Securities finance business is typically fully collateralised. This is done by the transfer of either eligible securities or cash. ‘Haircuts’ are set by the lender and applied to the collateral value meaning that lenders generally receive collateral of a greater value than the securities they have lent. However, when Lehman Brothers collapsed, lenders needed to liquidate the collateral they held to restore lent positions. This was in the most very successful. However, some borrowers struggled to reclaim the collateral that they had provided to Lehman Brothers against borrowed securities, partly due to the securities being rehypothecated and used for other collateral requirements.
(Rehypothecation describes the process where the receiver of collateral reuses that collateral. It is most commonly associated with Prime Brokerage arrangements and has risen to prominence after the financial crisis.)
So the financial crisis exposed the dangers of excessive rehypothecation. Firms created complex chains of risk exposure based on the use of securities as collateral. When the dominos fell in 2008, the EU concluded that the securities financing transactions (SFTs) underlying this process were insufficiently regulated. By introducing new transparency and reporting requirements, the SFTR aims to fill that gap.
What is the new regime?
The SFTR focuses on increasing the transparency of rehypothecation and shadow banking. It does so by establishing new disclosure and reporting requirements for SFTs, which are defined as:
- Repurchase transactions
- Securities or commodities lending and securities or commodities borrowing
- Buy-sell back or sell-buy back transactions
- Margin lending transactions. It requires that SFTs are reported to registered trade repositories, and obliges UCITS and AIFMs to report on their SFT activity. Counterparties will also have to disclose the risks of particular SFTs and acquire consent to rehypothecate certain types of collateral.
Am I affected?
The new requirements apply to a wide variety of entities, including:
- Financial, non-financial and central EU counterparties. This includes the EU branches of non-EU counterparties
- UCITS management and investment companies
- Any other entity engaging in rehypothecation in the EU
Requirements on firms
- Reporting: Counterparties to SFTs will have to report certain details of any SFT they have concluded, modified or terminated to a registered trade repository within one working day.
- Record-keeping: Counterparties will also have to keep a record of SFTs for at least five years following the termination of the transaction.
- Registration: Trade repositories accepting reported SFTs will need to register with the ESMA, in line with similar obligations under EMIR.
- Transparency: UCITS management/investment companies and AIFMs will have to inform investors of their use of SFTs and total return swaps in yearly or half-yearly reports depending on the category of firm.
- Disclosure: UCITS management/investment companies and AIFMs must provide investors with information on (a) what SFTs they are authorised to use and (b) how they employ said transactions.
- Restrictions on re-use: counterparties will only be able to reuse instruments received as collateral if the providing counterparty has been informed in writing of the risks and gives prior consent.
Timeline for implementation
- 13 January 2017: deadline for UCITS management/investment companies and AIFMs to inform investors on the use and make of SFTs and total return swaps in periodic reports
- 13 July 2017: compliance deadline for certain disclosure rules applicable to collective investment undertakings constituted before 12 January 2016
- 2018-2019: deadline for transaction reporting
In March 2017, ESMA published draft regulatory and implementing technical standards setting out detailed provisions on reporting, data collection and availability, defined access levels for different public authorities, registration and extension of registration of trade repositories and exchange of data on sanctions between authorities.
How can Bovill help?
Bovill’s funds team has extensive experience helping UCITS and AIFMs navigate the complex maze of European regulation. We also assist a wide variety of firms in fulfilling their regulatory reporting requirements, and can check that your internal systems and procedures are sufficient to ensure compliance. If you have any questions about upcoming deadlines under the SFTR or how to interpret its rules, please do give us a call.