THE DELTA REPORT
The Regulation on Transparency of Securities Financing Transactions and of Reuse (2015/2365) (the "SFTR") entered into force on 12 January 2016 following publication in the Official Journal of the European Union on 23 December 2015. As part of a wider EU initiative on shadow banking, a key aim of the SFTR is to improve transparency in securities and commodities lending, repurchase transactions, margin loans and certain collateral arrangements. While the regulation, transparency and monitoring of securities financing transactions ("SFTs") did not fall within the extensive ambit of EMIR51, the SFTR now extends requirements similar to those found in EMIR to such transactions.
The SFTR will require:
(a) reporting of all SFTs to trade repositories by both parties to the trade and mandatory record keeping (the "Reporting Obligation");
(b) detailed disclosure by certain investment funds of their use of SFTs and total return swaps ("TRS") to investors in pre-investment documentation and ongoing reporting (the "Disclosure Obligation"); and
(c) the obtaining of consent from, and disclosure of, risks to SFT counterparties entering into rights of use and title transfer collateral arrangements (the "Reuse Obligation").
The SFTR has been broadly drafted and further detail on the activities covered and the related requirements is needed. As well as the provisions subject to delegated legislation in the SFTR itself, it also seems likely that further initiatives (for example, in relation to risk mitigation requirements surrounding SFTs) will be brought into force down the line. Market participants and industry bodies will need to turn their attention to achieving standardised methods of compliance, updates to legal opinions and addressing issues such as confidentiality and the delegation of reporting.
Who is affected by the SFTR?
Article 2 of the SFTR states that the following entities will be covered:
(a) counterparties to an SFT that are established (a) in the EU (including all branches irrespective of location (i.e. non-EU branches)) or (b) outside of the EU if the SFT is concluded in the course of business of an EU branch of that counterparty;
(b) UCITS funds (and their management companies) and AIFMs authorised or registered in accordance with AIFMD52, irrespective of where they are established; and
in relation to the Reuse Obligation only, counterparties established outside the EU, in either of the following situations: (a) the reuse is effected in the course of business of an EU branch or (b) the reuse concerns 'financial instruments'53 provided as collateral by a counterparty established in the EU (or an EU branch of a third country entity (i.e. a non-EU entity reuses an EU entity's collateral)).
Which Transactions are covered?
SFTs. The disclosure and reporting requirements of the SFTR apply to SFTs54, which include the following:
(a) repurchase transactions (including reverse repurchase transactions) relating to securities or commodities;
(b) securities lending and securities or commodities borrowing (where there is a commitment to return equivalent securities or commodities);
(c) buy-sell back or sell-buy back transactions relating to securities or commodities; and
(d) margin lending transactions (which is likely to cover prime brokerage agreements).
TRSs. Those provisions of the SFTR which require disclosure to investors in certain funds such as UCITS and AIFMs also apply to TRSs.
Collateral Arrangements. Provisions relating to reuse of collateral will apply to "collateral arrangements" (both title transfer financial collateral and security financial collateral arrangements), as defined by reference to the pre-existing (and subject of much vexed analysis) Financial Collateral Directive55 (the "FCD"). Both title transfer financial collateral arrangements and security financial collateral arrangements (each as described and defined in the FCD) are covered.
Those definitions will overlap with SFTs to the extent that an SFT constitutes a "collateral arrangement". However, the obligations are not limited to "collateral arrangements" that are SFTs and could apply to collateral provided in connection with a transaction that is not an SFT (for example, the provision of collateral under an ISDA credit support annex or credit support deeds) where such arrangement falls within the definition of a financial collateral arrangement under the FCD. Such arrangements, to the extent they contain a right of reuse, will be covered by the disclosure and consent requirements, as explained further below.
Reporting Obligation (Article 4)
The Reporting Obligation for SFT counterparties requires that reports of the details of any SFT concluded, modified or terminated will need to be submitted to a trade repository56 on a T+1 basis. Counterparties must also maintain records of SFTs for at least five years following the termination of the relevant transaction.
As with reporting under EMIR, the obligation may be delegated, subject to certain mandatory rules, although the ultimate responsibility for compliance rests with the counterparty. Financial Counterparties entering into SFTs with Non-Financial Counterparties57 that qualify as 'small or medium sized enterprises' will be required to report on behalf of these counterparties and UCITS managers and AIFMs will have to report on behalf of their funds.
The details to be reported will be documented in RTS to be developed in due course by the European authorities (they are required to be submitted in draft by 13 January 2017). For pools of assets, it is likely that the position level collateral data should be sufficient.
A phase-in for the Reporting Obligation has been included in the SFTR which, in summary (and assuming timely progress) will mean that banks and investment firms will need to start reporting trades from mid-2018.
The Reporting Obligation also applies to SFTs existing at the relevant effective date of the phase-in, provided that they either have a remaining maturity in excess of 180 days or an open maturity and remain outstanding 180 days after that date.
Disclosure Obligation (Articles 13 and 14)
Under Articles 13 and 14 of the SFTR UCITS funds (and their management companies) and EU-authorised managers of AIFs will be required from 13 January 2017 to disclose to their investors their uses of SFTs and TRSs in their annual (and half yearly) reports. From 12 January 2016, prospectuses (or similar disclosure documents) for an AIF or UCITS are also required to specify the SFTs and TRSs that the manager is authorised to use and must contain detailed disclosure on the nature, uses and rationale of such transactions. Any funds pre-existing prior to 12 January 2016 will also be covered by such requirements (although the effective date is postponed to 13 July 2017).
Reuse Obligation (Article 15)
The SFTR restricts the instances in which counterparties have the right to 'reuse' 'financial instruments' received as collateral under collateral arrangements58. Compliance with this obligation (for new and existing collateral arrangements) is required by 13 July 2016.
Broadly, there are two conditions which will need to be satisfied for the collateral taker to reuse collateral. Firstly, the collateral provider must be notified in writing by the collateral taker of the risks and consequences involved in (a) granting consent to reuse of collateral and/or (b) concluding a title transfer agreement. The notification must include the risks and consequences that may arise on a default of the collateral taker. Secondly, the collateral provider is required to have granted its prior express consent in writing (or a legally equivalent manner), to a security collateral arrangement which provides for a right of reuse (in accordance with Article 5 of the FCD) or has expressly agreed to provide collateral by way of a title transfer agreement. These requirements will need to be dealt with by specific disclosures in master agreements/ related credit support documents or disclosure through standard terms of business and the execution of market standard securities financing/ related credit support documentation, amended as necessary.
Where the right of reuse is exercised, the reuse must also be undertaken in accordance with the prior written agreement between the parties and the 'financial instruments' received under the collateral arrangement must be transferred from the account of the collateral provider.
After industry bodies raised concerns over the issue, a safeguard has been included which provides that Article 15 shall not affect national law concerning the validity or effectiveness of the collateral arrangement. This protection means that a breach of the requirements outlined above should not render a transfer of collateral invalid (as this would be a matter for the applicable law where the transfer takes place). Crucially, this should mean that the enforceability of security and/or the operation of close-out netting in related transactions should be unaffected.
Sanctions for Non-compliance
EU Member States are required to set proportionate sanctions and measures that can be applied for breaches of the SFTR. Minimum suggested sanctions include withdrawal of authorisation, public warnings, dismissal of management, restitution of profits and administrative fines. Member States may also choose to apply criminal sanctions alongside these on notification to ESMA.
While there are no provisions for risk mitigation in the SFTR equivalent to those in EMIR, Article 29 requires that further consideration is given to this in the SFT context and a report is required to be submitted to the European Parliament by 13 October 2017. Specifically, this includes the Financial Stability Board recommendations for haircuts on certain non-centrally cleared SFTs. The BCBS also issued a consultation paper in November 2015 outlining similar proposals as well as suggesting high regulatory capital charges where the transactions do not meet minimum haircuts. It is therefore likely that further rules may be introduced in this area in due course.
Conclusions and Considerations
Much remains to be settled following the coming into force of the SFTR although the following points should be noted:
(a) As mentioned, in relation to the written consent requirement, we generally expect this to be satisfied through using signed legal documents to effect the reuse (notably industry standard GMRAs, GMSLAs and ISDAs (amended as appropriate)).
(b) The Reporting Obligation will apply in addition to existing disclosure requirements that may be triggered by SFTs59. These reporting requirements may be onerous, expensive to implement and comply with (particularly given the detailed nature of the disclosure). SPVs, pension fund and other institutions will likely to need to delegate to third parties to report on their behalf. Risk factor updates (where relevant) should be considered in respect of such obligations, the associated costs and potential sanctions for breach.
(c) The need for express consent from a collateral provider under a security financial collateral arrangement with a right of reuse may be straightforward to address in certain contexts (e.g. prime brokerage) but it may be necessary to carry out due diligence to identify other such arrangements that may include rights of reuse.
(d) Amendments to standard form documentation and developments in market practice will be required to and should be addressed alongside those needed for compliance with the margin rules (see article "Update: The EU Margin Rules"). It is also likely that "Next steps" outlined above will encourage parties to look towards central clearing for stock loans and repos.
51 Regulation No 648/2012 of the European Parliament and of the Council.
52 Directive 2011/61/EU.
53 As defined in accordance with MiFID II and thus includes government and corporate bonds, shares, derivatives and emissions allowances.
54 "Derivative" transactions are excluded as these are covered by EMIR.
55 Directive 2002/47/EC.
56 Such Trade Repository must have been registered under Article 5 of the SFTR or recognised in accordance with Article 19 of the SFTR. If a trade repository is not available, or in the event no repository has been registered or recognised in time for the start of reporting, counterparties are to report directly to ESMA.
57 Financial Counterparties and Non-Financial Counterparties are defined in Article 3(3) and (4), respectively, of the SFTR and track the classifications outlined in EMIR.
58 'Reuse' is defined under Article 3(12) of the SFTR as the use by a receiving counterparty, in its own name and on its own account or on the account of another counterparty, including any natural person, of financial instruments received under a collateral arrangement. Under this definition, 'reuse' includes transfer of title or exercise of a right of use in accordance with Article 5 of the FCD but does not include "the liquidation of a financial instrument in the event of default of the providing counterparty".
59 For example, the Transparency Amending Directive (2013/50/EU).
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