Letter from Nathanaël Benjamin and David Bailey – Fixed income financing thematic review

Letter to Chief Risk Officers (CROs) of banks operating in the UK following the Prudential Regulation Authority’s review of fixed income financing businesses.
Published on 05 October 2023

Please note: This letter has been prepared for the website. Square brackets show where this letter may differ slightly, along with formatting from those versions sent directly to firms.

5 October 2023

Dear Chief Risk Officer,

Fixed income financing thematic review

We are writing to share insights from our thematic review of regulated firms’ (‘firms’)footnote [1] liquid fixed income financing (or ‘matched book’ repo) businesses, which focused on the financing of developed market sovereigns and liquid credit fixed income instruments. As the Senior Manager responsible for identifying, assessing, and mitigating risks to the business, and a source of independent challenge, we consider that you are well placed to assess the extent to which the points raised below are relevant to your business and how they are being addressed.


Episodes of extreme volatility and illiquidity have been experienced in even the deepest of markets over recent times. These episodes have occurred as major economies have faced a series of pandemic related challenges, elevated geopolitical tensions, and a transition to tighter monetary conditions. Some of the risk parameter changes associated with these episodes were previously considered improbable tail events by many risk managers. These events have tested vulnerabilities in firms’ risk management defences. Within the broader context of the Prudential Regulation Authority’s (PRA) stance that firms need to adapt their risk management approaches to deal with these new challenges, we are writing to all the firms involved in our review to set out our findings.

The scope of our thematic review of firms’ matched book repo businesses,footnote [2] which the PRA had already planned, was widened to cover lessons learned from the large fluctuations in gilt prices in September and October 2022 which particularly impacted Liability Driven Investment (‘LDI’) funds. The appendix to this letter details a series of observations and expectations of practices that firms should incorporate into their risk management of these activities and against which we expect you to benchmark your own firm’s risk management framework.

Main thematic findings

In this review we found a number of shortcomings in firms’ counterparty risk management processes and margining arrangements that should be remediated. Some of our observations are drawn directly from the lessons learned from the gilt market stress event, but others are broader themes, derived from our review of global activities within this business area. Many of these counterparty risk management themes are consistent with findings we had previously made in relation to cash prime brokerage and synthetic equity financing following the default of Archegos, which we set out in our Dear CEO (‘DCEO’) letter published on 10 December 2021 and in subsequent supervisory communications with firms. While firms have made progress in strengthening their counterparty risk management controls for hedge fund clients within their prime brokerage businesses, more focus is needed on other business lines where leverage is provided to clients through secured or synthetic financing facilities.

In our DCEO letter of 10 December 2021, we directed firms to carry out a full read-across of the issues we highlighted in equity financing, together with our expectations, to all secured financing businesses. However, as demonstrated by firms’ experiences during the 2022 gilt market stress event involving LDI funds, there is still some way to go in applying these lessons to fixed income financing businesses. It is disappointing that the messages we communicated previously have not been fully addressed. Consequently, we emphasise the importance of our expectation that firms extend enhanced credit due diligence principles, client disclosure standards, and counterparty risk management controls, beyond those that have been introduced for hedge fund clients in equity financing, to all client types in all secured financing and other relevant trading businesses.

Our review into fixed income financing also covered settlement and operational controls, together with general liquidity risk management practices. Tight profit margins on liquid fixed income financing balances, coupled with internal balance sheet return targets, incentivise these businesses to operate in significant scale with a high degree of balance sheet netting efficiency. While this supports the liquidity and functioning of short-term funding markets, we observed that the magnitude of gross exposures leads to material counterparty credit risks from mark-to-market fluctuations in collateral valuations during periods of market stress. A sharp increase in the volume of margin calls and securities transfers associated with these changes in collateral valuations, in turn, places strain on firms’ margining and settlements processes.

Firms must ensure that operational processes and margining platforms are sufficiently robust and scalable to cope with extended periods of heightened market volatility which lead to exceptional margin payment flows and securities settlements that mitigate these counterparty risks. Furthermore, maturity mismatches of assets and liabilities within large, matched books are sometimes material. Liquidity risks would arise if firms were unable to monetise multi-currency secured financing collateral pools in stressed market conditions, for example due to operational frictions or constraints on the mobilisation of collateral across different legal entities or jurisdictions. Firms should conduct appropriate liquidity risk analysis in this area, particularly where internal treasury functions’ liquidity pools access third-party sources of secured financing collateral in multiple currencies, indirectly through their matched books.

Please confirm that you have shared a copy of this letter with your Board Risk Committee and that you have carried out a benchmarking exercise against our observations. Please share such analysis with your supervision team along with any remediation plans in this area by 8 December 2023. Such remediation plans should be fully scoped, with agreed timelines that address any weaknesses on a timely and systematic basis. We will follow up on individual firms’ responses through our normal supervisory channels. We are also publishing this letter so all firms can learn from the observations and expectations highlighted by our review.

If you have any questions relating to this letter, please do not hesitate to speak to your supervision team.

Yours sincerely,

Nathanaël Benjamin

David Bailey

Executive Director,
Authorisations, Regulatory Technology,
and International Supervision

Executive Director,
UK Deposit Takers


1. Counterparty risk management controlsfootnote [3]

1.1 Counterparty risk stress testing

Firms typically use Potential Exposure (‘PE’) based risk measures as the core component of their counterparty risk limit framework. While this risk measure enables firms to assess counterparty risk exposures on a consistent basis across their financing portfolios, it may not, on its own, sufficiently capture potential exposures from substantial changes in collateral valuations during stressed market conditions. In reaction to the gilt market stress event, some firms created ad hoc stress-based counterparty risk scenarios to assess risk parameter changes which exceeded those captured by standard PE measures. Other firms subject to our review already had stress-based counterparty risk exposure testing capabilities for their sovereign bond financing activities; however, stress scenario reports were run sporadically. Many firms did not run comprehensive stress scenarios to assess risk exposures of fixed income financing counterparties on a systematic and routine basis – having considered such tail risk events to be extremely unlikely or implausible.

With the recent shifts in the global macro environment, firms should enhance the way they assess their trading and counterparty risks, incorporating new and broader stresses into their risk management processes. Risk managers should challenge themselves to consider risks that were previously deemed improbable, even in global sovereign bond markets. Individual counterparty and portfolio-wide stress scenarios should be produced and reviewed by the second line of defence on a systematic, frequent, and timely basis, consistent with the dynamic nature of fixed income financing exposures. Stress scenarios should be linked formally to risk exposure monitoring and should be incorporated fully into the decision-making and governance processes of the second line of defence.footnote [4]

1.2 Counterparty risk concentrations

Many firms had made insufficient attempts to assess combined client and collateral concentration exposures and to establish formal controls around such exposures either at the individual client or portfolio level. However, examples of sound practice included where simple backstop notional-based exposure limits were imposed by the second line of defence at both individual fund and overall fund manager family levels, calibrated to overall internal risk appetite.

Firms should consider the adequacy of their counterparty risk management controls and limit frameworks in capturing concentrated financing exposures that may become illiquid under certain market conditions. Where existing controls and escalation protocols do not constrain, or flag, the build-up of such concentrated exposures, steps should be taken to address this.

1.3 Margin Period of Risk

There was inadequate use by many firms of extended, or non-standard, Margin Period of Risk (‘MPoR’) computations in their PE based risk management limit frameworks.

MPoR should be used by firms as a dynamic tool that complements other controls over concentrated counterparty risks. For example, MPoR should be extended in instances where the use of a standard close-out period upon the default of a counterparty is assessed as inadequate for concentrated exposures that are deemed illiquid due to their relative scale. Firms should establish formal criteria, owned by the second line of defence, for considering and establishing any non-standard MPoR inputs to risk exposure calculations, taking account of concentrated client exposures and the effective, operational close out-period for individual client portfolios.

1.4 Collateral haircuts

Several firms did not have a policy, which was established and owned by their independent credit risk function, which stipulated minimum collateral haircut requirements for all client types. Some firms did not require collateral haircut levels to be assessed and agreed by the second line of defence for certain important clients under any circumstances. These firms indicated that collateral haircut levels for such clients were determined by market convention and competitive dynamics rather than internal risk appetite, and that risk exposures were controlled by the second line of defence solely through counterparty credit limits and by regulatory capital constraints.

It is important that firms independently assess and calibrate haircut terms to cover potential collateral shortfalls based upon reasonable credit assumptions. Margin and haircut requirements imposed on bilateral secured financing exposures provide firms with a level of protection upon default of a counterparty and these terms should be set based upon prudent risk management principles – rather than solely dictated by commercial pressures. We believe that it is sound practice for firms to establish a collateral haircut policy, owned by the second line of defence, which sets out criteria for determining collateral haircuts for all counterparties. Such criteria should include, among other factors, the credit quality of individual accounts and the nature, concentration, and liquidity risk profile of underlying collateral. We would expect firms to adopt a formal process that involves the second line of defence in approving any exceptions to this policy.

1.5 Onboarding and ongoing client due diligence

A number of firms covered by our review had not carefully considered, or had not recorded within their systems, differences between underlying fund types specifically operated by LDI fund managers.

As the credit risk profiles of mandated LDI funds may differ from those of pooled LDI funds, firms should identify and record these differences during the client onboarding process. Risk appetite should be appropriately calibrated, considering the size and leverage profile of the fund, its available liquidity, and its investment strategy, together with other pertinent matters. Firms should also consider issues such as the extent of recourse to underlying fund investors, and whether any investor support is implicit or contractual, among other relevant factors. Timely and appropriate management information reports should be produced that differentiate between exposures to distinct types of underlying fund to inform risk management decision making. These counterparty credit due diligence steps were an area where we generally found insufficient focus by firms.

1.6 Fund manager disclosures

As in our earlier post-Archegos equity financing review, we noted different disclosure practices of individual fund managers relating to the systematic, and timely provision of fund level credit due diligence information, such as leverage profile, performance, net asset value, liquidity buffers and underlying strategy. As a result, firms were not always aware of the up-to-date financial condition of individual fund counterparties, hampering their ability to make fully informed, timely risk management decisions on counterparty exposure management during stress. Where operational delays occur in the receipt of collateral top-up for example, firms should be able to accurately assess their counterparty risk exposure.

We re-iterate our expectation, as set out in our DCEO letter following the Archegos default, that firms establish, document, and apply formal counterparty due diligence disclosure standards. Firms should explicitly implement any exceptions policies and related governance arrangements with respect to these disclosure standards. Independent risk management functions should properly link their assessment of the quality of clients’ credit disclosures to counterparty risk management controls such as the setting of internal credit risk appetite and haircut terms. Such policies should apply to all businesses and all non-bank financial institutions and not be solely limited to hedge fund accounts within prime brokerage.

2. Operations and settlement processesfootnote [5]

2.1 Operational constraints

In some cases, firms’ settlement and margining systems had deficiencies, lacking straight-through processing and automated management information capabilities. These deficiencies cause margin processing inefficiencies and lead to operational risks that are exacerbated during periods of stress.

Firms should prioritise necessary enhancements to downstream systems and controls where such weaknesses and inefficiencies in workflow processes exist.

2.2 Margining processes

Messaging protocols and dispute resolution processes supporting clients’ top up margining flows for matched book repo exposures remain highly manual for a material number of counterparties. While we have observed some recent progress by firms in this area, the overall lack of automation of these workflow processes creates additional operational risks for firms. These risks are heightened during periods of stress due to the large volume and scale of margin calls and associated collateral flows, reflecting the sheer notional size of matched books.

We expect firms to continue to focus on the automation of these margining processes.

2.3 Alternative collateral arrangements

Several firms had already established the operational capability to accept alternative top-up collateral postings in the form of cash payments from clients prior to the gilt market stress event. In other cases, firms had to take reactive steps to introduce these alternative means of collateral top-up, where available, during the stress.

Such optionality in margin fallback arrangements should be considered in new account onboarding processes; any alternative cash payment lines opened with clients should be tested on a periodic basis.

2.4 Critical operational processes and client due diligence

Firms had not fully assessed whether clients faced potential constraints in their internal operational processes or whether there were concentrations in their clients’ key servicing arrangements prior to the market stress event involving LDI funds. The ability of some custodian banks to keep pace with the volume and complexity of requests from their fund clients was highlighted during this episode.

An awareness of critical operational factors and relevant servicing arrangements should be factored into firms’ ongoing client due diligence processes.

3. Liquidity risk management controlsfootnote [6]

3.1 Treasury Liquidity Pool collateral monetisation controls

We observed limited instances of firms’ treasury functions comprehensively assessing the size and composition of High-Quality Liquid Asset (‘HQLA’) collateral pools that are held in multiple currencies against their ability to monetise holdings of sovereign bonds or sovereign reverse repo collateral sourced from internal matched books, in a stress. Treasury functions typically enter into a series of internal reverse repo transactions with the matched book that have a maturity roll off profile based on their assessment of the monetisation needs of the HQLA pool in a stress. The matched book, in turn, sources this collateral by entering into corresponding reverse repo transactions with external counterparties. Unless the HQLA pool balances are ring-fenced within the matched book they are effectively consolidated and managed by the business alongside other (i.e. third-party repo counterparty balances). In the normal course of business however, the matched book may engage in maturity transformation of its balances, including the external reverse repo exposures used to source the collateral held by the treasury function within its HQLA pool.

There is a risk that the roll-off profile of reverse repo collateral, recorded internally by treasury within the HQLA pool, may not therefore reflect the contractual maturity profile of these corresponding reverse repo exposures with external counterparties. Hence, in a stress the treasury function may not be able to monetise its reverse repo collateral through the matched book and generate cash liquidity in accordance with its needs. Sound practices included firms that routinely analysed the overall maturity profile of the matched book and imposed size limits and concentration constraints on their treasury liquidity pools’ HQLA reverse repo collateral and outright bond holdings in different currencies. These constraints were routinely calibrated to independent risk functions’ assessment of repo market access and additional secured funding capacity including central bank facilities under stress.

Liquidity risk analysis should consider the potential monetisation requirements of the Treasury HQLA liquidity pool in relation to the overall maturity profile of the matched book assets and liabilities. Firms should factor into their analysis the likely roll over rates for repo and reverse repo exposures of key clients who are important to the matched book franchise, together with additional sources of repo funding capacity, such as central bank facilities that are available across different jurisdictions. Where firms’ modelled liquidity stresses assume the use of additional central bank facilities globally Liquidity Risk Management should assess fully any internal operational frictions or constraints on the mobilisation of collateral across legal entities and address these restrictions.

3.2 Cross-currency exposure risk appetite

Some firms run large cross-currency exposures within their fixed income financing books from time to time, often with material maturity mismatch risks that may be difficult to manage in a stress. All firms imposed granular market risk limits on cross currency basis risk sensitivities. However, we noted a general lack of consideration, at business unit level, of the overall scale of any general wrong way risk positioning in cross-currency exposures that may hamper the ease of close out of risk positions in a stress. For example, where firms have longer dated cross currency swap maturity mismatches in currencies with a wide cross currency basis in significant scale their ability to close out these positions (should connected secured financing balances rapidly roll off in an idiosyncratic stress) may become challenging.

Where firms run material cross currency exposures within their matched books, internal risk appetite should consider the notional size of cross- currency wrong way risk positioning that is assessed against potential market access constraints that could be experienced by the firm in a stress event.

  1. References to firms in this letter should be taken to mean the banks and designated investment firms subject to the review.

  2. The review covered multiple firms, including global investment banks and large UK domestic deposit taking institutions, representing a material portion of the fixed income financing market.

  3. Requirements in respect of risk management are set out in various parts of the PRA Rulebook. Firms are directed, in particular to: (i) the high-level requirements in the Fundamental Rules of the PRA Rulebook requiring firms to have effective risk management systems and to control and organise their affairs responsibly and effectively; (ii) General Organisational Requirements in the PRA Rulebook to have effective processes to identify, manage, monitor and report the risks it is or might be exposed to, and internal control mechanisms, including sound administrative and accounting procedures and effective control and safeguard arrangements for information processing systems.

  4. Indented paragraphs set out PRA expectations of firms, in each relevant area.

  5. See supervisory statement (SS)1/21 – Operational resilience: Impact tolerances for important business services for the PRA’s approach and expectations in relation to operational resilience.

  6. See SS24/15 – The PRA's approach to supervising liquidity and funding risks for the PRA’s expectations and approach to liquidity risk management.