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How SFTR is Changing the Game of Shadow Banking

Executive Summary

A new EU legislation named The Securities Financing Transactions Regulation (SFTR) entered into force on January 12, 2016. The measure represents one component of a larger effort by the European Union to apply more oversight to previously obscured practices. These practices, or “shadow banking,” are characterized by financial intermediaries engaging in transactions that are unregulated. Examples of these unregulated transactions include hedge fund management, credit default swaps, and some unlisted derivatives.

How Does SFTR Work?

“Transparency” summarises the driving purpose of SFTR. The new provisions of the regulation mandate that any and all parties accepting collateral must notify their counterparties of the risks inherent in the decision to engage in title transfer agreements or the decision to reuse collateral (e.g. bonds or equities) with any security agreement. The term “reuse” refers to the act of using financial instruments previously received as collateral from a counterparty. “Counterparties” are entities including investment firms, credit institutions, insurance companies, central counterparties (CCPs), central securities depositories, undertakings for collective investment in transferable securities (UCITS) and their management companies, alternative investment funds (AIFs), occupational pension institutions (IORP) and non-financial counterparties. This “Reuse Disclosure Requirement” is described in Article 15(1)(a) of the SFTR. This rule doesn’t apply in the particular instance of the liquidation of the financial instrument resulting from the default of the providing counterparty.

Key Points

  • The regulation applies to securities financing transactions (SFTs) and total return swaps (TRSs) as well as collateral agreements involving resuse.
  • Firms must report securities financing transactions (SFT) to recognised trade repositories or ESMA if trade repositories are not established.
  • Investment funds must disclose their use of SFTs to all investors in the pre-investment documentation.
  • Firms must keep a five-year record of SFTs following termination.

Understanding Reuse Practices

Traditionally, the party accepting collateral is not permitted to dispose of the assets unless the party providing the collateral becomes insolvent. The practice of “reuse” broadens the power of the collateral taker. With a granted right of reuse, the secured party may transfer the legal and beneficial interest in the assets to a third party. In the derivatives market this reuse is sometimes referred to as “re-hypothecation.” The practice of reuse is effective in raising capital fast. In this case, the party that initially provided the collateral has a credit risk against the party engaging in reuse.

The SFTR mandates new requirements for the reusing party. To earn the privilege of reuse, the collateral taker must fulfil two obligations: First, the party offering the collateral must receive written notification of all the risks and consequences of agreeing to allow the other party to reuse assets or execute a title transfer agreement. Second, the granting of the right of reuse will occur only through the written consent of the party offering the collateral.

Transactions Covered

The provision applies to:

  1. SFTs Including:
    • Commodities and securities trading involving buy-sell back or sell-buy back transactions.
    • Transactions that engage in margin lending
    • Repurchase transactions (repos) and reverse repurchase transactions (rerepos) involving securities or commodities
    • Securities lending and securities or commodities borrowing requiring the return of equivalent assets.
  2. TRSs including certain funds such as:
    • UCITS
    • AIFMs

Planning Ahead

Record keeping and organization will be more critical than ever in adhering to these new regulations. This organization means having easy-to-access, signed documentation proving that all intentions, risks, and agreements were clearly and thoroughly communicated before any transactions involving reuse.
Give careful attention to the Reuse Disclosure Requirement. Read and understand the detail. Anyone in your firm engaging in any transactions that are even tangentially related to SFRT needs to be conversant. Communication within your firm is as important as the revised communication you’ll need to have with those issuing a right to reuse. The initial steps to enact changes on your side will be onerous at first. However, the long-term benefit of increased transparency will avoid greater costs and legal fallout later if a problem arises. On a long enough time horizon, major problems always present themselves.

The SFRT underscores the amplified risk of engaging in reuse. The message behind the message is this: reuse is risky. Consider this subtext carefully when engaging in future transactions. The very existence of the new regulation highlights the problems with accessing fast capital using assets that fluctuate in value and are by their very nature volatile.

Critically, the Reuse Disclosure Requirement is retroactive. Therefore it applies to all existing reuse agreements made before 2016.

References

  • Sidley. April 27, 2016. SFTR Information Statement: EU Securities Financing. Transactions Regulation and the Reuse Disclosure Requirement.
  • Securities Lending Times. August 8, 2016. SFTR Costs Will Mount Say Participants.
  • Ashurst. January, 2016. The Securities Financing Transactions Regulation.
  • White & Case. June 21, 2016. The SFTR – The EU Expands its Rulebook to Cover. Securities Financing Transactions and the Reuse of Collateral.
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