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):
- The counterparty needs to give its consent for its assets to be reused;
- The institution wishing to reuse should disclose the potential risks and consequences, for example those in the event of default;
- There should be a prior written agreement;
- The financial instruments should be transferred from the account of the client or that of the counterparty (i.e. the reuse should not take place on the client’s or counterparty's own account).