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Securities Financing Transaction Regulation

Securities Financing Transaction Regulation

The Securities Financing Transaction Regulation (SFTR) has not solicited a huge amount of attention from fund managers. This is understandable given most firms have been busy implementing the Alternative Investment Fund Managers Directive (AIFMD) and the European Market Infrastructure Regulation (EMIR) or getting up to speed with the requirements laid down by the soon to be enacted Markets in Financial Instruments Directive II (MIFID II).  SFTR is a regulation though that fund managers should take note of.

SFTR was published in the Official Journal of the European Union (EU) in December 2015 and came into effect on January 12, 2016. Compliance, however, is being phased in as the European Securities and Markets Authority (ESMA) is presently debating the Level 2 technical standards. The precise deadlines for the phase in for fund managers is not yet known although it is expected to occur at some point in 2016 or early 2017. The implications of SFTR should not be underestimated.

SFTR is in part a replication of EMIR, which was introduced in February 2014 and forced financial institutions to report details about their over-the-counter (OTC) and exchange-traded (ETD) derivative transactions to ESMA approved trade repositories (CME Trade Repository, Depository Trust & Clearing Corporation [DTCC], ICE Trade Vault Europe, KDPW, Regis-TR, UnaVista). The difference being is that SFTR forces firms to report details of their securities financing transactions (SFTs). This is all part of European regulators’ clampdown on potential risks in the shadow banking system.

  What are SFTs under SFTR?

         

Repurchase transactions for securities, commodities and guaranteed rights; Lending and borrowing transactions on securities and commodities; Buy-sell backs and sell-buy backs of securities, commodities and guaranteed rights; Margin lending transactions – extending credit in connection with the purchase, sale, carrying or trading of securities – but not other loans secured by collateral in the form of securities; liquidity swaps; collateral swaps

What is not an SFT under SFTR?

 

Any derivative contract as defined by EMIR

[1]

That SFTR is modelled on EMIR raises a number of questions. Derivative trade reporting under EMIR has been in train for two years now yet trade repositories are still struggling to reconcile reported derivative transactions. This is because ESMA demanded there be dual-sided reporting under EMIR – I.E. both counterparties to a derivative transaction must report details of that trade to the relevant trade repository.

As part of the reporting process, a counterparty must generate what is known as a Unique Trade Identifier (UTI), a bespoke alphanumeric code that helps trade repositories reconcile reported trades. The flaw in this process was that ESMA did not elaborate on which counterparty to the trade creates the UTI. Inevitably, both counterparties to derivative transactions developed UTIs, which frequently were not harmonised but completely different. This made it challenging for trade repositories to reconcile trades. As such, regulators are still unable to glean from the trade repositories whether there have been major build-ups of systemic risk in the derivatives markets.

 

ESMA has confirmed SFTR reporting must be dual-sided and carried out on a T+1 basis. European regulators have been advised to follow the example set by the Commodity Futures Trading Commission (CFTC), which under the Dodd-Frank Act, permits single-sided reporting of derivatives to swap data repositories (SDRs). European officials, however, have repeatedly said that it is the responsibility of market participants to resolve the on-going issue around UTI generation around EMIR. Nonetheless, European regulators have confirmed they will revisit the issue of whether to introduce single-sided reporting for SFTR after two years of the rules being implemented.

As with EMIR, fund managers can delegate SFTR reporting to third parties such as fund administrators or technology vendors although this cannot obviate the fund manager from responsibility for inaccurate reporting and records of SFTs must be maintained for five years after the contract has terminated. The Clifford Chance paper adds that SFTs with non-EU counterparties which are not subject to SFTR will still have to be reported. This obviously raises issues around extraterritoriality.  The only exemptions to SFTR reporting have so far been granted to European Central Banks, the Bank for International Settlements (BIS) and EU public bodies managing public debt.

SFTR also introduces enhanced transparency for managers of UCITS and Alternative Investment Funds (AIFs). SFTs and total return swaps must be disclosed in their bi-annual and annual investor reports as mandated under UCITS IV and the Alternative Investment Fund Managers Directive (AIFMD) as regulators feel these transactions can increase the risk-profile of the fund vehicle.  Investors must also be notified about SFTs and total return swap usage in any prospectuses. ESMA has yet to announce the exact details, but a legal brief by Freshfields believes the following will likely need to be disclosed to investors at the minimum.

Information likely to be reported to AIFM and UCITS investors

  1. Amount of securities and commodities on loan as a proportion of total lendable assets
  2. Amount of assets engaged in each type of SFT and total return swap expressed as an absolute amount and as a % of the fund’s total Assets under Management (AuM)

 

[2]

Other transparency obligations surround the re-use of collateral. Firms must notify clients about the risks associated with collateral re-use and solicit written consent and agreement from investors explicitly allowing the re-use of collateral. This again could be an operational headache for fund managers, and some believe it could be a precursor to a further regulatory clampdown on re-hypothecation practices. In the US, collateral re-use is capped at 140% of client liabilities by the Securities and Exchange Commission (SEC). European regulators have discussed the possibility of a hard and fast cap on re-hypothecation in the past, and such action should not be ruled out.

The consequences of infringements to SFTR are tough. A legal update by Dechert in December 2015 said firms could be fined up to €5 million or 10 per-cent of their total annual turnover for SFTR reporting requirement infringements. In the event of transgressions around the re-use of collateral, the sanctions could be up to €15 million or 10% of total annual turnover.[3] As such, firms need to make sure that they fully comprehend the rules and have adequate systems and processes to deal with SFTR and its requirements.

 

 

[1] Clifford Chance –“The SFTR: New Rules for Securities Financing Transactions and Collateral” – January 2016

[2] Freshfields – The Securities Financing Transaction Regulation  - November 2015

[3] Dechert – New EU Regulation on Securities Financing Transactions and Reuse of Collateral – December 2015