High up in a New York City skyscraper, China’s biggest bank is playing in the shadows of American finance.

The prize for Industrial & Commercial Bank of China Ltd. isn’t stocks, bonds or currencies. It’s the grease in the wheels of all those markets: repurchase agreements.

By exploiting a loophole in rules intended to keep U.S. banks from getting “too big to fail,” the state-owned ICBC has become a go-to dealer in repos in just a few short years, alongside longtime powerhouses like Goldman Sachs Group Inc. The short-term loans allow investors to borrow money by lending securities, serving a vital role in day-to-day trading on Wall Street.

ICBC’s rise reflects not only China’s global ambitions in high finance, but also how post-crisis rules have let a whole host of new players profit from the murky world of shadow banking, largely beyond the reach of bank regulators. As big banks face tougher standards, they’re being replaced by brokers, asset managers and foreign firms like ICBC, which can use more leverage and take greater risks. That has some regulators worried non-bank lenders are once again emerging as a threat to financial stability, less than a decade after panic in the repo market wiped out Lehman Brothers.

“The concern is that non-bank dealers are becoming a larger part of the repo market,” said Benjamin Munyan, who specializes in shadow banking and regulation at Vanderbilt University’s Owen Graduate School of Management. “These intermediaries are outside the scope of our traditional Federal Reserve safety net.”

Unintended Consequences

In some ways, the development is emblematic of how steps taken to stamp out financial risk-taking in one area have created unforeseen risks in another. But it also highlights the willingness and ability of firms to jump through whatever holes regulators leave or create.

Alan Levy, who oversees the repo desk as chief commercial officer for ICBC Financial Services, the bank’s New York-based securities unit, declined to comment.

Read more: The repo market explained — a QuickTake

In a repo, firms borrow money by putting up securities like Treasuries as collateral. The cash can then be used to buy higher-yielding assets, something hedge funds often do. When the agreement expires, the borrower “repurchases” the collateral, paying interest to the lender. The process can be repeated over and over, boosting a firm’s leverage, as long as the assets backing the repo maintain their value.

During the credit crisis, reliance on such short-term funding helped bankrupt Lehman and imperiled the financial system. Bailouts put the biggest securities firms under Fed supervision as banks, and Dodd-Frank regulations forced them to shrink their assets. A key provision has been the enhanced capital requirements, which made it prohibitively expensive for large U.S. banks to warehouse low-yielding Treasuries and finance repos.

Unlimited Credit

“You had unlimited balance sheet years ago and almost unlimited credit extension,” said Russ Certo, head of rates at Brean Capital. “These factors are radically reduced.”

That’s opened the door for independent brokers and foreign-backed entities like ICBC’s securities unit, just as another set of regulatory changes turned a low-margin business — government debt-backed repo financing — into a more lucrative one.

Beijing-based ICBC itself has more assets than JPMorgan Chase & Co. and Goldman combined, but its U.S. banking operation is tiny — with only $2 billion of assets. And since the Fed’s costly capital requirements don’t apply to an overseas lender’s non-bank units until combined U.S. assets reach $50 billion, that’s given ICBC Financial Services an edge.

Using an accounting practice called “master netting,” ICBC has kept its U.S. assets below the threshold where extra costs kick in, even as its repo business expanded well beyond that.

Master Netting

At the end of last year, ICBC’s repo business, which deals almost exclusively in financing backed by Treasuries and agency debt, grew to $95 billion, its latest regulatory filing showed. That’s more than double the level in 2011, ICBC Financial Services’ first full-year of operation and puts the firm among the top 10 repo dealers.

But thanks to master netting — which lets firms deduct offsetting agreements known as reverse repos with the same client — the unit reduced its net reported repo to $29 billion. In fact, the amount of netting that ICBC does suggests many clients enter into reverse repo agreements to keep its assets and liabilities in check. The upside is that it gives ICBC the flexibility to offer more repo at lower prices than its American rivals.

Staying under the $50 billion level also lets ICBC take advantage of a discrepancy in how banks and securities firms are regulated. Unlike the Fed, the Securities and Exchange Commission’s capital requirements vary based on how risky the assets are and therefore impose minimal costs on repos backed by Treasuries. So as long as firms can avoid the Fed’s capital rules, they can boost leverage to generate bigger repo profits.

History Lesson

ICBC has done just that. ICBC Financial Services had roughly $260 in assets for each dollar of capital at the end of 2016 — over 10 times the leverage used by JPMorgan’s securities unit. (Both figures exclude subordinated debt, which would lower the ratios.)

Some experts in the securities industry say firms like ICBC simply bring borrowers and lenders together and can therefore use more leverage without incurring undue risk. But others such as Daniel Tarullo, who was the Fed’s top bank watchdog until April, say such repo arrangements may still pose a risk to the financial system.

ICBC got into the repo business in 2010, when it bought part of the Fortis Securities unit of BNP Paribas SA. It was part of a strategy to expand the bank’s global reach, according to David Caruso, a former Fortis executive who helped ICBC get up and running.

Profits from the unit, run by a group of veteran Wall Street traders, would help pay for ICBC’s build-out. In 2013, ICBC Financial Services became the first Chinese-owned member of the New York Stock Exchange. Last July, it registered as a U.S. investment adviser.

‘A Lot of Money’

“These guys at ICBC Financial Services have done this for a very long time,” said Caruso, who briefly led the unit. “They make a lot of money.”

The model has spawned copycats. Last year, two executives from ICBC’s repo desk, Peter Volino and Richard Misiano, left to set up shop at Daewoo Securities America. Volino told the Securities Lending Times at the time that it was “crucial” for the outfit, now called Mirae Asset Securities (USA), to have support of a non-bank parent as constraints increase on bank-owned firms.

Regulators have taken notice. During his time at the Fed, Tarullo repeatedly voiced warnings about shadow banking and the perils of “regulatory arbitrage” in the repo market. Facing pressure from the Fed, the SEC has also held discussions with the industry to cap the amount of leverage dealers employ.

The SEC’s own rule making might be exacerbating the problem. Implemented in October, a requirement to make the money-market industry safer has created trillions of dollars in demand for government bonds. Profits from government repos have soared, and as a result, non-traditional dealers like ICBC’s unit have positioned themselves as the middlemen between money funds that need the securities and hedge funds that need the cash.

“The big hedge funds and money-market funds don’t really have anywhere else to go,” said Scott Skyrm, managing director of fixed-income financing at Wedbush Securities.

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