Proposals to reduce risk in the repo market could end up achieving the opposite, experts warn. The repo, or repurchase, market allows financial institutions to borrow cash by pledging securities as collateral. Because it offers secure borrowing, the €6 trillion ($8 trillion) European repo market helped prevent a new credit crunch in the region. “Regulation has pushed the unsecured market to the grave, so the secured market, including repo, is how lenders transact now to protect themselves from counterparty risk,” says Godfried De Vidts, the London-based chairman of the International Capital Market Association’s European Repo Council. Tougher capital requirements for unsecured loans have increased their cost to lenders.

But the Financial Stability Board, which recommends global reforms to Finance ministers and central banks, has put forward tough new repo regulations. The Basel, Switzerland–based FSB published its initial proposals in November, with final recommendations scheduled for September 2013. The most hotly debated proposal is for minimum “haircuts.” A haircut is the extra value of collateral pledged for a cash loan in the repo market. A haircut of 10 percent on collateral with a market value of $100 million, for example, lets the counterparty putting up the collateral borrow $90 million.

In its November report the FSB, which declined to comment, said minimum haircuts could “limit the build-up of excessive leverage.” The board calls for minimum haircuts of up to 16 percent for long-dated securitized products, even larger haircuts for equities outside major indexes and smaller ones for sovereign bonds.

The FSB aims to limit risk for the cash lender. But “what people are forgetting is that the haircut poses a risk on the other side,” says Staffan Ahlner, London-based head of global collateral management at Bank of  New York Mellon Corp. Ahlner points out that a compulsory 1 percent haircut on $100 million gives the institution pledging the collateral for cash $1 million in exposure to the cash lender. “If this exposure is to a bank, it might be manageable, but if you’re giving it to a lightly regulated hedge fund, it becomes a mandated unsecured exposure to a counterparty,” he warns. As counterparties respond to this risk, “some institutions will find it harder to borrow cash because of the credit risk, and some institutions will not be able to borrow at all,” Ahlner adds.