Balance sheet measures of leverage in the investment fund sector are misleading, according to ECB officials, due to a failure to capture effective leverage created synthetically through derivatives exposures or repo and securities lending transactions.

The latest paper from the central bank, which looks at systemic risks thrown up by the recent expansion of the investment fund sector, suggests securities financing transactions remain “under the radar” at present.

“Derivatives and securities financing transactions create contingent liabilities, which will become material if either a position creates a loss or margins are raised,” said the study, co-authored by Lieven Hermans, principal financial stability expert at the ECB and Christian Weistroffer, a senior economist at ESMA.

“Those liabilities do not necessarily show-up on balance sheets ex ante, however, they do add to overall risk.”

Concerns are that liquidity risk-taking, such as in securities lending or swap transactions, may further aggravate liquidity squeezes in a market downturn.

Authorities are currently addressing the acknowledged lack of transparency in securities finance transactions (SFTs), which include repurchase agreements and securities lending transactions.

Initiatives at global level as well as European regulations will also help the authorities identifying and managing risks in the financial system emerging from SFTs.

Current data availability, however, only allows for a limited monitoring of such activities, e.g.through market surveys.

“While limited balance sheet data suggest that vulnerabilities within the shadow banking sector are growing and links to the wider financial system and real economy are strengthening, data limitations prevent drawing a definitive conclusion on the systemic nature of the risks," added the study.

Experts at the ECB reckon additional balance sheet statistics for subcomponents such as SFTs are needed to draw firm conclusions.

In addition, the central bank suggests that monitoring based on an “entities-based approach” should be complemented by an “activities-based approach”.

That would encompass monitoring services related to securitisation transactions, securities financing transactions (repo and securities lending), collateral management services, or any economically equivalent functions through derivatives markets.

These activities will soon have to be reported under the European SFTR.