US financial infrastructure giant, The Depository Trust & Clearing Corporation (DTCC), has flagged ‘green bonds’ as a potential market risk, calling for equal treatment of the sustainability-linked fixed income instruments in the capital stack.
In a new paper outlining climate change risks for financial market infrastructure (FMI) providers, DTCC says while green bonds have a useful role to play “these instruments should not be given preferential treatment if used for collateral purposes or in terms of how they are otherwise risk managed”.
Michael Leibrock, DTCC chief systemic risk officer, said in a statement that favouring green bonds would “in our opinion, would be to prioritize environmental considerations above the core mandate of FMIs of ensuring a resilient post-trade infrastructure for the securities industry”.
For instance, the white paper says central counterparty providers (CPP) should not be compelled to grant “collateral haircuts” to green bonds.
“… CCPs should not be required, either directly or indirectly, to trade-off appropriately addressing market and liquidity risks, to address climate-related risks.”
Green bond issuance has been growing rapidly over the last few years as part of a broader sustainable investment trend that is showing bubble tendencies, according to the DTCC paper.
“The creation of a so-called ‘green bubble’ is a potential unintended consequence of the success of green bonds that should be monitored as it might pose certain risks,” the report says. “The lack of standards around green bonds may be another problematic area. That said, green bonds still represent a very small percentage of the overall debt market – albeit one that is growing significantly.”
But overall the DTCC paper suggests FMIs – the small group of firms responsible for the smooth functioning of financial markets – should take climate change physical and transition risks into account.
Considering the short-term risks involved in settlement processes and indirect exposure to longer-term effects, however, the paper says current regulatory standards are sufficient for FMIs in reporting climate-related issues.
“Given that transition risk takes several years, if not decades, to materialize, it can reasonably be expected that financial institutions will have considerable time to manage their second-order exposure to these types of risks,” the report says. “As such, it seems unlikely that a (large) financial institution would fail due to the potential second order impact of transition risk. It is therefore equally unlikely that FMIs would be impacted by any meaningful third-order effects of transition risk that would be transmitted due to the failure of a financial institution.”
Furthermore, DTCC argues against rigid climate scenario reporting rules for FMIs. Some regulations, including the imminent NZ regime, require financial entities to report on risks across several climate scenarios, typically described in temperature change terms.
“… we think it appropriate for regulators of FMIs to consider using climate scenario analysis to identify potential exposures of FMIs, but not use these results to prescribe specific regulatory responses beyond those otherwise required by applying the existing [regulatory] approaches to managing those risks relevant to the functioning and operations of an FMI,” the paper says.
The US-based DTCC manages the background processes of many global financial systems, processing more than US$2.4 quadrillion of securities in 2021 while providing custody and other services to more than US$87 trillion of assets across 177 jurisdictions.