The first Securities Financing Transactions Regulation was published in November 2015 by the European Commission as a response to increase the transparency in the use of securities lending and repo and reverse repo markets. It was also a partial answer to the calls made at times by the FSB and ESRB to reduce the risks in the shadow banking sector. This ambition is intended to be satisfied by introducing new reporting requirements for securities financing transactions not dissimilar to those introduced long ago to derivatives transactions under EMIR.
In Europe, shadow banking has bloated once again to a somewhat scary proportion (though it has yet to reach its 2008 size) and since the last crisis, we are all aware that not only is it closely linked to the regulated financial sector, but also that, if anything, in the times of economic distress, it becomes even more closely linked to it. The pre-2016 European Union also offered the institutions engaged in shadow banking an ample regulatory arbitrage opportunity.
Whereas the SFTR has applied since January 2016, its effective application was hindered by a lack of supervisory technical standards: The regulatory piece has been lying dormant since March 2017 as the European Commission could not reach an agreement with the ESMA on several topics and, in the middle of a large number of other reforms, the SFTR was frankly probably not the Commission’s biggest concern. Whilst (at the time of writing) not fully effective, the Commission has already endorsed a number of rules and their entering into force seems to be only a question of time (and not very much of it at that).
The regulators hope that the regulation will lead to increased transparency, which in turn is crucial for regulators (as well as the institutions) to understand both the developments and shifts in the market as well as the risks therein. More specifically, the European Commission hopes that the regulatory framework will improve the transparency in the following ways:
The scale of application of this regulatory piece is fairly large; the reporting requirements in particular will apply to all European Union entities, whether the transactions take place in or outside the EU. Furthermore, all entities that have a branch in the EU also have to report on all transactions of that branch, whether or not they take place in the EU. To give a complete list, the regulation applies to:
It has been noted that a number of foreign supervisory entities and central banks may take exception in this as it may lead to the EU institutions getting information that may be regarded as strategically important.
Securities Financing Transactions occur when financial securities are used as a collateral or in other ways as a means for an institution to gain or facilitate an access to a channel to borrow cash. A specific example of SFTs provided by the European Commission are:
A simplified way of thinking of SFTs is that it is a roundtrip of exchanging money for security and then exchanging that same security back for the money (plus some premium), effectively resulting with both institutions being reverted to their original state – with one party securing itself a loan with which to finance some new projects and the other receiving a premium along the way and the financial instrument effectively working as a collateral.
From a regulatory standpoint, the derivative contracts that are covered by EMIR are not Securities Financing Transactions as their inclusion in EMIR renders SFTR redundant. However, transactions that are commonly referred to as liquidity swaps and collateral swaps (which do not fall under EMIR) are considered to be SFTs.
For investment funds in particular, the SFTs and total returns swaps are used to the procurement of funds for new investments and to enhance returns. In doing so, the investment funds take on additional risks (counterparty and liquidity risks at the very least).
All European entities, and those operating in Europe, whether financial or non-financial, will have to report on their SFT’s. The two exceptions to this rule are the small- and medium-sized enterprises who need not to report on the transactions with financial companies, but only because the financial counterparties themselves are obliged to do the reporting. The central banks, BIS and other similar national/supranational institutions are also exempted. This information will be accessed by and will inform policies of the national competent authorities and the central banks as well as the ESRB and ESAs.
The reporting requirements are very similar to EMIR, so there could be a suspicion of creeping attempts to extend the EMIR framework to all of the SFTs; whilst not yet published in their final form, the reporting rules are said to be cut-and-pasted – some of them literally – from EMIR. The reporting framework under SFTR certainly borrows heavily from EMIR; the process itself too is very similar: The counterparties to SFTs will report the details of the transactions to a trade repository. The main supervisory burden over this process will be shouldered by the ESMA which will also further specify it with guidelines and technical standards, particularly on reporting procedures, access to data procedures and registration procedures for trade repositories.
What we so far know points to a major similarity with EMIR, both procedural and material. The institutions that have a previous experience with EMIR thus have a substantial advantage in implementing SFTR. The institutions that do not may save themselves a lot of pains, trouble, costs and uncertainty by enlisting the help of institutions that do.
The tables below show the main high-level similarities and differences between SFTR and EMIR reporting requirements:
|High level differences||SFTR||EMIR|
|Asset classes covered||Securities financing transactions - Repurchase transactions, securities lending or borrowing transactions, buy-back/sell back transactions and margin lending transactions.||Derivatives (OTC and ETD) in equity, credit, interest rates, foreigh exchange and commodity.|
|Branch obligation||The EU branches of non EU entities have the obligation to manage the reporting.||Branches do not need separate LEIs from headquarters (a head office level is requested)|
|Territorial scope||EU counterparties, non-EU branches of EU firms and EU branches of third-country firms.||EU counterparties|
|Content and structure of data||153 fields across four categories: margin data, transaction data, re-use data and of course, counterparty data.||129 fields from three categories: counterparty data, collateral data and common data.|
|High level similarities||SFTR and EMIR|
|Counterparties in scope||Financial and non-financial|
|Trade repository||ESMA licenced Trade Repository|
|Data management||Counterparties need to keep the details of the transaction for at least 5 years.|
|Delegation||The delegation of the reporting can be agreed with the counterparty or with a third party provider.|
As a company that already has ample experience with helping institutions to cope with similar EMIR-related requirements, we identify the following three as the chief challenges that this regulatory piece poses to all institutions:
The first challenge is the sheer scope of the regulation – time and again we have requests of institutions that are not clear on what their EMIR supervisory requirements actually are. We feel that this may be similar with SFTR. The institutions are again and again required to go through hundreds of pages of regulatory content in order to understand what is actually required of them. It is important to note that their raison d'être is primarily something completely different than studying regulators’ whims. And those rules are complex! It will be a challenge for institutions to identify what rules specifically apply to them and to their assets. What data must be disclosed and from what sources? The disclosure of what information is optional and mandatory? If anything, the novelty of the new rules (and in part also the confusion raising from their similarity to EMIR) may be very pronounced at the beginning of the application of these rules. Whether having to perform a legal analysis on their own, enlisting someone else’s service, following rules they need not follow or (god forbid) regulatory fines, this is going to be a very crucial and potentially costly step.
The second challenge will relate to the data necessary to be reported; their required granularity will oblige the institutions, particularly smaller ones with limited access to the data, to pool the data from various different sources. Finding the appropriate data sources and making the information from them comparable will often prove challenging.There is a silver lining to this challenge: the data required should be such that the institutions should really be able to find them. If the required data is unavailable or is of dubious quality, then that alone should raise some serious red flags regarding these transactions. Perhaps that alone will stop some institutions from making some bad decisions.
The third challenge arises from the requirement for each counterparty to manage the reporting on their own side (it does not apply to small and medium enterprises’ transactions with financial companies). As, in part due to the first challenge, a number of aspects of SFTR will be understood, or interpreted, differently, there will be a strong need for reconciliation between the two reports. Even after years of EMIR being put to practice, this still happens fairly regularly with EMIR reporting. Due to the novelty of SFTR however, we can expect that to be much more of an issue at the beginning of the regulation coming into practice, because a common understanding of it is not going to be quite as strong. Bear in mind that the relatively large number of files (129) on which the counterparties need to agree may also contribute to the number of instances where the counterparties disagree in at least one point.
In the case of funds, there is also a requirement to provide the relevant data on SFTs to the investors. These requirements are different from those for the supervisory authorities. Investors should not be overloaded by a score of information on each transaction, but a more high-level, aggregate and concise report should instead be provided.
Reuse is the act of (predominantly financial) entities using the assets that they received again as a collateral (or in a similar manner) to procuring themselves an access to funding, effectively creating a chain of ownership, a chain of obligations and, naturally, a chain of risks. The ownership of the asset from the party in the centre is replaced by a contract to return an equivalent asset, which in effect is not much better than an unsecured transaction. It also means that a similar instrument secures multiple obligations, which makes to some degree all parties involved dependent on each other, thus increasing the interconnectedness of the broadly practised reuse of financial assets in the financial markets. It is important to note that these complex chains, and sometimes even webs, have a great potential to remain hidden from regulators, investors, other market participants and even their counterparties themselves, which justly creates concerns.
The regulation seeks to harmonise the European regulatory endeavours regarding reuse: It does so by providing four criteria that serve as minimum requirements (but national and European authorities are free to demand more stringent requirements):
As a regulatory piece, SFTR technically already applies almost in its entirety since early 2016. This pertains particularly to the disclosure requirements and the reuse agreements that are already in use since then, but they do not seem to provide too much potential challenges to our clients and are therefore mentioned only briefly.
Reporting requirements are slightly more problematic: The reporting cannot be done without clarifying the exact information that needs to be reported. The implementation of this part of the SFTR is thus conditional on the release of various technical standards.
When the regulation was released in autumn 2015, it was not expected that the Commission was going to stall quite so much to endorse the technical standards that were duly released early 2017. The Commission however took steps to endorse them only in autumn 2018, and that with the condition of the ESMA making some changes, which the ESMA refuses to do. Likely due to these differences, the European Commission has extended its scrutiny session for the RTSs to six months instead of three. This would postpone the implementation date of these requirements for credit institutions and investment firms to Q3 2020 (giving them 12 months to implement reporting). CCPs and CSDs would have an extra 3 months, pension funds, insurance/reinsurance companies, AIFs and UCITS an extra 6 months and non-financial counterparties an extra 9 months – or so it is believed.
In truth, nothing regarding the timing of the implementation of these technical standards went as expected, and it is conceivable that the institutions will change our expectations yet again. However, major changes with regard to the content of these RTSs seem unlikely, as it remains constant and has been disclosed to the public since early 2017.
Whenever the technical standards come into effect, we can be quite sure that they will come into effect one day, and what their content is going to be is quite clear. All institutions are thus advised to keep an eye on these, and prudent institutions may already contemplate the best way to implement them, using their own EMIR-related experience or (if they lack such) seek the counsel of some firm that has it.