Implementing SFTR – what is required for hedge fund managers?

By Owen Lysak, Senior Associate; Jacqueline Jones, Senior Professional Support Lawyer, Clifford Chance

Published: 31 March 2016

A new European regulation has come into force which will be important for EU and third country hedge funds engaging in securities financing transactions, such as repo and securities lending, or transactions which involve the reuse of collateral.

The Securities Financing Transactions Regulation, or SFTR as it is known, came into force in January 2016, imposing new rules, most - but not all - of which will be phased in over the next two years or so. This article focuses on the key requirements for hedge fund managers and highlights some of the issues that need to be addressed by the market as it moves towards implementation.

SFTR requirements

The SFTR imposes requirements in three keys areas:

 

  • In relation to the re-use of collateral received through a security or title transfer collateral arrangement;
  • Disclosure to investor requirements for managers of UCITS and AIFs;
  • Trade reporting requirements, to a trade repository following the model in EMIR.

 

Perhaps surprisingly, given its name, the regulation is not restricted to securities financing transactions, as it also applies in some instances to commodities financing transactions, to total return swaps and to any transaction where collateral is received under securities or title transfer collateral arrangements. This is because the scope of the three key requirements differs, applying to different trades or to different parties. The starting point, therefore, is for managers to give the scope requirements of the SFTR careful consideration.

Disclosure to investor requirements (Article 13 and 14)

The SFTR requires EU authorised managers of UCITS and AIFs to make disclosures with respect to SFTs and total return swaps. Managers must make detailed disclosure through:

  • Periodic reports: including disclosure of certain prescribed information in the six monthly and annual reports required under the UCITS Directive or the annual report required under the AIFMD;
  • Pre-contract disclosure: including disclosure of certain prescribed information in the prospectus, as required under the UCITS Directive or relevant pre-contractual/offering documentation required under the AIFMD.

Managers already have to comply with the pre-contractual requirements in respect of funds constituted after 12 January 2016, which was the day the SFTR came into force. Funds already in existence do not have to comply until 13 July 2017 because of the transitional provisions. For the periodic disclosure requirements there is a 12-month grace period, for both new and existing funds, so managers will have until 13 January 2017 to comply, although they will need to start thinking about those requirements now to ensure that they are capturing the required information for the coming year.

Not surprisingly, the issues which have emerged so far concern the pre-contractual disclosure requirements, as they already apply for 'new' funds. Questions have been raised about what this means in practice and, in particular, whether new sub-funds in an existing umbrella structure would be able to take advantage of the grandfathering provisions. It appears that national regulators have different views on this. It is reported that the current view of the UK FCA is that the pre-contractual disclosure (prospectus) requirements in article 14 apply to all new sub-funds of UCITS and AIFs, as well as entirely new schemes, whereas other regulators, for example the CSSF in Luxembourg, have taken the opposite view, so that new sub-funds of an umbrella structure which existed before the SFTR came into force will be grandfathered.

Managers have also been considering the level of detail that has to be included in pre-contractual disclosures. The SFTR, in section B of the Annex, lists the information to be provided to investors, but gives no indication of the level of detail required. ESMA may develop RTS in respect of periodical reports and pre-contractual disclosure by managers of UCITS and AIFs, but no timeline is specified for these, as they are optional. These means that managers will need to reach a view on an appropriate level of detail and it would be beneficial for the market to come up with a consistent approach to this.

Reuse of collateral (Article 15)

The SFTR imposes conditions on the reuse of financial instruments provided as collateral. From July 2016, all counterparties, not just financial intermediaries, will have the right to reuse financial instruments received as collateral under a security or title transfer collateral arrangement only if the disclosure and consent provisions in the SFTR are satisfied. Even if those conditions are satisfied, so that a party has the right to reuse collateral, there is more to be done, as the SFTR also stipulates additional conditions which apply to the exercise of any right of reuse, namely: that the reuse must be undertaken in accordance with the terms of the collateral arrangement; and the financial instruments received under a collateral arrangement must be transferred from the account of the providing counterparty.

The requirements on reuse of collateral in Article 15 are broad. They apply to ´counterparties´, which is any 'undertaking' established in the EU or in a third country, that receives collateral with a right of reuse. The requirements apply to counterparties established in the EU even if they are acting through a branch outside the EU. They also apply extraterritorially to non-EU counterparties, but only if they are receiving collateral from counterparties established in the EU or if the non-EU counterparty is acting through a branch in the EU. Also notable the scope of the reuse provisions is wider than just SFTs, as they apply to the reuse of securities and other financial instruments provided as collateral under all security and title transfer collateral arrangements in any context, not just in the context of SFTs.

There are limited exemptions e.g. the reuse requirements will not apply to members of the European System of Central Banks (ESCB), but this does not apply to both sides of the trade as counterparties receiving collateral from exempt entities must still comply with the reuse requirements.

In order to give the market time to prepare, the reuse requirements will take effect six months after the SFTR comes into force, on 13 July 2016. However, the requirements will have retroactive effect, as they will also apply to collateral arrangements existing on the date the reuse requirements take effect.

The SFTR reuse requirements will impact hedge funds e.g. through their repo activity or prime brokerage arrangements. The main focus for the market now is on ensuring that there is adequate disclosure to providing counterparties, as the requirements seem likely to go beyond existing disclosures. Industry associations have collaborated to prepare market standard disclosures which would be sent to existing counterparties before the new rules come into effect and incorporated into new arrangements going forward. Aside from the wording of the disclosures, the market is thinking about the logistical exercise of making the disclosures, a challenge in itself, and is aiming for as a consistent approach as possible across the market.

Reporting to trade repositories (Article 4)

The SFTR reporting regime generally follows the model for derivatives reporting under EMIR. Under the SFTR, both parties to a trade (whether they are financial or non-financial counterparties) will have to report new, modified or terminated SFTs to a registered or recognised trade repository by T+1 and must maintain records of SFTs for at least five years following the termination of the transaction. UCITS managers and AIFMs will have to report on behalf of their funds.

The reporting requirements apply to counterparties established in the EU, including their branches outside the EU, and to EU branches of third country counterparties. There is, however, some uncertainty as to the application of the reporting requirements to AIFs, in particular where a non-EU AIF is managed by an EU AIFM. It seems likely that these queries will be resolved by FAQs in the two to three years before the reporting obligation would apply to these entities. ESMA is expected to consult on the reporting requirements of Article 4 in the spring of 2016, so more information on the reporting requirements may be forthcoming shortly.

To allow the market sufficient time to prepare for SFTR reporting, the requirements will be phased-in over a period of between 12 and 21 months after the detailed rules (known as Regulatory Technical Standards or RTS) for trade reporting come into force and thus the full requirements are known.  The length of the transitional period will vary depending on the type of reporting counterparty, with UCITS and AIFs having 18 months. Non-financial counterparties will not need to begin reporting their trades until 21 months after the relevant RTS comes into force.

In contrast to the reporting requirement, there will be no grace period for record-keeping. Counterparties must comply with the record-keeping obligation from 12 January 2016.This may be onerous for entities that currently do not keep records of SFTs in this way, even though the SFTR does not specify a particular form or content requirements for these records.

Although still some way off, it is already clear that there are a number of issues around SFT reporting. Much of these relate to overlapping reporting requirements.  The SFTR sets out the information that must be reported to the trade repository and further detail will be provided in the RTS and ITS to be adopted under the SFTR. These will need to ensure consistency with the reporting regime under EMIR and internationally agreed standards, in particular the Standards and Processes for Global Securities Financing Data Collection and Aggregation published by the FSB (November 2015).  However, other regulatory or supervisory authorities, such as the ECB are introducing SFT reporting regimes in addition to SFTR, and the requirements overlap to a degree. This is challenging from an implementation perspective and would lead to inefficiencies, so the industry is working with regulators to develop a consistent approach to the interpretation of the requirements and the collection of data in order to comply with as little duplication of effort as possible.

Implementation

Although less extensive than other recent regulatory reforms, most notably MiFID2, the SFTR nonetheless presents significant compliance challenges. At the core will be identifying in-scope entities and transactions, which may require systems build and establishing internal processes e.g. to capture all new in-scope collateral arrangements by 13 July 2016. Some solutions, such as those for the collateral re-use disclosures and reporting, would be optimal if they applied across the market, so efforts by the trade associations to work collaboratively on this are to be welcomed. In some cases, notably trade reporting, further regulatory guidance will be required before the issues can be fully resolved. It is hoped that further clarity will be provided as the Level 2 process unfolds.

 

Box: SFTR highlights

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New information and execution conditions on the reuse of securities collateral

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Disclosure requirements on the use of SFTs and total return swaps by fund managers to fund investors

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New requirements to report SFTs to a trade repository by T+1

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Applies to financial and non-financial counterparties and fund managers

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Applies to a broad range of transactions in addition to SFTs – derivatives collateral, total return swaps and some commodities finance transactions

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Extraterritorial scope

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Very limited exemptions

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Phased implementation of most requirements

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Some requirements (e.g. record-keeping and pre-contractual disclosure for new funds)  apply from 12 January 2016

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

owen.lysak@cliffordchance.com

jacqueline.jones@cliffordchance.com

www.cliffordchance.com