Helping markets thrive and managing systemic risk: the FCA’s approach to non-bank leverage

Cultivating well-functioning markets

At this time of year, it’s almost impossible not to think about spring. Warmer weather, a bit of sun. It’s always a joy to see the world come back to life after a dull, grey winter. It might be a cliché comparison, but I find that the world of financial markets is not dissimilar to a garden. Certainly, as a regulator, we think about markets as a gardener might think about their plants – we want them to grow and thrive, we want them to be able to manage changing or uncertain weather conditions, and we want to see plants return year after year.

In many ways, I think this is a helpful way to frame our thinking about leverage. In the same way that a garden needs water and nutrients to flourish, leverage underpins a great deal of essential activity in financial markets. As the gardeners amongst you will know, though, measurement is key – too much water or the wrong balance of nutrients have the opposite effect. And the amount of water or nutrients required at any time needs to be calibrated according to weather predictions and seasonal conditions.

Over the past few years, financial regulators globally have been acutely aware of this need for balance – focusing on ensuring that NBFI entities have access to leverage in the ways, means, and quantities that allow the markets to prosper. And with sufficient mechanisms in place to monitor and measure it.

An overview of leverage

The NBFI sector – by which I mean the diverse ecosystem of activities, entities, and infrastructures that sit outside the traditional regulatory framework for banks – is an increasingly essential aspect of the UK economy.

Like other parts of the financial system, it provides a range of services to the UK market, managing approximately £14.3 trillion of client assets, including circa £2.9 trillion of UK pension assets, and operating one of the largest global hubs for insurance, with annual premiums written of £326 billion across life and general insurance. The services provided by this large and growing sector bring significant benefits to the UK economy.

Today, I want to focus on one specific feature of NBFI, and that is its use of leverage.

Up front, I want to acknowledge that leverage is, of course, not inherently a cause for concern. The NBFI sector’s use of leverage is an essential component of the deep and efficient capital markets we have in the UK. Leverage helps NBFI entities hedge their risks, it funds productive investment, helps achieve target returns for investors, and provides liquidity to the system. Leverage underpins well-functioning markets.

However, the presence of leverage can create vulnerabilities, especially when it’s poorly managed, there’s a lack of transparency, or it is concentrated. In those cases, when a shock occurs, what normally brings benefits to the economy can suddenly become an amplifier of instability and a cause for loss of confidence. For regulators, that’s a real concern – we know that market stability is a prerequisite for an efficient economy and sustainable growth.

But when do we need to worry that NBFI leverage is becoming a threat to financial stability? How do we tell when leverage use crosses the line from investment risk, a normal and healthy aspect of financial markets, into systemic risk – a risk to the system itself? This is a crucial question, and one we must answer to know when and where leverage usage constitutes a risk to be addressed.

We can be informed by a few recent episodes of market volatility when NBFI leverage use contributed to market disruption and amplified instability. From those, we can identify a few common characteristics.

The first is the presence of NBFI leverage in what we call ‘core markets’: those markets which are essential to the functioning of the financial system and ultimately the real economy, such as government bond markets. We saw this during the dash for cash in March 2020, when a number of hedge funds were forced to unwind highly leveraged relative value positions in U.S. Treasury markets, amplifying selling pressure and contributing to the dislocation that led the Federal Reserve to intervene.

We saw this again in the autumn of 2022, when fiscal policy announcements led to a surge in long-dated yields and unexpectedly large margin calls on repo borrowings and interest rate derivatives for UK pension funds’ investments in liability-driven investment (LDI) strategies. As a result, LDI investors needed to liquidate gilts to de-lever. This created a further cycle of falling prices and increasing margin calls, until the Bank of England intervened to restore market functioning. In both cases, the presence of significant NBFI leverage in core markets contributed to market disruption and exacerbated financial instability.

The second characteristic is interconnectedness between leveraged NBFI entities and the banking sector or systemically important institutions. Most NBFI entities are not systemically important and can and should be able to fail if they take on too much investment risk through leverage. However, when a leveraged NBFI is heavily interlinked with the banking sector and fails, this can become a systemic risk if it threatens the stability of that systemic institution.

We were reminded of this possible threat by the collapse of family office Archegos in March 2021 which led to large losses for many of its bank counterparties. The interlinkage between certain non-banks and a systemically important clearinghouse also played a key role in the nickel crisis of 2022.

Finally, recent market crises show that leveraged exposures that are concentrated or crowded might merit additional attention. This factor is also currently a difficult risk to spot and respond to. Archegos obtained significant synthetic leverage from numerous bank counterparties to build large, concentrated positions in a small number of relatively illiquid equities. When one of its largest holdings experienced a material adverse price shock, Archegos failed to make its margin calls and defaulted within days. Many of its bank counterparties had failed to identify the full extent of its concentrated exposures, leaving several of them with significant losses when the cost of liquidating their exposures far exceeded the margins they held.

Likewise, in autumn of 2022, the large number of pension funds pursuing similar LDI strategies led them to 'crowd' into similar positions in long-dated inflation-linked gilts, so that when gilt yields (and margin calls) suddenly spiked, they moved in unison to liquidate those gilts, leaving few natural buyers and amplifying the downward pressure on gilt prices.

So, past evidence and experience highlights several key factors that might merit particular attention. The presence of NBFI leverage in core markets, leverage use by NBFIs interconnected with systemically important institutions, and NBFI leverage which is highly concentrated or crowded can generate not only investment risk but can produce outcomes that amplify market instability and start to look a lot closer to systemic risk.

Our approach

These recent market stresses teach us that market participants, counterparties, and authorities all have a role to play in spotting and managing risk from NBFI leverage use.

We at the FCA believe that the first line of defence against the build-up of systemic risk related to leverage use is NBFIs themselves appropriately managing their own investment risk. When individual market participants manage their investment risks effectively, this can reduce the build-up of risks within the system as a whole.  However, for NBFIs to effectively manage their risks related to leverage use, they need to have access to adequate data and information about the markets in which they operate and the risks to which they're exposed.

For this reason, we support regulatory initiatives that enhance the availability of that information.

Information which can help NBFIs manage their own risk includes information available through public disclosure – in the form of anonymous, aggregated information on concentrated positioning and liquidity conditions which allows market participants to better understand market dynamics and identify emerging risks. This kind of information can feed into NBFIs’ calculation of liquidation costs, help them identify crowded trading strategies, and then adjust their leverage use accordingly. For example, commitment of trader reports published by futures exchanges give helpful knowledge of dynamics in commodity derivatives markets. We believe this style of disclosure could be useful in other areas.

If NBFIs’ risk management is the first line of defence, then the second is counterparty credit risk management. When NBFIs fail to manage their risk sufficiently, their leverage providers' counterparty risk management should act as a second check. However, in recent stress episodes, we've seen that counterparty credit risk management has often failed to prevent systemic risks from crystallising. Again, this is in part because the right people don't necessarily have the right information – leverage providers haven’t always had sufficient transparency on the risks they face.

Enhancing private disclosure between counterparties would give those leverage providers more information about the overall risk exposures of their NBFI clients, allowing them to manage their counterparty risk more effectively. This should, in turn, indirectly reduce the build-up of unknown concentrated or crowded NBFI leverage use – as with greater consistency of data, leverage providers would be more easily able to spot concentration or crowdedness and could then make their own decisions on how much leverage to extend or how to price it in those circumstances.

That said, if NBFIs are required to disclose too much information, this could reveal proprietary information about their investment strategies.

The complexity of balancing improvement in counterparty risk management with the need for client confidentiality makes this an area where we believe regulators would benefit from continuing close dialogue with industry. Rather than authorities unilaterally mandating requirements, we think industry has an important role to play in establishing best practice and in developing solutions that can balance the interests of leverage users and providers to improve data availability so that NBFIs and counterparty credit providers can continue to operate as the 1st and 2nd lines of defence.

Relatedly, transparency to market operators can also be helpful. Operators of listed derivatives trading venues may need information on related over-the-counter (OTC) exposures to ensure they can identify potential concentration risk and maintain market integrity. For these reasons, we have recently issued a policy statement on the commodity derivatives regulatory framework which sets out trading venue surveillance requirements and aims to enhance private disclosure of OTC positions to trading venues so they can identify risks early on.

In short: we believe that targeted improvements to public and private disclosure could go a long way in mitigating the build-up of systemic risk from NBFI leverage.

But we’re also realistic. We know there will be instances where increased transparency for market participants cannot on its own prevent the build-up of systemic risk from NBFI leverage. There will be firms that still fail to manage their risks well, and there will be risks, including many of those which are more systemic in nature, which firms simply don’t have the ability to spot because they don’t have a system-wide view. For example, prime brokers will only know about their own clients' exposures, so they may be unable to identify concentration or crowdedness risks building up across the market. Similarly, market participants may be able to identify possible concentration or crowdedness from public disclosure, but its aggregate nature means they will not be able to spot everything.  This is where the regulator comes in: as the third line of defence.

Regulators need to have the necessary data, systems and tools in place to effectively monitor NBFI leverage use from a systemic perspective to uncover the risks to financial stability that market participants miss.

The focus for regulators

So what, exactly, do regulators need to be looking at?

NBFI leverage use is complex; there is no universal metric that will accurately capture the leverage-related risk of all NBFIs. Instead, we need a range of metrics to be assessed together.

For example, we understand that notional-based measures of leverage can significantly overstate the actual exposure of an NBFI and are therefore not necessarily good indicators of its risk. That said, these metrics can still be useful to regulators in monitoring the build-up of aggregate leverage across cohorts of NBFIs in specific areas.

To assess the risks from use of leverage at the individual NBFI level, we need to rely on other metrics such as those which capture default and liquidity risks, sensitivity to market risk, and concentration risk. Using a suite of diverse metrics will allow us to develop a better sense of the risks related to leverage use in individual NBFIs, but also to understand whether risk is building in specific segments of the markets.

In cases where regulators do spot systemic risk from the build-up of NBFI leverage, they have a range of tools they can consider to address and mitigate the risk. There are measures which constrain leverage indirectly, usually by increasing the cost of leverage use. These are typically applied at the activity level and are especially effective in cases where leverage use may not be properly priced with respect to the associated risks. Examples include minimum margins and haircuts on derivatives and repo transactions. On the other hand, there are also measures which constrain leverage much more directly, by imposing a limit on its use or setting some kind of resilience standard, and these are usually applied at the entity-level. Having this broad toolbox is important, as one size will not fit all. And that is fine.

When thinking about which measures are more effective for which circumstances, I find recent analysis[1] conducted by the FCA and Bank of England staff for a Bank Underground blog post particularly useful. It finds that fixed-notional leverage limits applied at the entity level can be effective when entities employ simple investment strategies in highly similar assets. However, in the case of entities which employ more complex investment strategies, fixed leverage limits are not as effective in reducing overall risk and may even increase portfolio concentration or crowd funds into certain strategies which use less leverage but may feature riskier assets. Meanwhile, activity-based measures set marginal prices on individual assets and effectively reduce risk from leverage use without the unintended shift towards higher risk assets.

In practice, we see these trade-offs feed into regulators’ approaches to constraining leverage. Real estate funds engage in simple investment strategies with highly similar assets, so fixed entity-based leverage limits can work to reduce risk. Meanwhile, LDI funds have not been faced with fixed limits on leverage, but instead regulators have set resilience standards to ensure these funds maintain the liquidity necessary to meet margin and collateral calls.

In the case of LDI funds, resilience standards were more practical to implement because they are risk sensitive, and they were feasible to design and implement as LDI funds’ risks are relatively simple and straightforward to measure. When considering more complex entities such as multi-strategy hedge funds, a fixed-notional leverage limit is unlikely to be effective in reducing risk for reasons I have just laid out, and setting a resilience standard would not be as straightforward as it was for LDI funds, as the risks in a complex fund are much harder to measure.

Now, what does all this mean from a regulatory perspective here in the UK? As mentioned, we see risk management by NBFIs and their counterparties as the first and second lines of defence against systemic risk from NBFI leverage use, and we are working with international peers to set out how improvements in public and private disclosure could bolster these.

We are also thinking about our own role as the third line of defence within the UK, and whether we have the right data and tools for performing that role. Given the FCA’s regulatory remit and patterns of leverage use in the UK market, fund managers covered by the Alternative Investment Fund Managers Directive (AIFMD) will be an area of focus for us. Although it is important to note the NBFI sector is much broader than alternative investment funds.

The good news is we already have a large portion of the data necessary to identify risks from funds’ leverage use, so we do not need to start from scratch. That said, there may be some targeted changes we could make to our data collection to ensure we are able to assess leverage use in a comprehensive and risk-sensitive manner. We will consider this as part of our upcoming AIFMD review. We are conscious that any change in reporting will come at a cost, and so any proposals will be proportionate and subject to a full consultation and cost benefit analysis. We will also engage closely with industry on this when the time comes.

International collaboration

The NBFI sector is global in nature, and so are the financial stability risks that can arise from it. And global risks often require global solutions. Therefore, in addition to collaboration with other UK authorities, international collaboration is essential for effective oversight and regulation, particularly when addressing an issue as complex as leverage.

Authorities need to work hard to deliver a consistent global regulatory environment. Consistency is good for firms, ensuring predictability and reducing costs. Authorities should, where possible, engage with international counterparts to enhance their supervision and monitoring efforts, and work together to improve access and use of data.

Of course, international collaboration brings its own challenges, especially in a period of increasing uncertainty and economic competition.

Nonetheless, we strongly believe that co-operation brings benefits to all and supports global economic well-being. We remain as committed as ever to being an advocate not just for international co-operation, but also for the UK to be a leader in global regulatory innovation.

As such, I’m pleased to be co-chairing the FSB’s Working Group on Leverage in NBFI (WGLN) alongside Cornelia Holthausen of the European Central Bank.

The WGLN is a core component of the FSB’s ongoing NBFI work programme and is carrying out significant work on addressing financial stability risks arising from NBFI leverage on a global level. Its current consultation report is ambitious, requiring authorities to identify and monitor financial stability risks, and then to address those risks that they identify. But the proposals that are set out are flexible and outcomes focused, allowing authorities to select and calibrate policy tools in a way that is appropriate to the specific risks that exist within individual jurisdictions, and to combine complementary tools where necessary, to deliver a consistent set of agreed outcomes.

The consultation focuses on availability of data and metrics to help identify financial stability risks arising from leverage – and then on the policy measures that jurisdictions could employ to respond in circumstances where financial stability risks arise. In many cases, the issues highlighted in the report are the same ones that the FCA is already prioritising in our domestic work.

We encourage you to actively participate in the FSB consultation – it is open until the end of this month. I’d also like to ask for your future help as we seek to reform the data that is obtained via AIFMD through our reform work this year – making sure that the right data exists to help the first, second and third lines of defence monitor and proactively manage their levels of risk is important.

We are cognisant of the need to avoid unduly burdening firms, disrupting investment and hedging activities- and we know that leverage delivers benefits. But we believe there is scope for improvement.

Helping markets thrive

To turn back to where we started: what does all of this mean for our garden of financial markets? There’s no simple answer to that question. Ultimately, though, it’s about making sure we’re all equipped with the knowledge and tools we need to help the garden flourish. We need to ensure that our plants have the right amount of sunshine, water, and nutrients to grow – that they are resilient enough to manage the weather or any unexpected storms and that we can detect the storms that may be brewing.

As a final comment, I want to emphasise how vital it is that the voices of firms operating in the UK are heard during the policy development process, both domestically and internationally. To those of you that have already responded to the WGLN consultation[2] – thank you. Your comments will help us strengthen our final set of policy recommendations. Thank you also to the IA for hosting today’s event. I look forward to hearing from you all in our roundtable discussion.