LONDON (Reuters) - Financial Services Authority chairman, Adair Turner, will call on Thursday for stricter rules for the multi-trillion-dollar repurchase or repo market as part of a "shadow banking" crackdown.
Repos are the sale of securities, typically government bonds, with an agreement to buy them back at a later date at a higher price. They are widely used to raise short-term finance - often just overnight - but the sector's opacity and size has raised concerns among regulators.
Turner and others on the Financial Stability Board (FSB), the G20's regulatory arm, are studying new rules for shadow banks, which also include money market mutual funds, conduits, special investment vehicles and hedge funds.
"We are committed to deliver to G20 leaders by the end of this year policy proposals that will address shadow banking drivers of financial instability," Turner will say in a speech in Washington on Thursday.
Supervisors fear that as mainstream banking faces much tighter rules, risky financing activities will migrate to the $60 trillion shadow banking sector.
"The vital policy implications of the story of shadow bank financial innovation are indeed that we should seek to constrain the instability potentially created by credit and money creation processes," Turner will say, according an advance copy of the speech.
"That implies ... appropriate constraints on shadow bank credit and money equivalent creation - for instance through 'asset-equity' controls at the contract level - minimum initial haircuts. These will be considered by the FSB this year," Turner will say.
This would mark a big change for the market.
The International Capital Market Association (ICMA), which represents repo trading firms, said minimum initial margins on repos are not universally applied, nor are they of significant size, at least in the bulk of the market.
The total value of European repo contracts outstanding in December was 6.2 trillion euros ($8.1 trillion).
As the 2007-09 financial crisis unfolded, regulators argued that increasing haircuts or margins when markets fell was "procyclical", meaning it amplified the drop by sparking the need to for some banks to sell assets to pay the higher margins in a cycle that repeats itself.
Policymakers were also alarmed by the use of so-called Repo 105 by Lehman Brothers, the U.S. bank whose collapse in September 2008 triggered a near global meltdown in markets.
Dubbed an "accounting gimmick", Lehman used a repo to sell some loans at the end of each quarter to raise cash, helping it show, temporarily, that it had a less risky balance sheet for the purpose of financial reporting.
A minimum initial margin would be set at a high-enough level so there would be no need to raise them immediately in rocky times, a step supervisors believe would limit procyclicality.
"We think that a minimum initial margin appears to be an overreaction because we don't think the underlying problem you are trying to address is as marked as regulators believe," said David Hiscock, a senior ICMA director. "It does not need to be micro managed in this way."
Minimum margins may deter some transactions altogether.
"It's going to be make it more expensive and people are going to have find more and better quality collateral," said Peter Snowdon, a financial lawyer at Norton Rose law firm.
"If you trying to minimise risk there comes a point where people think it's not worth doing. The very attractive deals will still be done but they will cost more, while those more on the margin will be difficult to get off," Snowdon said.
The industry worries that a minimum initial margin would exacerbate the wider financial market problem of scarce collateral as regulators push for other transactions to be backed by collateral as well.
Repos are seen as a mechanism for channelling collateral around the financial system. "We are concerned there is going to be a squeeze on collateral," Hiscock said.
The FSB is also looking at "through the cycle" margining, meaning an extra margin requirement if repo markets were growing excessively to threaten broader financial stability.
The European Union's European Systemic Risk Board and the Bank of England's Financial Policy Committee are also assisting in the FSB's work.
Reporting by Huw Jones; Editing by Hans-Juergen Peters