By Joe McHale, Regulatory Affairs Specialist for Bloomberg in EMEA
By Joe McHale, Regulatory Affairs Specialist for Bloomberg in EMEA.
Though the smoke from MiFID II implementation has barely cleared, one of the next regulatory challenges facing firms operating in the EU is already on the horizon: the Securities Financing Transaction Regulation (SFTR). The rules aim to increase transparency on the use as repos and stock loans, and on the risks around entering collateral arrangements.
Having been dormant for over a year as detailed implementing rules awaited endorsement by the European Commission, SFTR sprang back to life this summer; the Commission informed ESMA of its intention to endorse the Regulatory Technical Standards published in March 2017 but only if ESMA would make certain changes first. ESMA however declined to do so the ball is now back in the Commission’s court.
Who is impacted and how?
Following the financial crisis, regulators were concerned that the same piece of collateral was being used multiple times as part of transaction chains, leading to a buildup of leverage, which could complicate reliance upon such collateral in times of financial stress. They were also worried that collateral providers might not understand all the risks involved in entering collateral arrangements and allowing its reuse.
Under the new rules firms that enter into collateralized transactions such as repos, securities or commodity lending or borrowing transactions as well as margin loans and total risk return swaps need to comply with SFTR. Both financial and, ultimately, non-financial companies will be required to report such transactions to approved trade repositories.
This doesn’t represent a small or niche market by any means.
Moreover, SFTR will not only extend reporting requirements, but it will also directly impact trading and collateral management. If it ever truly was previously, collateral will no longer be completely fungible. And that will have practical trading and process implications.
Indeed, some elements of SFTR are already in force; Collateral providers must be made aware of the risks involved in allowing collateral to be reused. For example, when a ‘pledge’ is used – whereby the counterparty lends the collateral but retains ownership – explicit consent must now be given if the receiving party wishes to use the collateral as part of another transaction with a third party.
Also in force already are the requirements which increase the disclosure obligations for funds – such as managers of UCITS and alternative investment funds – regarding their use of SFTs in periodical reports for investors.
Are you ready for the reporting rules?
The Commission is now expected to move forward with formal adoption of the rules despite ESMA’s objections, and as reporting starts one year after, this could mean that reporting goes live in Q4 of 2019 or Q1 of 2020.
While the draft reporting rules are still draft, they are already quite familiar. They have been available for over a year and many of the rules were cut-and-pasted – some of it literally – from the European Market Infrastructure Regulation (EMIR), which requires reporting of all derivatives to Trade Repositories (TRs).
As with EMIR, dual reporting applies, i.e. if both counterparties are based in the EU then SFTR requires both of them to report to TRs by close of business the next day. The challenges of this process under EMIR – which include transaction reconciliation despite the lack of unique product identifiers – led some market participants to hope SFTs would be subject to simpler reporting standards.
However EU policymakers took the view that such matching issues stemmed from organizations’ compliance and reporting failures—and the market should improve such general standards rather than expect watered down standards.
Many institutions may be able to realize operational leverage from using solutions developed for EMIR and MiFID II. Additional infrastructure may therefore be more evolutionary than revolutionary. As often with increasingly prescriptive regulation, organizations benefit from using unified, real-time reporting systems.
Watch out for extra-territorial issues
While SFTR is part of a global commitment towards greater transparency in the SFT market, the European approach remains, at least to date, relatively prescriptive. It is not clear that the US or Asian jurisdictions will ever consider the TR reporting route for SFTs.
This, of course, raises extra-territorial issues for European-based counterparties and could impact current market practices and flows. For example, SFTR requires entities operating in the EU to report all SFT trades with non-EU central banks, which would lead to the European regulator having visibility on potentially sensitive trades – such as repos – that are part of a sovereign nation’s monetary policy. It remains to be seen if this affects the choice of counterpart of such central banks.
