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The Securities Financing Transactions Regulation (SFTR) is the EU’s answer to the Financial Stability Board’s policy framework for addressing shadow banking risks in securities lending and repo. The regulation is centred largely on transaction reporting, and impacts firms in the EU and beyond.
What is SFTR?
“The introduction of reporting for SFTs is significant,” says Pauline Ashall, capital markets partner at Linklaters.
The SFTR regime is equivalent to derivatives reporting introduced under the European Market Infrastructure Regulation (Emir) in 2012. There was no prior requirement to report these transactions. “It covers a very broad range.,” adds Ashall. This includes securities lending, repurchase agreements (repos), and collateralised operations that consist of a transfer of ownership.
SFTR will apply to the counterparty of any SFT established in the EU – including branches that fall outside of the region – if the transaction takes place in a branch based in a member state. It also covers the management companies of undertakings for collective investments in transferable securities (Ucits), Ucits investment companies and alternative investment fund managers (AIFMS).
Non-EU parties are also subject to the regulation if any part of the transaction involves work within an EU branch or using a financial instrument in the EU.
“SFTR is unique in that it introduces big changes around systems and controls,” says Catherine Talks, product manager at UnaVista, referencing the transparency requirements for investor protection. “SFTR requires firms to report in an accurate, complete way.”
As noted in Article 13 of the regulation, Ucits management companies, Ucits investment companies and AIFMs are obliged to inform investors on their use of SFTs and total return swaps. Information to be included in the Ucits prospectus and AIF disclosure to investors includes a general description of the SFTs and total return swaps used by the collective investment undertaking and the rationale for their use, as well as the overall data to be reported for each type of SFT and total return swaps.
Counterparties will also have to disclose the criteria used to select counterparties, collateral that is acceptable, collateral valuation and risk management. Inevitably, this makes for a lot of reporting.
How will this impact the market?
Ashall warns that, at present, the regime’s scope is grey around the edges, with questions remaining for commodity lending and margin loans in particular.
“Reporting requires an enormous system-build with a lot of repapering and documentation to agree on, as it’s not always clear who is responsible for what – for example, generating the unique transaction identifier (UTI),” she says.
Regardless, Ashall does not think the legislation will change what people are doing significantly in terms of driving market practice. “It’s more of a cost issue,” she adds, speculating that at the margin, the costs could push some smaller participants out of the market.
Effectively, firms will have to provide reports on a daily basis during the life of the transaction as changes occur, and adjust to 155 reporting fields,” she says.
UnaVista’s Talks thinks data is the biggest issue. “SFTR is written in a way that you won’t just need to know what you’re doing but also what your counterparty is doing,” she says. “It means that, in a number of circumstances, firms will have to reach out to counterparties and understand what they are doing. This ranges from UTI generation and dissemination to backloading techniques.”
What is the industry doing?
“I think the industry has evolved quite quickly,” says Talks, who adds that the European Securities and Markets Authority (ESMA) has been explicit about reporting action but not delegation, which although not ideal, does mean that firms have been able to adapt infrastructure to prepare for the reporting involved.
“In Emir we saw firms delegating to their counterparties – they may have eight or nine counterparties reporting to numerous trade repositories,” she says. “Oversight of that data held in so many different places can be complex. I’ve found that firms aren’t talking about electing to delegate their reporting for SFTR as they do not want to add additional fragmentation.”
There’s a general feeling that these rules are cumbersome. Jonathan Lee, senior regulatory reporting specialist in SFTR at Kaizen Reporting pointed out that firms are genuinely doing their best but have been repeatedly frustrated by rules that don’t reflect how the market functions and a lack of clarity and instruction about how to report certain transactions and lifecycle events.
What have been the key challenges for firms?
Ashall points out that the reporting of reuse of collateral received under SFTs is the source of many problems.
“This is especially the case where a financial counterparty is facing a small non-financial counterparty and is obliged to report for both parties,” she says. “The financial counterparty may not have access to the data on the non-financial counterparty that the financial counterparty needs to report.”
This is indicated in Article 4 (3), where the regulation states that the financial counterparty shall be responsible for reporting on behalf of both counterparties for an SFT, should the non-financial counterparty not exceed the limits of at least two of the three criteria as defined by Article 3 (3) of the 2013 Accounting Directive. These limits are: a balance sheet total of €20,000,000 ($21,945,100); a net turnover of €40,000,000 ($43,889,400); or a maximum average of 250 employees during the financial year.
Ashall adds that there are also issues relating to the timing for reporting lifecycle events. For example, if there is an amendment to a transaction, do you have to report at the time you agree the amendment, or when it becomes effective?
“In other words, whether you report on a contractual basis or an actual basis,” she explains. “One example is if the return leg of a SFT fails to settle on the day it should have settled. Esma says the SFT is to be reported as continuing, whereas the industry would say it has matured.”
What is the timeline?
As with other regulations, such as initial margin and Basel III, implementation has been spread out over different dates for different sized firms.
"SFTR is written in a way that you won’t just need to know what you’re doing but also what your counterparty is doing"
On April 11 2020, credit institutions, investment firms and relevant third country firms were originally required to start reporting SFTs. However, due to the Covid-19 outbreak, this has now been shifted to what was provisionally the phase two reporting start date of July 11 2020, when central securities depositories (CSD) and central clearing parties (CCP) will also need to begin reporting. Other financial counterparties will be expected to comply from October 11 2020; nonfinancial counterparties from January 11 2021.
By this time, the Brexit transition period will have come to an end. While no one is realistically expecting major divergence, some have their concerns.
“Most transaction documentation is based on English law, and that has not changed [as a result of Brexit],” says Dentons partner Michael Huertas. “However, French and German documentation may have to catch up to the standard of English-law governed documentation. This has not yet been the case, and there needs to be more dialogue between London and the rest of the EU.”
This is evidenced by the fact that, on the continent, there have been moves to create English law courts to maintain normality in the EU’s financial sector. In 2018, the International Chamber within the Paris Court of Appeal was formally created. It is speculated that the chamber has been opened to lure EU banks and financial services who would have previously settled commercial disputes in London. It will be a case of wait and see as to whether this is a success.
With this level of reporting being so new, it will take time before it’s business-as-usual (BAU).
“Given the lack of reporting and full end-to-end reconciliation today across much of the industry, only once common standards, practices and processes are adopted widely will this seem BAU,” says Lee. “When firms execute the same transactions, book and apply lifecycle events to these transactions in the same way, then we can start to see reporting become more of a formality.”