Preparing for SFTR pt.1: What are the regulation’s aims?
The financial crisis highlighted the need to improve regulation and monitoring outside the controlled world of banking. The volume of transactions carried out by banks had increased enormously and the risks created could be systemic.
‘Regulation (EU) 2015/2365’ of the European Parliament and of the Council on transparency of ‘Securities Financing Transactions and of reuse and amending Regulation 648/2012’ (SFTR) responds to the necessity to improve the transparency of securities financing markets as part of the financial system.
It creates a unified framework under which details of Securities Financing Transactions (SFTs) can be efficiently reported to Trade Repositories (TRs) and information on SFTs as well as total return swaps are disclosed to investors in collective investment undertakings. The definition of SFT in SFTR does not include derivative contracts as defined in Regulation (EU) No 648/2012 of the European Parliament and of the Council (EMIR). However, it does include transactions that are commonly referred to as liquidity swaps and collateral swaps, which do not fall under the definition of derivative contracts in EMIR.
What is the new play?
The SFTR aims to increase markets´ transparency by introducing the following measures and requirements:
- The transactions in scope of the regulation must be reported to a trade repository to allow increased monitoring of the risks associated with SFTs
- Use of SFTs and total return swaps (as well, as related practices) must be disclosed by ‘Undertakings for Collective Investment in Transferable Securities’ (UCITS) management companies, UCITS investment companies and Alternative Investment Funds Managers (AIFM)
- Re-use of financial instruments received under collateral arrangement must meet minimum conditions, such as requirements to disclose associated risks and gain express consent of the counterparty (the ‘Reuse Requirements’)
Which transactions are considered SFTs?
Securities financing transactions (SFTs), generally speaking, are transactions used to borrow cash against some kind of security, or vice versa. This broad definition includes a variety of collateralised transactions that have similar economic effects such as:
- Lending or borrowing cash, securities or commodities,
- Repurchase (repo) transactions
- Reverse repurchase transactions
- Buy-sell back or sell-buy back transactions
According to the definition in the Official Journal of the European Union, ‘securities financing transaction’ means:
- A repurchase transaction
- Securities or commodities lending and securities or commodities borrowing
- Buy-sell back transaction or sell-buy back transaction
- A margin lending transaction
The most frequently used SFTs are securities lending and repos, in which the ownership of the given securities temporarily changes in return for cash for a certain, pre-agreed period of time, or open end, and under some economic conditions (price, fee, or haircut). At the end (maturity) of the SFT, the change of ownership reverts and the assets are with the counterparties that originally possessed them.
Securities lending is primarily driven by market demand for specific securities, and in this type of transaction, the lending counterparty lends securities for a fee against a guarantee in the form of other financial instruments or cash provided by their clients or counterparties.
Repos/reverse repos are based on the counterparty’s need to borrow or lend cash in a secure way. This practice consists of selling/buying financial instruments against cash, while agreeing in advance to buy/sell back the financial instruments at a predetermined price on a specific future date.
SFT Reporting also requires disclosure of specific information concerning ‘total return swaps’. A total return swap is defined as a derivative in which one counterparty transfers the total economic performance, including income from interest and fees, gains and losses from price movements, and credit losses, of a reference obligation to another.
The need for regulation development is also based on the probability that transactions and activities currently made by the banks might be shifted to the ‘shadow banking’ sector and encompass financial and non-financial entities. The shadow banking sector needs to be better monitored because of its size, its close links to the more regulated financial sector, and the systemic risks that it may bring.
There is also a particular need to prevent the shadow banking system being used for regulatory arbitrage, whereby firms use loopholes to try and circumvent regulation. To achieve this, it is important that any structural separation measure is accompanied by measures improving transparency, hence also the establishment of reporting obligations to trade repositories. It would allow supervisors to access detailed, reliable and comprehensive data to monitor risks and to intervene when necessary.
What kind of banking is hidden in the shadows?
‘Shadow banking’ is a term, which is a collective noun for a system of objects and activities (e.g. taking deposits and providing loans) outside the common banking system, and are not regulated like traditional banks. They are in the scope of the SFTs regulation, because the shadow banking also includes securitisation, securities lending, repurchase deals, and other risk-taking transactions.