The Bank of England’s deputy governor has issued a warning that the burgeoning liquidity swaps market could pose too much of a threat to the financial stability of U.K. markets.

Paul Tucker, who is also a member of the nine-man Monetary Policy Committee that sets U.K. interest rates every month, told a London insurance gathering this week that he has concerns that the invisibility of the market—in effect, insurance firms that are building ‘shadow banks’ within their organizations—could pose systemic risk.

The shadow banking system is a term for the collection of financial entities that support financial transactions that occur beyond the reach of existing regulations.

Liquidity swaps, also known as collateral swaps, arise when an insurer exchanges high-quality liquid assets such as gilts with less liquid assets such as asset-backed securities held by banks. The deal allows the bank to boost its stock of liquid assets to use as collateral while the insurer receives a fee for lending out the more liquid asset.

However, problems can occur when the bank uses the securities in question to secure overnight loans in the money markets and then fails to tell the insurer that the collateral has been lent out.

“Nothing must be done to jeopardize the essential functions of securities lending,” said Tucker. “But [it’s the Bank’s desire] in line with our traditions, [we need] to find market-led solutions where we can.”

Tucker highlighted the need to put some structure around the market, and hinted at introducing a trade repository, where all transactions are recorded, that would make the market easier to monitor and regulate. It would also prevent the same securities from being lent to several places at the same time.

The Bank of England will become the main regulator in the U.K. from next year when the Financial Services Authority is scrapped. While Tucker is also chair of the Committee on Payment and Settlement Systems, the global rule-setter for clearing, and his views on trade repositories may yet have a more global reach.

Last week, the FSA issued new guidance on liquidity swaps saying that it now sees a role in the market for such transactions on a sensible scale providing risks are properly identified and managed by both parties. Previously, the FSA had shown concern at the rise in the practice.

However, despite wanting tougher regulations to be introduced for liquidity swaps, Tucker is dismayed over the new Solvency II rules—a European Union directive—for insurers.

Tucker says the new capital requirements that insurance companies are likely to have to hold from 2014 to reduce the risk of insolvency will prove onerous on insurers.

“I am dismayed by how much it is costing the industry and regulator [the FSA] to adapt to Solvency II,” he said. “Like the initial attempts at Basel II [a global regulatory standard on capital adequacy rules] for banks, it risks being too complicated in its desire to introduce a ‘risk sensitive’ regime. We need to be wary of regulators drowning in masses of data going beyond anything they can get their hands round. Unless we are careful, it risks distracting supervisors from the big risks.”

Global insurer Prudential, which has its headquarters in the U.K., this week issued a warning to the EU that it will have to move its base from London to Asia in a bid to avoid Solvency II.

“Fighting US competitors who don’t have to worry about Solvency II; we just won’t have a market, we won’t be able to sell any products at all,” said Tidjane Thiam, chief executive of Prudential.

Netherlands-based insurer Aegon has also warned that it might be force to leave the EU over the directive.