Consultation paper on further considerations for the implementation of the NSFR in the EU

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1 8 July 2016 European Commission Directorate General for Financial Stability, Financial Services, and Capital Markets Union (DG FISMA) Rue de Spa Brussels Belgium Submitted by RE: Consultation paper on further considerations for the implementation of the NSFR in the EU Dear Sirs, BlackRock welcomes the opportunity to respond to the European Commission s consultation on the implementation of the Net Stable Funding Ratio (NSFR). BlackRock is a premier provider of asset management, risk management, and advisory services to institutional, intermediary, and individual clients worldwide. BlackRock has a pan-european client base serviced from 22 offices across the continent. Public and private sector pension plans, insurance companies, third-party distributors and mutual funds, endowments, foundations, charities, corporations, official institutions, banks and individuals select BlackRock to manage their investments on their behalf. This response is being submitted specifically on behalf of our International Cash Management business, which manages over $110 billion in European liquidity investments 1 on behalf of clients globally, helping them manage their cash and treasury needs. Cash Management operates in the short-term capital markets (or at the front end of the credit maturity curve), which are already characterised by supply-demand dislocations because Basel III, specifically the liquidity coverage ratio (LCR), is designed to encourage banks (the most frequent issuers in this market) to issue in longer dated maturities; meanwhile the demand for short-dated assets remains consistent. We expect that the additional impact of the NSFR will make it considerably more expensive for banks to be active in many short term transactions (in particular, short term reverse repo), and would see them reduce activity which is vital in helping MMFs manage their short-term (daily and weekly) liquidity to meet investors demand for cash. At the very same time that the full impact of the NSFR will be felt, and likely significantly reduce the volume of short term transactions, EU legislation currently being finalised in Level 1 (the MMFR) will force MMFs to be even more reliant upon banks for short term liquidity. While the specific impact of the NSFR on banks activities in short term markets may be an intended consequence of the regulation, we believe the combined effect of the Money Market Fund Regulation (MMFR) and the NSFR would have the unintended consequence of undermining the viability of many MMFs 2. 1 Investments denominated in Euro, Sterling and Swiss Francs (combined AUM figure expressed in dollar-equivalent). 2 The effect will be most strongly felt by MMFs whose investment policy is restricted to high-quality government debt. The aim of MMFs which invest in bank or other corporate credit (called prime funds) is to diversify counterparty credit risk (many investors in MMFs are firms who would not be covered under bank deposit insurance schemes, and so use MMFs as alternatives to concentrating counterparty risk in a single deposit account, as these MMFs hold invest in the short term securities of many banks); however, government debt MMFs provide an alternative to bank counterparty risk altogether by constructing portfolios of only the highest-quality government debt. Because these funds are intended to be exposed only to government credit risk, they have fewer options at their disposal to manage their liquidity. Their reliance on short-term reverse repo collateralised by high-quality government securities makes them particularly susceptible to the NSFR changes. i

2 We believe that this unintended consequence can be avoided by providing an appropriate level of flexibility in how MMFs are allowed to manage liquidity under the MMFR as well as through refined calibration of the NSFR. In both cases, the recognition of high-quality government debt as a liquid asset a concept consistent with other European and global legislation is central to finding a workable outcome: In the MMFR, we believe that high-quality government debt should be considered a daily liquid asset, and that MMF managers should be able to manage their regulatory liquidity requirements in a flexible manner between holdings of government debt and the use of overnight liquidity from banks (where it is available). In the NSFR, we believe that the final calibration should remove asymmetries between reverse repo and repo when high-quality government debt is used as collateral. MMFR and the NSFR: on a collision course? Short-term reverse repo is a key liquidity management tool for Money Market Funds (MMFs), however, the impact of the NSFR is to decrease bank appetite for providing it, while regulatory changes via the MMFR make these funds increasingly reliant on it. Today funds manage liquidity mainly 3 through a combination of overnight reverse repo, overnight deposits with banks (for prime funds) and holding high quality government debt. Short-term reverse repo and deposit markets have already been significantly impacted by Basel III regulation (the LCR and the Leverage Ratio) designed to reduce bank reliance on short term funding. This has been evidenced through a consistent contraction in short term bank balance sheets and increased cost of accessing such balance sheet for counterparties, both of which are particularly evident over reporting periods such as quarter and year ends 4. Providing overnight balance sheet has already become more expensive for banks due to regulatory constraints, once banks bear in addition the full cost of the NSFR, this could reduce further their willingness to continue their current limited offering. The shrinking availability of overnight liquidity management tools is more pronounced in the Sterling and Euro markets, and will become more so, as these do not benefit from the relief that a backstop overnight facility such as the US Federal Reserve s reverse repo program (RRP) provides for US Dollar markets. To cope with the trend in downward supply in overnight liquidity (deposits and reverse repo), MMFs have sought to maximise their access through an expanded list of counterparties and the collateral they take back in reverse repos. But further pressure on the ability of banks to continue providing overnight liquidity may stretch supply beyond the point where expanding counterparties and collateral can meet demand. Under the recent Council General Approach on MMFR, funds will be required both to hold increased levels of daily and weekly liquidity (10% and 30% of the assets of the fund, respectively, for short-term funds), and to manage it in accordance with a narrower definition of what constitutes such liquidity. The approach specifically limits the use of high quality government assets to counting towards the weekly liquidity bucket, to a maximum of 10% of the overall 30% weekly liquidity requirement, provided that they have a maturity of 190 days or less. 3 The actual matching of securities to mature in daily or weekly increments is part of the liquidity management toolkit, however these securities do not exist in sufficient volume to be a principal method of meeting daily or weekly liquidity needs. The implementation of Basel III (in particular the LCR) has extended the average maturity of most bank-issued debt (one of the primary investments of most European MMFs) further out the maturity curve. Issuance in sub-one month maturities is a practically non-existent market across financials, corporates and sovereigns. The management of weekly liquidity needs must therefore primarily be managed through overnight liquidity. 4 A second key consideration for pricing and liquidity is when banks report for their Leverage Ratio requirements. While some banks (notably US and UK banks) are required to apply daily averaging for their reporting, many banks only apply monthly averaging. This affords the possibility of trading repo on net balance sheet between reporting dates, while significantly reducing activity (to the point of closing their books) over reporting dates. This also helps to explain the increase in repo rate volatility and sharp reduction in liquidity observed over month and quarter ends. As some respondents noted, if and when all banks move to daily average reporting this will help to smooth out the month-end and quarter-end price aberrations; however, it will also mean that overall repo market activity will have to reduce significantly from current levels. (p. 13, The current state and future evolution of the European repo market, ICMA, November 2015) ii

3 This therefore implies that funds will be required to fulfil higher liquidity needs through a greater reliance on overnight bank balance sheets (and specifically on reverse repo, in the case of government debt MMFs). The end result raises two concerns. Firstly, the NSFR, as proposed by the Basel Committee, will accelerate the permanent contraction of short-term, particularly overnight, bank balance sheets. Secondly, the combination of the MMFR with the NSFR could lead to investors bearing greater counterparty credit risk through the reduction in counterparty or collateral quality or if there is broadly reduced or discontinuous access to overnight liquidity from banks, the funds may not be able to take on customers capital reliably and their utility would be greatly undermined. This outcome need not be inevitable: principled policy solutions exist that can help achieve a workable and consistent outcome that does not negatively impact liquidity, and does so in a manner that ensures a consistent and high level of investor protection. NSFR impact on short-term reverse repo markets The NSFR calculation is designed to discourage short-term trades, less than 12 months, through the available stable funding (ASF) and required stable funding (RSF) weightings applied across tenors. NSFR impacts repos (which generate ASF gains) and reverse repos (which generate RSF needs) differently where the lifespan of the trade is less than 6 months, creating asymmetries depending on the type of entity and collateral involved in the transaction. The table below illustrates how NSFR discourages short-term reverse repo transactions with a financial institution such as a MMF by providing a 0% gain towards their ASF. It further discourages banks from entering into both repo and reverse repo transactions with financial institutions (like MMFs) by removing the ASF-NSF offsetting benefit and generating a cost. With the primary participants in repo and reverse repo markets being financial institutions operating in tenors shorter than 12 months, the permanent contraction in repo desks/ activity and increase in pricing is an inevitable consequence of NSFR implementation. Repos / Reverse Repos Assets (Required Stable Funding) Liabilities (Available Stable Funding) < 6M 6M-12M > 12M < 6M 6M-12M > 12M Reverse Repos Repos Net NSF Corporate, sovereign, supras and other non FI -50% -50% -65 / - 85%** 50% 50% 100% 50% NSFR gain if the cash is borrowed from a non-financial institutional / sov / corp for the term below 6 months 50% NSFR cost if the cash is lent to an instit/sov/corp for the term below 6 months Financial Institutions (FI) -10% / - 15%* -50% -100% 0% 50% 100% Back to back ASYMMETRY: 10 to15% NSFR cost if financial counterparties enter both the repo and the reverse repo Central banks 0% -50% -65 / - 85%** 0% 50% 100% *10% if HQLA L1 (A et B) 15% if L2 (A/B) or non HQLA ** 65% if < 35% Risk Weighted; 85% if >35% Source: Societe Generale 22/06/2016 Conclusions The parallel policy discussions on the MMFR s restriction on the use of government debt as a liquidity management tool, along with the NSFR s likely impact on banks ability to continue providing short-term funding iii

4 to other financial institutions (like MMFs) creates a contradiction of policy aims: to restrict banks provision of short-term liquidity to other market participants, while at the same time making certain market participants more reliant on that liquidity. To avoid this contradictory outcome, we believe that adjustments need to be made to both the MMFR and the NSFR, and can be done so in a principled manner. Securing workable liquidity management rules in the MMFR We believe that the final agreement of the MMFR should recognise the holding of high-quality government debt as a daily liquidity management tool 5. High quality government assets are accepted globally as daily liquid assets today by the markets, and under regulation such as the Basel III LCR HQLA definition and the US 2a7 Money Market Fund rules (to a maximum MMF maturity of 13 months). Explicitly allowing their use in the MMFR would be consistent with EU and global legislation and help MMFs more effectively manage the impact of the NSFR on short terms markets. From an investment management perspective, holding government debt is one of the best liquidity management techniques we can employ (we currently proactively chose to use government debt for daily liquidity management in our prime MMFs, despite the fact that government debt yields less currently); and we would hope to continue being able to use it to comply with regulatory requirements. Forcing reliance on short-term liquidity from the banking sector could leave MMFs in the difficult position of being unable to meet regulatory liquidity requirements. This would in turn expose investors to greater risk (via the use of wider counterparty/ collateral limits) or undermine the operation of the funds altogether (by making it more likely that the funds would trigger mandatory gates based on contractions of the overnight market), despite there being an excellent liquidity management tool at the MMF s disposal in high-quality government debt. Appropriate calibration of the NSFR We believe that the final calibration of the NSFR rules should remove the asymmetry between short-term reverse repo and repo especially for high-quality government debt, or Level 1 High-Quality Liquid Assets (HQLA). One of the main reasons why high-quality government debt is accounted for as Level 1 HQLAs is due to the material amount of historical liquidity associated with these assets. Therefore, if the reverse repo counterparty of the bank that borrows in the repo market to finance this trade becomes insolvent, the bank that executes the reverse repo should be able to seize the collateral and liquidate it immediately at a minimal loss to pay off the bank s repo financing whole and on time. The EBA engaged in intensive historical back testing of the liquidity of Step I Level I HQLAs 6 and their conclusions do not support the need to mandate that 10% of the reverse repo notional be financed with longterm debt and equity. A joined-up approach These two policy solutions, addressing both the MMFR Level 1 finalisation and the NSFR implementation, can help avert the unintended consequences of undermining the ability of MMFs to continue providing liquidity management solutions to investors across Europe. As the direction of travel of these two initiatives risk contradiction, we would ask the European Commission to help achieve a more consistent and workable policy outcome. 5 Numerous EU regulatory bodies (including the EBA and the ESRB) have put significant work into exploring the use of high-quality government debt as a liquidity management tool for banks, CCPs, and other market participants. Their analysis has supported the fact that high-quality government debt (generally defined as debt issued by a country within credit step 1 in that country s own currency) should be considered highly liquid and therefore, we believe, meet the definition of a daily liquid asset for the purpose of the intention of these rules under the MMFR (meeting possible investor redemptions from the fund). 6 The full EBA Report on Level 1 HQLA can be found at: ( iv

5 We appreciate the opportunity to address, and comment on, the issues raised by this discussion paper and we will be happy to assist in any way we can and would welcome any further discussion on any of the points that we have raised. Yours faithfully, Beatrice Rodriguez Managing Director Co-Head International Cash Management, Chief Investment Officer, non-dollar Cash Joanna Cound Managing Director Head of Public Policy, EMEA v