knowledge | 18 January 2016 |
The Transparency of Securities Financing Transactions Regulation Enters into Force
Regulation 2015/2365 on transparency of securities financing transactions and of reuse entered into force, for the most part, on 12 January 2016 (the “SFT Regulation”). As its title suggests, the SFT Regulation seeks to enhance the transparency of securities financing markets and the reuse of collateral. In doing so, it introduces requirements regarding the ‘reuse’ by a recipient of financial instruments received as collateral, the reporting of SFTs to trade repositories by both financial and non-financial counterparties, and investor disclosure requirements for UCITS and investment managers and for alternative investment fund managers. While a number of these requirements will apply on a phased-in basis, some have immediate implications for those falling within their scope.
Importantly, the SFT Regulation has a broader application than would appear from its title: its requirements on the reuse of collateral received are not limited to securities financing transactions (“SFTs”) but also encompass certain commodities transactions. Further, the SFT Regulation’s investor disclosure requirements extend to total return swaps.
SFTs comprise the lending or borrowing of securities (and commodities), repurchasen(repo) or reverse repurchase and buy-sell securities or commodities transactions and margin lending transactions where the relevant credit is advanced in connection with the purchase, sale, carrying or trading of securities.
In the wake of the 2008 financial crisis, both securities lending and repos came under scrutiny as they were widely perceived to have contributed to a build up of hidden leverage and interconnectedness prior to the crisis and to the transmission of financial distress across the financial system during the crisis. In particular, as regulators focused in on the risks associated with the shadow banking sector, they became increasingly uneasy about the lack of transparency in the use of SFTs and their consequent inability to correctly monitor associated risks and levels of interconnectedness.
On 29 January 2014 the European Commission (“Commission”) issued its proposed Regulation on reporting and transparency of SFTs as part of a series of measures intended to reduce risks in the shadow banking sector. The proposed Regulation was designed to complement the proposal for structural reform of the EU banking sector, which also issued on that day, as the Commission was concerned that imposing structural measures on banks could result in certain activities being shifted to the shadow banking sector. The proposed SFT Regulation was partially based on the Financial Stability Board’s policy framework for addressing shadow banking risks in securities lending and repos, which was published in August 2013.
The SFT Regulation
As set out above, the SFT Regulation lays down rules on the reuse of collateral and the transparency of SFTs, including reporting requirements. Generally these rules apply to both financial1 and non-financial counterparties2, with the exception of certain counterparties, such as members of the European System of Central Banks. The SFT Regulation also sets out investor disclosure obligations which apply to UCITS management and investment companies (“UCITS Managers”) and alternative investment fund managers (“AIFMs”) as well as requirements regarding the registration and supervision of a trade repository.
Reuse of collateral
The SFT Regulation harmonises requirements on reuse in the EU. The term ‘reuse’ refers to the use by a receiving counterparty, in its own name and on its own account, or on the account of another counterparty, of MiFID financial instruments received under a title transfer or security collateral arrangement, excluding liquidation in the context of default by the provider.
Under the SFT Regulation, an in-scope recipient of collateral only has the right to reuse it if it:
- informs the collateral provider of the risks and consequences of granting its consent to reuse the collateral in a security collateral arrangement or its entry into a title transfer collateral arrangement, as applicable. The information provided must at least cover the risks and consequences that may arise in the event of the recipient’s default; and
- obtains the collateral provider’s prior express consent in writing or equivalent to the right of use in a security collateral arrangement, or the provision of collateral by way of a title transfer collateral arrangement, as applicable.
Moreover, the recipient can only exercise its right of reuse if:
- such reuse is undertaken in accordance with the terms specified in the relevant collateral arrangement; and
- the collateral in question is first transferred from the account of the collateral provider.
Counterparties will need to comply with the new reuse requirements from 13 July 2016; there are no grandfathering arrangements, meaning that all collateral arrangements existing on that date will be subject to the new requirements.
The SFT Regulation also specifically provides that the new rules on reuse are subject to any stricter rules set out in EU sectoral legislation, including the UCITS Directive 2009/65 and the Alternative Investment Fund Managers Directive 2011/61.
The SFT Regulation introduces new reporting requirements for financial and non-financial counterparties to an SFT, which are largely modelled on Regulation 648/2012 on OTC derivatives, central counterparties and trade repositories (“EMIR”).
EMIR requires information on all European derivative contracts to be reported to trade repositories and requires counterparties to keep records of any derivative contract concluded for five years. Similarly, the SFT Regulation requires financial and non-financial counterparties to an SFT to:
- report details of the transaction to a trade repository within one working day of the transaction’s conclusion, modification or termination; and
- keep records of the SFT for at least five years following its termination.
Each counterparty to an SFT is obliged to report details of the SFT transaction. A financial counterparty is responsible for reporting the details of the SFT transaction on behalf of both counterparties where it concludes an SFT with a non-financial counterparty which on its balance sheet does not exceed at least two of the following three thresholds of; a €20,000,000 balance sheet total, a €40,000,000 net turnover, and 250 employees on average during the financial year. Where a UCITS or alternative investment fund (“AIF”) is the counterparty to an SFT, the relevant UCITS management company or AIFM is responsible for reporting the details of that SFT. Any counterparty subject to the reporting obligation may delegate the task of reporting, however the ultimate responsibility for complying with the obligation remains with the counterparty.
The SFT Regulation specifies the minimum information to be reported, which includes the parties to the SFT, the principal amount, the currency, the assets used as collateral and whether the collateral is available for reuse. ESMA and the European System of Central Banks are responsible for developing regulatory technical standards further specifying the details that must be reported, which must then be adopted by the Commission.
The reporting obligation is subject to a number of transitional periods (the “transitional period”) which start to run from the time the Commission adopts the relevant technical standards and which depend on the status of the relevant counterparty. The transitional periods are as follows:
- banks and investment firms and non-EU equivalents - 12 months;
- central counterparties and central securities depositaries – 15 months;
- all other financial counterparties and non-EU equivalents – 18 months; and
- non-financial counterparties and non-EU equivalents – 21 months.
The reporting requirement applies to all SFTs entered into on or after the expiry of the relevant transitional period as well as to SFTs concluded before but outstanding at such expiry which have a remaining maturity in excess of 180 days, or have an open maturity and remain outstanding 180 days after such expiry. While a breach of the SFT reporting requirements will give rise to sanctions3, significantly, the SFT Regulation states that it must not affect the validity or enforceability of the SFT itself or give rise to compensation rights from a party to an SFT.
Certain types of over-the-counter (“OTC”) derivative (total return swaps), are subject to the EMIR reporting requirements as well as the transparency requirements of the SFT Regulation. In order to ensure coherence in the scope of the applicable reporting and transparency requirements, the SFT Regulation amends EMIR to create a new procedure for recognising ‘equivalent’ non-EU markets, so that derivatives traded on those markets are no longer treated as OTC derivatives for the purpose of EMIR.
The SFT Regulation requires UCITS Managers and AIFMs to disclose specified information to investors about their use of SFTs and total return swaps.
From 13 January 2017, UCITS Managers must disclose their use of SFTs and total return swaps in their half-yearly and annual reports, while AIFMs must disclose this information in their annual reports. The minimum information to be disclosed includes:
- the amount of securities and commodities on loan as a proportion of total lendable assets;
- the amount of assets engaged in each type of SFT and total return swaps;
- the ten largest collateral issuers across all SFTs and total return swaps;
- the top 10 counterparties of each type of SFT and total return swaps, separately;
- transaction data;
- the share of collateral that is reused; and
- details regarding safe-keeping arrangements.
UCITS Managers must specify which SFTs and total return swaps they are authorised to use, and include a clear statement that these transactions are used, in the UCITS prospectus. AIFs must provide this information in their pre-contractual documents. This is to ensure that investors understand and appreciate the inherent risks before they decide to invest in a particular UCITS or AIF. Examples of information which must be disclosed include a general description of the SFTs and total return swaps used by the collective investment undertaking and the rationale for their use, and the maximum and expected proportion of assets under management that can be subject to these transactions. This disclosure requirement applies from 13 July 2017 for UCITS and AIFs constituted before 12 January 2016 and immediately with respect to all other UCITS and AIFs.
In the case of both the periodic and pre-contractual disclosures, ESMA may, but is not required to, propose regulatory technical standards further specifying the contents of the disclosures.
The SFT Regulation has an extensive territorial scope, which reaches well beyond the EU. It applies to an EU entity as well as to each of its branches, regardless of where located, that is party to an SFT or engaging in reuse. It also applies to a non-EU entity that is party to an SFT or engaging in reuse, if:
- the SFT is concluded or the reuse is effected by an EU branch of that non-EU entity; or
- the reuse concerns financial instruments provided under a security or title transfer collateral arrangement by an EU counterparty or EU branch of a non-EU counterparty.
The SFT Regulation imposes:
- new requirements regarding the reuse of collateral;
- new reporting requirements for both financial and non-financial counterparties; and
- new disclosure obligations for UCITS Managers and AIFMs.
While these requirements are subject to certain transitional arrangements, the SFT Regulation has a number of immediate consequences for those affected.
Regarding reuse, once the new rules come into effect on 13 July 2016, they will apply to all collateral arrangements existing on that date. Consequently, it would be advisable to review existing collateral arrangements now, to ensure compliance with the new rules before they take effect and, of course, to ensure that all new collateral arrangements are in compliance.
While the reporting requirements are subject to relatively extensive transitional periods, these do not apply to the record-keeping requirements which apply from 12 January 2016.
Finally, UCITS and AIFs constituted after 12 January 2016 must comply with the pre-contract disclosure requirements immediately, as the 18 month transitional period only applies to funds constituted before that date.
- Eg, investment firms, credit institutions, insurance undertakings, UCITS and UCITS management companies, EU authorised or registered alternative investment fund managers, institutions for occupational retirement provision, EMIR central counterparties, central securities depositaries, and certain third-country entities
- Entities which are not financial counterparties
- Member States are required to empower competent authorities to impose sanctions at least for breaches of the reuse and reporting requirements
This briefing is for general guidance only and should not be regarded as a substitute for professional advice. Such advice should always be taken before acting on any of the matters discussed.