Securities Financing Transaction Regulation (SFTR) was published in the Official Journal of the European Union (EU) on December 23, 2015, landing it on the radar of market participants. The Level 2 technical standards are still being discussed by European regulators though, and while the implementation date is still unconfirmed, industry experts have told Global Custodian they expect the rules to come into force in 2018.
As such, compliance is some way away, but the impact it will have on financial institutions should not be underestimated.
SFTR forces firms to report information around their securities financing transactions (SFTs), such as repurchase transactions, any securities lending or borrowings, buy-sell backs, sell-buy-backs and collateral swaps such as total return swaps. Firms must report data on their SFTs on a T+1 basis to the six ESMA approved trade repositories. These are the Depository Trust & Clearing Corporation (DTCC), KDPW, Regis-TR, UnaVista, CME Trade Repository and ICE Trade Vault Europe.
“SFTR has not really been on the radars of many fund managers and we have only been fielding inquiries in the last few weeks. However, we anticipate the number of inquiries will increase significantly over time. One of the issues is that ESMA has not finalised all of the details yet, particularly around the reporting template. As such, it is very difficult for fund managers to prepare until they have the granular information around reporting,” said Abigail Bell, partner at Dechert in London.
One regulatory expert, speaking anonymously, said SFT reporting was mirrored on EMIR and likely to fall victim to many of the setbacks faced by EMIR. Perhaps the biggest issue for SFTR surrounds dual-sided reporting whereby both counterparties to a transaction report details of that trade. To enable trade repositories to match these trades, a counterparty must generate a Unique Trade Identifier (UTI), an alphanumeric code designed to enable trade repositories to reconcile reported trades. The generation of UTIs under EMIR has not been straightforward as there was little clarity from regulators in 2014 over which counterparty created the UTI. As such, both counterparties have generated UTIs under EMIR making it difficult for trade repositories to reconcile reported OTCs and ETDs.
Lessons to learn
“EMIR was introduced in February 2014 and nearly two years later, only a small proportion of OTCs and ETDs are being matched by the trade repositories. The majority are not being matched by trade repositories. This is because ESMA demands dual-sided reporting, which means both counterparties have to report. However, there has yet to be any clarity over which counterparty generates the UTI. As such, we have both counterparties to an OTC trade generating UTIs and these may not be the same code. This is a problem, and yet ESMA is still demanding firms undertake dual-sided reporting under SFTR. I believe the same issues that impacted EMIR will affect SFTR,” said the regulatory expert.
Camille McKelvey, product management & trade matching, Trax, believes however that some of the problems with EMIR can be avoided, despite the similarities.
“If you look at EMIR there are some lessons we can learn. Firstly it is important is that everybody understands what is and what is not in scope, and do this before the go-live date,” says McKelvey.
“With SFTR you want to do it the other way round to EMIR. So you send your trade, match it, get confirmation and then we (both parties) submit – after confirming – it to the TR. Whatever we have submitted is what we both know and we have a common UTI. If we go towards that model, then this will mean a much smoother transition. It is the data quality that is very important, nobody wants more fines.”
Some have urged ESMA to adopt the stance embraced by the Commodity Futures Trading Commission (CFTC) which allows for single sided reporting of derivatives to swap data repositories (SDRs). The inability to match derivative transactions at an EU trade repository level means that build-ups of systemic risk in the derivatives market are potentially going un-checked by regulators. Daniel Jordan, associate at Dechert, said there was an explicit reference in the regulation that ESMA must report on the appropriateness of single-sided reporting within 24 months of SFTR coming into force. As such, there is a possibility that single-sided reporting could be introduced in due course.
SFTR data reports will include information around SFT counterparties, the principal amount, currency and assets used as collateral and whether that collateral is available for re-use.
“Counterparties to SFTs need to expressly agree to the reuse of collateral – although this is often likely to be met by existing contractual arrangements – and the collateral provider should be informed of the risks and consequences of consenting to such reuse,” says Stephen Kiely, head of securities finance new business development, BNY Mellon.
Kiely also emphasised the importance of getting these data reports right. “The reporting requirements are quite extensive and will require the counterparties to determine how they will source the necessary information, who they will provide the information to, and how,” he adds.
“While the reporting itself is not complex, SFT counterparties need to be certain that the data is available and accurate.”
SFTR also imposes additional disclosure obligations on managers of UCITS and Alternative Investment Funds (AIFs), which the policy expert described as onerous. It is believed service providers who undertook delegated reporting under EMIR will assist with SFTR reporting. “The majority of vendors offering delegated reporting will probably assist with SFTR although there are questions over who will take liability and will there be an increase in fees for providing such a service,” commented Bell.
Investors must be notified by AIFMs and UCITS about how SFTs and total return swaps are used in their portfolios in bi-annual and annual reports, as well as prospectuses and pre-contract documentation. This will include information about the absolute amount of assets engaged in SFTs and total return swaps, and how much this makes up of the fund’s total assets.
SFTR also seeks to improve transparency around the re-use of collateral. Again, firms must obtain written consent and agreement from clients permitting the re-use of collateral. Furthermore, clients must be made fully aware of the risks that collateral re-use can entail.
“SFTR is interesting because conceptually they have brought out the regulation for transparency. It isn’t something that we have been used to in this market,” said McKelvey, referring to the repo and securities lending markets.
“The regulators want to understand where the collateral goes. Billions and billions of securities get moved around every day and they want to keep track of where it goes.”
The reporting obligations will require firms to build new systems and processes, and this will add to the workloads of asset managers. However, this might not be too onerous. “When collateral is posted to a counterparty such as a prime broker, it is done so based on the principle of title transfer. In other words, the counterparty has a right of re-use. As long as the re-hypothecation practices are outlined in the hedge fund-investor agreement, then that should be satisfactory,” commented Bell.
There is speculation as to whether this will herald a further EU-wide clampdown on re-hypothecation. Regulators have made it no secret they wish to clamp-down on certain shadow banking activities, and there is speculation the EU could introduce limits around the amount of assets that can be re-hypothecated in line with practices adopted by the Securities and Exchange Commission (SEC).