New EU Law to Enhance Transparency of Securities Financing Transactions
European Union (EU) policymakers reached a political agreement on a new law on reporting and transparency of securities financing transactions (SFTs) in June. SFTs allow market participants to use their assets as collateral to secure financing for a variety of activities. This includes the temporary exchange of assets as a guarantee for a funding transaction, such as repurchase transactions; securities or commodities lending and securities or commodities borrowing; buy-sell back transactions or sell-buy back transactions; or margin lending transactions. In essence, SFTs are a form of collateralised lending. However, due to the complexity of these transactions, SFTs can cause risks to financial stability without effective rules and supervision. Therefore, they will be subject to new disclosure requirements, including mandatory reporting to a registered trade repository, once the new law has been fully implemented in all EU Member States. Investment firms engaging in SFTs will also have to issue detailed reports of their activities to investors.
Links to Shadow Banking and New Banking Rules
The European Commission (EC) published the proposal for an SFT Regulation in January 2014. The need for further rules on SFT activities was already highlighted in the Commission’s September 2013 Communication on Shadow Banking (also see our report on shadow banking), which underlined the complex and sometimes opaque nature of SFTs. Without a full understanding of who-owns-what, particularly where collateral is re-used in a chain of transactions, both investors and regulators have struggled to identify counterparties, and to measure and monitor risk concentration. The EC also noted that the lack of transparency in the use of SFTs has hindered the assessment and monitoring of SFTs’ bank-like risks and the level of interconnectedness in the financial system.
In conjunction with the SFT Regulation proposal, the Commission also published a proposal for a Regulation on structural measures improving the resilience of EU credit institutions that aims to tackle the ‘too-big-to-fail’ concerns related to large banks. The new rules would give supervisors the power to require large banks to separate certain potentially risky trading activities from their deposit-taking business if the pursuit of such activities compromises financial stability. The political discussions in the EU on the bank restructuring proposal are still ongoing, with an agreement unlikely in 2015.
Focus on Safe and Transparent Reporting
For investors, the key focus points of the SFT Regulation are three measures to improve the transparency of SFT activities.
First, all SFTs, except those concluded with central banks, will now have to be reported to a trade repository. The European Securities and Markets Authority (ESMA) will be tasked with drafting the details of the requirement (the so-called ‘technical standards’), and to ensure that these obligations are consistent with the European Markets Infrastructure Regulation (EMIR) requirements on centralised clearing for derivatives.
Secondly, the draft regulation introduces new disclosure requirements for Undertakings for the Collective Investment in Transferable Securities (UCITS) and Alternative Investment Fund (AIF) managers. The existing periodical reports that UCITS management or investment companies and AIFMs have to produce will now have to be supplemented by additional information on the use of SFTs and total return swaps. Moreover, a fund’s investment policy with respect to SFTs and total return swaps will have to be clearly disclosed in the pre-contractual documents, such as the prospectus for UCITS funds and the pre-contractual disclosures to investors in AIFs (such as hedge funds). The new rules aim to ensure that investors have a better understanding of the use of SFTs and their risks before deciding to invest in a particular UCITS or AIF. These new rules go, to some extent, beyond the current AIFM and UCITS rules, and the details of the new reporting requirements will also be clarified in ESMA’s technical standards.
Thirdly, the new regulation introduces some restrictions to the reuse of collateral. While the reuse of collateral improves the provision of funding and market liquidity, the lack of transparency on the extent to which financial instruments provided as collateral have been reused, as well as the respective risks in the case of bankruptcy, can undermine confidence in counterparties and magnify risks to financial stability. Accordingly, the new regulation notes that the reuse of collateral can only take place if the providing counterparty has been notified in writing and has explicitly given its consent.
Global Work by the Financial Stability Board
Globally, the SFT regulatory agenda is led by the Financial Stability Board (FSB), which published a Regulatory Framework for haircuts on noncentrally cleared SFTs in October 2014. The FSB noted that in the absence of clearing, SFTs raise major risks if they are not robustly collateralised with a sufficient margin over and above the value of the amount lent. In line with the Commission’s proposal, the FSB highlighted that further transparency on the reuse of client assets would be the first step towards facilitating counterparties’ capacity to analyse and prevent risks.
A summary of existing regulations surrounding SFTs and the FSB’s recommendations on haircuts are contained in a CFA Institute report on shadow banking. The FSB is due to complete its work on a set of recommendations on haircuts on noncentrally cleared SFTs to prevent excessive leveraging and to mitigate concentration and default risk by 2016.
Current State of Play
A full political agreement on the SFT Regulation was reached by the European Commission, Parliament, and Council on 17 June 2015. As the next step, it is expected that the full European Parliament Plenary session, with all the Members of the Parliament, will vote on the political compromise text on 27 October 2015. The plenary vote acts merely as a ‘rubber stamp’ to formally approve the text already approved by the Parliament’s Economic and Monetary Affairs (ECON) Committee.
In the Council, the EU Member State Finance Ministers are also expected to officially sign the final text in October 2015. The SFT Regulation will become applicable in all EU Member States in phased periods from the moment ESMA’s regulatory technical standards have been approved. The approval process is likely to take place in 2016.
A robust framework surrounding the reuse of collateral in relation to SFTs is needed to mitigate the build-up of excessive leverage in the financial system. CFA Institute broadly supports the SFT Regulation as it should provide greater transparency to investors and regulators over SFT activities and enable better monitoring and assessment of potential financial stability risks.
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