Preparing for SFTR

One of the potential risks associated with the series of regulations introduced following the financial crisis was that systemic vulnerability would be moved from banks, mutual funds and insurance firms and shifted into new corners of financial markets. Specifically, the realms of non-traditional credit intermediation known as “shadow banking" Shadow banking comprises activities involving some element of maturity and liquidity transformation, credit extension, and risk transfer, conducted partly or wholly outside the “traditional” banking system. It covers a wide range of activities, including securitization, repos, and money market funds as well as some activities of non-bank financial institutions such as finance companies and credit hedge funds.

Source: https://www.bis.org/review/r130628g.pdf, the chains of collateral that post-crisis regulation mandated for many large transactions, as well as clearing houses and trade reporting repositories.

The European Union (EU) introduced the Securities Financing Transactions Regulation (SFTR)SFTR entered into force on January 12, 2016, as part of the European Union’s efforts to mitigate the risks of shadow banking and to improve transparency in the securities financing transactions market.

Source: RBC I&TS Regulatory Update, November 29, 2016 in late 2015 to address this risk.¹ The European Securities and Markets Authority (ESMA) published draft technical standards to give effect to SFTR in March 2017. In a recent communication² the European Commission (EC) indicated its willingness to accept those standards, with some minor revisions. In practice, this means SFTR will likely come into effect at the end of 2019 or early 2020.

A regulation with sweeping, global reach

The broad objective of SFTR is to improve transparency and monitoring in the securities financing marketSecurities Financing Transactions are transactions where securities are used to borrow cash, or vice versa and includes repurchase agreements (repos), securities lending activities, and sell/buy-back transactions.

Source: https://www.lseg.com/markets-products-and-services/post-trade-services/unavista/regulation/securities-financing-transactions-regulation , which covers collateralized transactions such as repurchase agreementsIn a repo, one party sells an asset (usually fixed-income securities) to another party at one price at the start of the transaction and commits to repurchase the fungible assets from the second party at a different price at a future date or (in the case of an open repo) on demand. If the seller defaults during the life of the repo, the buyer (as the new owner) can sell the asset to a third party to offset his loss. The asset therefore acts as collateral and mitigates the credit risk that the buyer has on the seller.

Source: https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/1-what-is-a-repo/ or repos, stock and commodity loans as well as margin loans A margin loan is a loan from a broker to a client that functions as a margin account. The client may use the funds for any purpose and usually secures the loan with securities.

Source: https://www.occ.treas.gov/topics/credit/commercial-credit/margin-loans.html and total risk-return swaps A total return swap is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets for periodic cash flows, typically a floating rate such as Libor.

Source: https://www.bis.org/publ/work343.pdf. This is not a peripheral or niche concern. The latest International Capital Market Association survey sets the baseline size for the European repo market alone at EUR 7.25 trillion.³ This is the largest figure recorded since the survey began in 2001, a testament to the growing post-crisis importance of repos as a mechanism to move collateral around the financial markets.

SFTR is exceptionally broad in scope. It applies to both financial and non-financial entities which are either established in the European Union (EU), including all branches irrespective of location, as well as all entities that are established in a third country, where SFTR is concluded in the operations of a branch of that counterparty in the EU. Notably, central counterparty clearing houses (CCPs) A CCP is a financial market infrastructure that stands between buyers and sellers in financial transactions, ensuring that obligations will be met on all contracts cleared through the CCP. By managing and mitigating counterparty credit risk, CCPs have the potential to reduce systemic risk, thereby reducing the potential for financial shocks to be transmitted throughout the financial system and supporting the ability of markets to remain continuously open, even in times of stress (Chande, Labelle and Tuer 2010).

Source: https://www.bankofcanada.ca/wp-content/uploads/2012/12/fsr-1212-chande.pdf and central securities depositoriesA CSD is an entity which provides a central point for depositing financial instruments (“securities”), for example bonds and shares. CSDs’ clients are typically financial institutions themselves (such as custodian banks and brokers) rather than individual investors.

Source: https://ecsda.eu/facts/faq are also within the scope of SFTR.

A new era of consent and disclosure for collateral reuse

The most important components of SFTR concern disclosure around the use of collateral and strengthened trade reporting requirements. Following the financial crisis, regulators became concerned that the same piece of collateral was being used multiple times as part of transaction chains, leading to a buildup of leverage. A further concern was that collateral providers might not understand all the risks involved in leaving their collateral open to reuse. Under SFTR, collateral provider counterparties will now be required to make explicit their consent for the reuse and rehypothecation of collateral by third parties.

When it comes to trade reporting, SFTR is structurally identical to the European Market Infrastructure Regulation (EMIR)The European market infrastructure regulation (known as ‘EMIR’), lays down rules regarding over-the counter (OTC) derivative contracts, central counterparties (CCPs) and trade repositories, in line with the G20 commitments made in Pittsburgh in September 2009.

EMIR aims to reduce systemic risk, increase transparency in the OTC market and preserve financial stability.

Source: https://eur-lex.europa.eu/legal-content/EN/LSU/?uri=CELEX:32012R064. Counterparties will be required to report to trade repositories the details of any lifecycle event of a securities financing transaction (SFT) on a T+1 basis, and to keep a record of all transactions that have concluded, been modified or terminated for at least five years following their termination. In addition, fund managers will need to disclose their use of SFTs in periodic reports to investors.

There remains some ambiguity around the requirement that SFT reporting must include legal entity identifiers (LEIs)The LEI is a 20-character code used to identify entities that enter into financial transactions.

Source: http://www.osc.gov.on.ca/en/Derivatives_legal-entity-identifier_index.htm for branches and unique transaction identifiers (UTIs)A key data element required for regulatory reporting purposes is the Unique Transaction Identifier (UTI), also known as the Unique Swap Identifier (USI).

Source: https://www2.swift.com/uhbonline/books/public/en_uk/us3u_20170720/con_488484882.htm . This will be clarified before the regulations comes into effect, though market participants will need to closely study the EC's final form wording to ensure compliance with any requirements on the inclusion of standard transaction and entity identifiers.

Keep your eye on the timetable

From the date the EC adopts the technical standards and those standards come into force, SFTR's reporting obligations will be phased in as outlined below:

If the regulation comes into effect in December 2018, investment firms and credit institutions will have until December 2019 to begin complying with their reporting obligations under SFTR.

It is important to note that SFTR is more than a simple trade reporting practice. Many institutions will realize operational gains by using solutions developed for EMIR and the second Markets in Financial Instruments Directive (MiFID II)The Markets in Financial Instruments Directive (MiFID) is EU legislation that regulates firms who provide services to clients linked to ‘financial instruments’ (shares, bonds, units in collective investment schemes and derivatives), and the venues where those instruments are traded. MiFID II is made up of MiFID (2014/65/EU) and the Markets in Financial Instruments Regulation (MiFIR - 600/2014/EU).

Source: https://www.fca.org.uk/markets/mifid-ii . While additional infrastructure may be more evolutionary than revolutionary, the new regulation will demand more than a simple replication of practices under EMIR and MiFID II. Firms both within and outside the EU will need to react promptly to put plans in place to ensure compliance with this next wave of European financial regulation.