The EU's latest effort to combat shadow banking - SFTR - risks replicating two-sided reporting problems still plaguing EMIR, says AIMA's associate director of markets regulation, Oliver Robinson.

Since 2008, increasing political pressure has been exerted by many commentators to introduce strict regulation of the pejoratively named ‘shadow banking’ sector.  

However, asking numerous proponents of such burdensome regulation to actually define what shadow banking is can lead to a great deal of uncertainty. 

This is understandable as the sheer breadth of activities that are often termed ‘shadow banking’ means that the idea of simply introducing a single regulation would be impossible and arguably irresponsible.

The Financial Stability Board (FSB) has been leading the charge to develop appropriate recommendations and standards for the regulation of different types of shadow banking activities, recognising the need to ensure oversight to address bank-like risks whilst not inhibiting sustainable non-bank models that do not pose such risks.

One sector that has been broadly recognised as in need of particular regulatory focus to monitor systemic risk build-up is that of securities financing transactions (SFTs) – namely repos, buy-sell backs, securities lending and margin financing.

On 12 January of this year, Regulation (EU) No.2015/2365 on transparency of securities financing transactions and of reuse (SFTR) entered into effect across the EU. 

It is the EU’s implementation of the FSB’s recommendations, in particular, to ensure that regulators have greater visibility of the potential build-up of systemic risks in repo and securities lending markets and to provide greater disclosures to end-investors by fund managers that enter SFTs. 

Thankfully, the SFTR is consistent with its name and remains about transparency.  

Despite a slight wobble in the European Parliament, the EU has resisted the temptation to extend the SFTR beyond transparency to include rules to stymie SFT markets, such as minimum haircuts on collateral or exposure limits. 

Nonetheless, as always, the devil is in the detail. Furthermore, much detail has yet to be finalised.

Reporting

The headline reporting obligation under Article 4 of SFTR gets off to a bad start by being based explicitly on that for derivatives under Article 9 of EMIR;  i.e,. reports are two sided, T+1 and to be submitted to a registered trade repository. 

The issues still plaguing EMIR reporting even after two years – including extremely poor report-matching rates and data quality – will likely impact SFT reporting once in effect. 

It is good then that a generous phase-in has been provided under SFTR, within which we must hope two-sided reporting issues are rectified. 

The first round of reporting will enter into effect 12 months following the entry into force of relevant Level 2 technical standards currently under consultation at ESMA Level, the latter having until January next year to submit final technical standards to the European Commission. 

AIMA hedge fund manager members with funds established within the EU will have 18 months from the entry into force of the Level 2 measures to start reporting. 

Nonetheless, for the majority of AIMA members utilising a non-EU fund structure, it is AIMA’s understanding that the Article 4 SFTR reporting and recordkeeping obligations will not apply regardless of the location of establishment of the fund manager inside or outside of the EU.

Investor disclosures

Notwithstanding the scope of the scope of SFT reporting and recordkeeping, authorised EU AIFMs are directly caught alongside authorised UCITS managers by the SFTR periodic and pre-contractual investor disclosure obligations under Articles 13 and 14 of SFTR on their authorisation and use of both SFTs and total return swaps (TRSs). 

Policy concerns that led to these obligations were founded upon the fear that such contracts could materially change the risk profile of a fund to an investor, as well as result in conflicts of interest as to how returns are shared between the fund and the manager. 

However, as for many investor disclosure obligations, whether investors will actually use this information remains to be seen.  

Pre-contractual disclosures became effective for newly constituted funds as of 13 January this year, and will apply to legacy funds on 13 July 2017. Periodic disclosures will become effective on 13 January 2017. 

ESMA has made clear that it intends to monitor the implementation of the rules before considering further Level 2 standards developing upon the content and form of investor disclosures.

Reuse

Finally, but most certainly not least in importance, is the set of rules under Article 15 of SFTR relating to the reuse of collateral. 

As of 13 July this year, all EU counterparties engaged in reuse and any non-EU counterparties engaging in reuse using an EU branch or over collateral provided by an EU counterparty must make written risk disclosures and obtain written counterparty consents for reuse of collateral passed both by way of security interest and by title transfer. 

Such counterparties must also exercise reuse in accordance with the terms of their relevant collateral arrangement and transfer the financial instruments from the collateral provider’s account. 

One could be forgiven for assuming that this obligation would be related only to collateral for SFTs, however, this requirement is far broader and would apply to any collateral arrangement in which financial instruments are subject to reuse, thus including OTC derivatives. 

It is considered that the consent obligations should not impose additional requirements to amend industry standard form documentation, nonetheless, documentation for other arrangements may need to be changed. 

The obligation to transfer financial instruments from the account of the providing counterparty may also introduce operational complexity.

Overall, the SFTR is but one piece of the regulatory pie facing participants of SFT markets and collateral globally. 

Nonetheless, it must be hoped that the information provided can accurately inform policymakers, regulators and investors such that any future regulatory initiatives dealing with SFTs remain proportionate and effective.