NBFI sector is the large liquidity needs to respond to redemptions or margin requirements in case of market stress. Under such conditions, investors tend to have recourse to redemptions to get quick access to cash, exposing funds to liquidity risks due to misalignment between redemptions and the ability to liquidate assets they hold.

NBFIs use SFT to ‘transform’ their assets into cash to respond to various needs such as redemptions or fulfil variation margin calls. As such, the repo market is an important source of cash for non-banks, especially since the introduction of the mandatory clearing of standardised OTC derivatives.^[3]

NBFIs rely on banks to access repo markets, usually through uncleared channels. However, in times of stress, banks’ capacities to intermediate in an uncleared landscape are significantly reduced. In contrast, cleared repo markets provide reliable access to liquidity. As an illustration of the role of clearing as a safe harbour, the graph below shows significant spikes in cleared repo volumes in times of stress, pointing to the fact that cleared markets are a reliable source of liquidity.

Cleared repo markets can therefore be a useful tool for NBFI liquidity transformation. However, these markets are currently mainly operated by banks. To support NBFIs' broad access to the cleared liquidity we need to find solutions to the limited capacity of banks to intermediate those markets.

CCPs have developed models facilitating buy-side’s access to cleared markets’ liquidity. Said models, including LCH Sponsored clearing, extend the benefits of direct CCP membership to the broader investor community with the support of a bank. As illustrated below, this model enables Sponsored Members (a buy-side firm in our example) to become a direct member of the CCP, sponsored by an Agent Member (bank). Agent Members provide a range of services for their Sponsored Member, including provision of Default Fund and potentially margin payment and management. On the other hand, Sponsored Members are responsible for the provision of margin and trade settlement. The Sponsored Member does not transact via the balance-sheet of its Agent bank but directly with the market, alleviating the balance sheet capacity of the intermediary.

References to CCPs in the NBFI debate have been limited to the impact of margin increases on specific markets such as commodity or energy markets. We believe they have a central role to play in supporting NBFIs' access to liquidity, especially in market stress.

Whilst policymakers have started to adapt the rulebook to accommodate these models (e.g. recent changes to the MMF Regulation adapting counterparty ratio of MMF), we believe a holistic review of the legislative framework is needed to facilitate their uptake.

Examples:

• Clarifying the capital treatment of the obligations of the Sponsoring Agent under banks capital rules. The current lack of clarity leads to a conservative treatment, rendering such models not viable compared to bilateral transactions.
• Adapting Solvency II rules to explicitly foresee insurance undertakings to be direct clearing members of CCPs. EIOPA’s recent consultation is a step in the right direction.^[4]
• Adapting UCITS Directive and associated guidelines to remove existing restrictions where securities received in a reverse repo transaction can be pledged/transferred back to meet CCP margin requirements would further promote the use of such clearing models.

Whilst Sponsored clearing models are not yet fully adapted for all types of NBFIs, they are an additional tool supporting liquidity preparedness for the likes of MMFs, pension funds, and insurance companies.

We therefore call on policymakers to not only integrate Sponsored clearing as a solution to support NBFI liquidity preparedness, but also adapt regulatory regimes to facilitate direct access to cleared repo markets under these models.

[1] Non-bank financial institutions include investment funds, insurance companies, pension funds and other financial intermediaries per the FSB

[2] Discussion Paper: An approach to macroprudential policy for investment funds, Central Bank of Ireland, page 3

[3] Frequently Asked Questions on Repo, International Capital Market Association (ICMA), page 5

[4] EIOPA consultation on the capital treatment of insurers’ direct exposure to central clearing counterparties in the standard formula, 31 July 2024.