The Securities Financing Transactions Regulation - the EU seeks to shine a light on shadow banking
By Robert Daniell, Senior Counsel, Will Sykes, Partner, Macfarlanes LLP
Published: 30 June 2016
The European Union Securities Financing Transactions Regulation (SFTR) came into effect in January 2016. However, its implementation has been staggered over the coming months and years, with most of its more onerous obligations yet to come.
The SFTR is intended to create transparency for regulators and investors on the use of securities finance transactions (SFTs), and requires disclosures of risks associated with providing collateral.
The primary driver behind the SFTR has been a reaction to the bank-like credit intermediation known as “shadow banking”. The opening words to the SFTR describe the scale of the shadow banking sector as “alarming”, noting that it has been estimated as being half the size of the regulated banking system. One form of SFT, repurchase transactions (repos), is a core component of the shadow banking system. The SFT reporting requirement in particular is intended to give regulators a better understanding of the scope of the SFT market and its users. In addition to the reporting obligation, SFTR seeks to give retail investors transparency over the use of SFTR, as the use of SFTRs by apparently safe investments such as money market funds was a major source of instability in the financial crisis (see box “How the crisis in the shadow banking system has led to the SFTR”). Finally, SFTR seeks to ensure that risk disclosures are made for collateral for which legal ownership is passed, covering all financial transactions rather than just SFTs.
Which transactions are affected?
The SFTR affects the following SFTs:
- Repos, including reverse repos and buy-sell backs. Repos are a means of securing cash loans with bonds or shares as collateral.
- Securities lending, which involve shares or bonds being lent against cash collateral. Securities lending is frequently used in conjunction with short-selling of the lent securities.
- Commodities lending, which involve commodities being lent against cash, typically as a means of obtaining secured financing.
- Margin loans in connection with the purchase, sale, carrying or trading of securities, but excluding any other cash loans secured by securities.
The investor transparency obligations under the SFTR also apply to total return swaps (TRSs).
A recipient of collateral must give risk disclosures before receiving title transfer financial collateral or, for collateral held in custody, borrowing or otherwise reusing that collateral. Title transfer collateral is a means of passing collateral by transferring ownership of the collateral to the collateral recipient. Borrowing or reuse of collateral similarly involves the passing of the ownership of the collateral to the collateral recipient, and is often described as “rehypothecation". 
Which entities are affected?
- Any EU entity, including its non-EU branches.
- A non-EU entity if the SFT is entered into by an EU branch of that entity.
- UCITS and their management companies.
- Alternative investment funds (AIFs) and their managers (AIFMs) authorised or registered under the Alternative Investment Fund Manager Directive (AIFMD), irrespective of where the AIFM’s fund is established.
- For reuse of collateral:
- any EU collateral receiver (including its non-EU branches); and
- non-EU entities if:
o the reuse is done by an EU branch; or
o the collateral provider is (i) an EU entity or (ii) an EU branch of a non-EU entity.
What obligations are imposed?
- The Reporting Obligation – Both counterparties must report details of each SFT to a trade repository within one business day of trading, modifying or terminating the SFT. With regard to trading by a UCITS or an AIF, the obligation to report is placed on the manager, not the fund. Parties must also keep a record of any SFT they have concluded, modified or terminated for five years after termination of the SFT. A non-financial counterparty  (NFC) trading with a financial counterparty  is exempted from the reporting obligation if the NFC does not exceed more than two of (i) a balance sheet of 20 million euros, (ii) turnover of 40 million euros, and (iii) 250 employees. Further, the parties to an SFT can delegate one party to report for both, and we expect dealers will agree to report for clients, as commonly occurs for derivatives. Although the SFTR sets out the principal information that must be reported, the European Securities and Markets Authority (ESMA) has been delegated with the responsibility to determine the specifics of what is to be reported, and has recently taken public comments on the scope of the obligation. As with reporting of derivatives under EMIR, a contentious point has been the requirement that both parties to the SFT must report the transaction, with many submissions to ESMA recommending that one dealer counterparty to an SFT should be obliged to report on behalf of the dealer’s counterparty as a single-sided report.
- The Transparency Obligation - UCITS funds and AIFMs must disclose their use of SFTs and TRSs in prospectuses and periodic reports to investors. The required disclosures for prospectuses and reports are each specified in an annex to the SFTR.
- The Reuse Obligation – Any recipient of title transfer collateral, or custody collateral on which it wants to exercise a re-use right, must:
(i) obtain from the collateral provider written consent to do so, and
(ii) disclose to the collateral provider the credit and other risks caused by title transfer and reuse.
As well as SFTs using financial collateral, also covered are securities under collateral agreements that rely on transfer of title, such as the English law ISDA Credit Support Annex.
Notably, existing collateral arrangements must meet this requirement. To assist in the meeting the requirement, a number of industry bodies have recently jointly published a standard risk disclosure document to assist users of collateral in this. 
Entities must have policies for reporting to regulators any breaches of the reporting and reuse obligations.
What are the penalties for breach?
Member states must set their own penalties for breaches, which include possible bans and suspensions, and in financial terms must include a maximum penalty of at least:
- €5 million or 10% of annual turnover for breaches of transaction reporting requirements.
- €15 million or 10% of annual turnover for breaches of collateral reuse requirements.
What do fund managers need to do?
For those entities that are one of the affected entities listed above, the obligations that currently apply are:
- Record-keeping, for SFTs entered into or existing on or after 12 January 2016; and
- Prospectus disclosure, for UCITS and funds of AIFMs incorporated on or after 12 January 2016.
Obligations that will apply in the future are:
- From 12 July 2016, the reuse obligation.
- From 12 January 2017, periodic reports to investors for UCITS and AIFMs.
- From 12 July 2017, prospectus disclosure for UCITS and funds of AIFMs incorporated before 12 January 2016.
The reporting obligation implementation is not yet fixed. ESMA must submit draft reporting Regulatory Technical Standards (RTS) by 12 January 2017, and a few months after submission the finalised RTS should come into force (the date of coming into force, the RTS Date). The time reporting then starts is:
- 12 months after the RTS Date for investment firms and credit institutions;
- 15 months after the RTS Date for clearing houses and central securities depositories;
- 18 months after the RTS Date for insurance undertakings, AIFMs, UCITS and pension schemes; and
- 21 months after the RTS Date for non-financial counterparties.
All SFTs entered into from the relevant reporting start date must be reported by the entity to which the reporting start date applies. As a retrospective reporting obligation, within 190 days of reporting start date the affected entity must report any SFTs existing at the reporting start date that (i) had a fixed period of at least 180 days to run, or (ii) didn’t have a fixed period left to run but remained open for at least 180 days after the reporting start date.
In addition to ESMA’s recommendations with regard the reporting of SFTs, there are a number of other current or potential EU regulatory developments regarding SFTs and shadow banking. These include:
- SFTs with financial firms have, along with other financial contracts, become subject to a temporary stay on counterparties’ ability to terminate, and the possibility of bail-in, under the EU Banking Recovery and Resolution Directive.
- The Financial Stability Board in November 2015 published a framework of minimum haircuts for non-centrally cleared SFTs. The FSB has mandated that these be introduced by regulators in jurisdictions of the largest levels of SFT activity by the end of 2018.
- In September 2013 the EU published a proposed regulation on money market funds with the intention of improving resilience in a future crisis. If adopted, the regulation would mandate minimum levels of liquid assets and limiting concentration risks.
How the crisis in the shadow banking system has led to the SFTR
The shadow banking system operates in parallel to the regular banking system, acting as a previously largely unregulated conduit between borrowers and providers of finance. Shadow banking typically involves non-bank firms using high leverage and short-term wholesale funding. Entities that are commonly seen as part of, or participating in, the shadow banking system are securitisation vehicles, asset-backed commercial paper conduits, money market funds, hedge funds, mortgage companies and investment banks.
As an example of one common route that cash flows through shadow banking, a mortgage lender may repackage its loans by creating a mortgage-backed security (MBS) issued by a special purpose vehicle. The MBS may then be bought by an investor (sometimes this is simply the mortgage lender that created the MBS) that then repos the MBS to a money market or other fixed income investment fund. The cash used by the fund in the repo comes from the retail public buying shares in the fund. In this way, money from retail customers is recycled to borrowers in a way that avoids the traditional, and heavily regulated, bank deposit route.
In the lead-up to the sub-prime mortgage crisis of 2007-8 money market funds were a popular means for US retail investors in particular to invest cash short-term, typically with little inkling that their funds were a key entry point for the shadow banking system. In consequence, at the time of the financial crisis the shadow banking system was a significant percentage of the financial system in the United States. As the prices for asset-backed securities linked to the US property market started to fall, lenders of cash under repos on those securities began to refuse to roll the repos over. The restriction to the flow of cash in the shadow banking system threatened the broader banking system, as many banks were reliant on repo funding for their holdings of asset-backed securities. The spread of the crisis has been described as “the silent bank run” or “the run on repo”, reflecting how the shadow banking system seized up due to the problems in the repo market. In an effort to put a floor under prices and so maintain the shadow banking repo market, the Troubled Assets Relief Program was implemented, which directly bought hundreds of billions of dollars of asset-backed securities at above-market prices. At the same time US money market funds were given government guarantees to try to maintain the flow of funds from retail investors. Government intervention prevented a complete collapse of the shadow banking system, but at considerable cost.
The crisis brought home the interconnectedness of the shadow banking system with the regulated sector. Regulators were conscious that their response to the crisis was hampered by a lack of a clear picture of the scale of the shadow banking system. In recognition of this, the Financial Stability Board (FSB) in 2013 made a number of recommendations with regard to SFTs, including collection of data, reducing pro-cyclical effects, promotion of central clearing and reform of bankruptcy law. The SFTR is among the EU’s first steps in response to these.
Although the EU shadow banking sector was smaller than the US shadow banking sector at the time of the crisis, unlike in the US the EU shadow banking sector has since grown, and at the end of 2015 the FSB reported data showing the US and EU shadow banking sectors as now roughly equal in size.
 Rehypothecation literally means re-pledging a pledged asset, so as a semantic point is used inaccurately to describe reuse of custody collateral. SFTR does not refer to ”rehypothecation”, instead preferring the word “reuse”. It would be welcome if SFTR managed to displace in commercial parlance the word “rehypothecation” with the plain English term “reuse”.
 An NFC is an entity that isn’t a Financial Counterparty (see next footnote).
 A Financial Counterparty includes any of (i) an investment firm authorised under MiFID II, (ii) a credit institution authorised under CRD IV, (iii) an insurance undertaking authorised under Solvency II, (iv) a UCITS (or, where relevant, its manager) authorised under the UCITS Directive, (v) an AIF that is managed by an AIFM authorised or registered under AIFMD, and (vi) an institution for occupational retirement provision under the IORP Directive.
 Available at http://www.icmagroup.org/News/news-in-brief/five-industry-associations-publish-sftr-information-statement/