Regulation Update: Lifting the lid on the NSFR

Sakhila Mirza

By Sakhila Mirza
LBMA General Counsel

In May 2021, LBMA responded to the UK Prudential Regulation Authority (PRA) consultation on Basel III. The response highlighted that the current proposals regarding the Net Stable Funding Ratio (NSFR) fail to take into account the damaging effect that the rules will have on the precious metals clearing and settlement system, potentially undermining the system completely, and on the increased costs of financing precious metals production. In addition, the proposal fails to take account of the quantitative evidence, which suggests that, in a liquidity crisis, gold acts as an extremely high-quality liquid asset (HQLA).

The PRA published a policy statement in July, which effectively provided an exemption for clearing services but dismissed the argument in favour of gold as a HQLA. See section 2 for more details on the PRA policy statement.

Basel III

The Basel Committee on Banking Supervision (BCBS) published its final report on the Net Stable Funding Ratio (NSFR) in October 2014, imposing an 85% stable funding requirement on all commodities, which also included gold. Under the NSFR rules, banks are required to maintain a stable funding profile in relation to their on-and-off-balance sheet activities, thus reducing the likelihood that disruptions to a bank’s regular sources of funding would erode its liquidity position in a way that could increase the risk of its failure and potentially lead to broader systemic stress. Though the rules have the aim of mitigating a repeat of the 2008 liquidity crises, LBMA has argued that this approach to precious metals is disproportionate and that precious metals should be treated differently from other commodities.

Clearing and Settlement

London Precious Metals Clearing Limited (LPMCL) operates the clearing and settlement system for precious metals transactions. LPMCL serves clients including central banks, central counterparties (CCPs), other commercial banks, financial institutions and many varied non-bank market participants. CCPs rely on the LPMCL system to manage precious metals collateral and the physical delivery of precious metals derivative contracts. Commercial banks rely on the LPMCL system for safe clearing and settlement of precious metals transactions. Non-bank market participants rely on the LPMCL system for short-term liquidity. With daily average cleared gold transactions alone of over $30 billion, the LPMCL system is unique and indispensable. In summary, LPMCL works as an administrator and ensures that counterparties can access the bullion market, particularly those who do not have the ability to store physical gold.

Precious metals are recorded on the balance sheet of LPMCL members and are accounted for as assets subject to a proposed 85% Required Stable Funding (RSF) factor. These assets have to be matched by liabilities for which the proposal ascribes a 0% Available Stable Funding (ASF) factor under certain criteria. Therefore, in some funding circumstances, there is no offsetting effect. To address the negative impact of the NSFR, LBMA has lobbied for an exemption so that the NSFR rules are disapplied when providing clearing and settlement services.

1 NSFR – Background

Precious Metal Loans

Refiners have used gold (as well as other precious metal) loans to fund their gold inventory and work-in-process. The gold loan/lease is an integral part of the supply chain in the bullion industry. This is due to the inherent high cost of gold and the need to borrow short-term loans to finance the cost of the finished products. Furthermore, the gold loan protects the refiner from any adverse price movements in the precious metals, as in the absence of a gold loan, the refiner would have to own its precious metals requirements outright. Often the refiner’s clients are large industrial users, such as the automotive and aerospace industries. These clients require ‘just in time deliveries’, making these gold loan facilities critically important for any refiner. The gold loan removes the metal price risk associated with the difference in timing between acquiring the metal feedstock and selling the finished product. Sufficient availability and reasonable pricing of gold loans are therefore critical to the industry.

The NSFR would have a detrimental effect on these refiners, but also key players in the industry, culminating in higher cost of execution for end clients. If the banks are forced to raise the costs of providing the gold loans, end users fear that such costs will be transferred to them. An additional cost in increased interest payments would therefore severely impede their business model and could result in the reduction or even closure of some production lines.

For most banks, the gold business is extremely small to the point of being easily dispensable should the cost or hassle of the business become prohibitive. Therefore, the fear is not just of a higher cost that the broad industry would have to pass to the customers – covering such industries as electronics, jewellery and investment – but also of there being fewer viable funding facilities available, resulting in a potential fall in liquidity.

Therefore, to address this problem, it is fundamental that gold is recognised as a HQLA.

With daily average cleared gold transactions alone of over $30 billion the LPMCL system is unique and indispensable

It is fundamental that gold is recognised as a HQLA

In its policy statement published on Friday, 9 July, the PRA recognised the argument in favour of providing the precious metals clearing and settlement service with an exemption but decided not to change its position on gold as a high-quality liquid asset (HQLA).

Clearing and Settlement

The PRA’s policy statement, under paragraph 13.91, confirmed as follows:

“The PRA has considered the responses and decided to amend its approach to precious metal holdings related to deposit-taking and clearing activities. The PRA has introduced an interdependent precious metals permission for which firms may apply in respect of their own unencumbered physical precious metal stock and customer precious metal deposit accounts. When the permission is granted, firms would apply a 0% RSF factor to their unencumbered physical stock of precious metals, to the extent that it balances against customer deposits.”

LBMA understands that, at a minimum, anyone who holds physical gold with a client liability on the other side for clearing purposes can apply to the PRA for 0% RSF because their client deposit can be treated as an interdependent asset and liability, thus, effectively exempting the clearing services from the 85% funding requirement. This recognition of interdependent asset and liability by the PRA is consistent with the Basel III text within the NSFR rules under article 45.

This has been welcomed by LBMA, as it ensures that the London clearing system can continue to support the market in providing a smooth and effective service.

2 The PRA Response and Impact of the NSFR on the Precious Metals Market

Gold as HQLA

The PRA’s policy paper, paragraph 12.28, confirmed as follows

“The PRA considers that while gold is a commonly traded and held asset, including as a reserve asset by central banks, the PRA has not found sufficient evidence of its liquidity, risk characteristics, and price stability to warrant treatment as HQLA. The PRA also notes that the Basel III LCR standard does not include gold within HQLA.”

LBMA believes further engagement with the Basel Committee Banking Supervision (BCBS) and other members of the BCBS will be helpful in discussing the relevant data that was presented to the PRA in response to the consultation.

Other Funding Factors

Other funding factors in the UK version have been set in line with other jurisdictions. Secured precious metals financing dependent on whether the collateral is level 1 or 2 will be set at 0% or 5% RSF. Gross derivatives liabilities will also attract a 5% RSF. Within Europe, the European Banking Authority (EBA) and the Bank for International Settlement have published impact assessments for all Basel III rules on a semi-annual basis. At the end of this year, it will be possible to view all European bank exposure to the NSFR for every asset class, including gold.

The EBA shall assess whether it would be justified to reduce the NSFR for assets used for providing the clearing and settlement services

United Kingdom

As outlined above, the UK PRA has consulted on the implementation of the Basel III standards and provided its position. The policy material in its policy statement, as published, is near final. The PRA does not intend to change the policy or make significant alterations to the text of the instruments before the making of the final policy material. The PRA expects to publish the final rule instruments in a subsequent Policy Statement, after HM Treasury has published the relevant Statutory Instrument to support the implementation. This policy is intended to take effect on 1 January 2022.

European Union

Following a request by LBMA to the European Commission, an assessment is being carried out by the EBA. The EBA shall assess whether it would be justified to reduce the NSFR for assets used for providing the clearing and settlement services of precious metals or assets used for providing financing transactions of precious metals of a term of 180 days or less. The assessment will be published in November 2021.

Other Jurisdictions

Through the support of LBMA members, LBMA is exploring further lobbying efforts with other jurisdictions given that the data LBMA holds is new and was not available when the policy decisions were made.

3 What’s Happening Now?

Find out more here.

Sakhila Mirza

By Sakhila Mirza
LBMA General Counsel

Sakhila Mirza, LBMA General Counsel and Executive Director of the LBMA Board works very closely with the CEO on the strategic development of the association, leading on a range of market development initiatives. She also takes responsibility for all the legal work affecting the Association, lobbying on matters affecting the market and building key relationships with governmental officials and regulators around the world.

She previously worked in the energy and commodities industry on compliance, legal and regulatory matters. She read law at the LSE and is a qualified solicitor.