Update On Securities Financing Transactions Regulation

by Morgan Lewis
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Morgan Lewis

In light of recent efforts by UK and EU financial authorities to incorporate the SFTR, managers of Alternative Investment Funds and Undertakings for Collective Investment in Transferable Securities that engage in securities financing transactions should consider any necessary actions regarding disclosure, reporting, or consent.

In late September 2016, the Financial Conduct Authority (FCA) published changes to its Collective Investment Schemes sourcebook (COLL) and Investment Funds sourcebook (FUND) to incorporate elements of the Securities Financing Transactions Regulation (SFTR). Additionally, the European Securities and Markets Authority (ESMA) recently published its Consultation Paper on draft regulatory technical standards (RTS) and implementing technical standards (ITS) for SFTR.

This LawFlash considers the changes introduced by these publications and the effects, in particular, on managers of Alternative Investment Funds (AIFs) and Undertakings for Collective Investment in Transferable Securities (UCITS) that engage in securities financing transactions.

What Is the SFTR?

The Regulation on Transparency of Securities Financing Transactions and of Reuse (more commonly referred to as the Securities Financing Transactions Regulation or SFTR) came into force on 12 January 2016. The SFTR forms part of the European Union’s action plan on shadow banking[1] and seeks to improve transparency in securities and commodities lending, repurchase transactions, margin loans, and certain collateral arrangements.

What Does the SFTR Require?

The SFTR’s key measures relate to the following:

  • Disclosure. Disclosure by UCITS and AIFs regarding their use of securities financing transactions (SFTs) and total return swaps (TRS) to investors in offering documentation as well as regular ongoing reporting.
  • Reporting. All SFTs are to be reported to trade repositories.
  • Reuse. Obtaining consent for and providing disclosure regarding risks to SFT counterparties entering into rights of use and title transfer collateral arrangements.

SFTR’s Scope

The disclosure and reporting requirements of the SFTR apply to

  • repurchase transactions, including reverse repurchase transactions, relating to securities or commodities;
  • securities lending and securities or commodities borrowing that involves a commitment to return equivalent securities or commodities;
  • buy-sell back or sell-buy back transactions relating to securities or commodities; and
  • margin lending transactions (which is likely to cover prime brokerage agreements).

Aspects of the SFTR which require disclosure to unitholders of UCITS and AIFs also apply to TRS.

Collateral Arrangements

Additionally, SFTR provisions relating to reuse of collateral will apply to both title transfer financial collateral and security financial collateral arrangements (as defined by the Financial Collateral Directive).[2] Such definitions will overlap with an SFT to the extent that it constitutes a “collateral arrangement”.

Potential Applicability to Non-SFT Transactions

Collateral arrangements could apply to collateral provided in connection with non-SFT transactions, such as collateral provided under an International Swaps and Derivatives Association (ISDA) credit support annex/deed, where such arrangements fall within the definition of financial collateral arrangements under the Financial Collateral Directive.[3] If those arrangements contain a right of reuse, they will be covered by the disclosure reporting requirements.

The Disclosure Obligation (Articles 13 and 14)

From 13 January 2017, all UCITS management companies (ManCos) and alternative investment fund managers (AIFMs) should include detailed information regarding the criteria for the use of SFTs in their investor reports and offering documents to ensure that investors are aware of the risks associated with SFT usage.

Article 14—Pre-Contractual Disclosure

Article 14 requires ManCos and AIFMs to disclose the following information on SFTs and TRS in fund offering documents:

  • A general description of the SFTs and TRS employed by a fund and the rationale for their use.
  • The data to be reported for each type of SFT and TRS, specifically

    (i) the types of assets that may be subject to them;

    (ii) the maximum proportion of assets under management (AUM) that may be subject to them; and

    (iii) the expected proportion of AUM that will be subject to each of them.

  • The criteria used to select counterparties, such as domicile and credit rating.
  • A description of acceptable collateral with regard to asset types, issuer, maturity, and liquidity as well as the collateral diversification and correlation policies.
  • A description of the collateral valuation methodology used and its rationale, and whether daily mark-to-market and daily variation margins are employed.
  • A description of the risks linked to SFTs and TRS as well as risks linked to collateral management.
  • Information on how assets subject to SFTs and TRS and collateral received are safely maintained.
  • Information on any restrictions (regulatory or self-imposed) on reuse of collateral.
  • The policy on sharing of returns generated by SFTs and TRS, including a description of the proportions of revenue generated by SFTs and TRS that is returned to the fund, the costs and fees assigned to the manager or third parties, and whether these third parties are related parties to the ManCo or AIFM.

Article 13—Periodic Reporting

Article 13 requires information on the use of SFTs and TRS to be disclosed by ManCos and AIFMs in the half-yearly and annual reports relating to the UCITS that they manage or in the annual reports of their AIFs, respectively.

The information which must be included in the reports comprises seven categories:

  1. Global Data. (i) The amount of securities and commodities on loan as a proportion of total lendable assets; and (ii) the absolute and relative amounts of assets employed in each type of SFT and TRS.
  2. Aggregate Transaction Data. Data must be provided separately for each type of SFT and TRS and broken down across (i) type and quality of collateral; (ii) maturity tenor of collateral; (iii) maturity tenor of SFTs and TRS; (iv) currency of collateral; (v) country in which counterparties are established; and (vi) form of settlement and clearing.
  3. Concentration Data. The ten largest issuers across all SFTs and TRS and the top ten counterparties of each type of SFT and TRS.
  4. Data on Reuse of Collateral. Share of collateral reused compared to maximum amount specified in prospectus or in disclosure to investors; and cash collateral reinvestment returns to the fund.
  5. Safekeeping of Collateral Received by Fund as Part of SFTs and TRS. Identifying details for custodians and amount of collateral assets under safekeeping by each custodian.
  6. Safekeeping of Collateral Granted by Fund as Part of SFTs and TRS. Proportion of collateral held in segregated accounts or pooled accounts.
  7. Information on Return and Cost for Each Type of SFT and TRS. A breakdown between the fund, ManCo/AIFM, and applicable third parties, both in absolute terms and as a percentage of overall returns for that type of SFT and TRS.

Implementation

In ESMA’s view, the disclosure requirements as stipulated in the Annex of SFTR provide a sufficiently clear basis for the requirements’ application by ManCos and AIFMs. Therefore, ESMA is of the opinion that further specifying the contents of the Annex by issuing RTS would not be the best approach at this stage. However, ESMA will monitor market practice as well as the quality of reporting data in order to determine whether standards require issuance.

The SFTR provides for transitional periods in respect of the investor disclosure requirements in Articles 13 and 14. Article 14 will apply from 13 July 2017 in respect of UCITS or AIFs that are constituted before 12 January 2016. UCITS and AIFs authorised on or after 12 January 2016 cannot benefit from the transitional period. Whereas, Article 13 will apply from 13 January 2017, consequently, UCITS half-yearly and annual reports and AIF annual reports published from that date onwards (which will most likely relate to a period before that date) will need to provide the required information on SFTs and TRS.

The Reporting Obligation (Article 4)

SFT counterparties are required to report the details of any SFT concluded, modified, or terminated to a recognised trade repository on a T+1 basis. Counterparties must also maintain records of SFTs for at least five years following the termination of the relevant transaction.

Similar to reporting under the European Market Infrastructure Regulation (EMIR), the obligation may be delegated (subject to certain mandatory rules), though the ultimate responsibility for compliance rests with the counterparty. Financial counterparties entering into SFTs with non-financial counterparties that qualify as “small or medium sized enterprises” will be required to report on behalf of such counterparties. UCITS managers and AIFMs will have to report on behalf of their funds.

In summary, ESMA proposes the grouping of the data elements to be reported into four categories:

  1. Data related to the parties involved in the SFT, such as counterparties, beneficiary, broker, clearing member, entity responsible for reporting, and entity submitting the report.
  2. Information concerning the economic terms of the loan and of the collateral, as well as the valuation of the latter.
  3. Information on the margin posted or received for cleared SFTs.
  4. Data relating to the reuse of collateral pertaining to all SFTs.

Exemption

Where a non-financial counterparty, on its balance sheet date, does not exceed at least two of the following three thresholds, the financial counterparty will have an obligation to report on behalf of both itself and that non-financial counterparty:

  1. Balance sheet total of EUR 20 million
  2. Net turnover of EUR 40 million
  3. Average of 250 employees during the financial year

Implementation

ESMA is obliged to submit draft RTS and draft ITS by 13 January 2017. ESMA published a consultation on 30 September 2016 which sets out its draft RTS and ITS.

In that consultation, ESMA references that it is mandated “to minimise overlaps and avoid inconsistencies between the technical standards” adopted pursuant to SFTR and those under EMIR. The legal framework laid down by the SFTR should, so far as is possible, be the same as that of EMIR for the reporting of derivative contracts to trade repositories. This should also enable trade repositories registered or recognised in accordance with EMIR to fulfil the repository function assigned by the SFTR, if such trade repositories comply with certain additional criteria, subject to completion of a simplified registration process under Article 5 of the SFTR.

ESMA proposes to use ISO 20022[4] as the format for reporting SFTs, since it considers the standard would “provide open and transparent standards and. . .ensure that SFT reporting would be subject to robust governance from the regulatory community.”

The implementation of the reporting obligations will be phased in after the finalised RTS become effective. Depending on a firm's status, it will have to start reporting from 12 to 21 months after the entry into force of the RTS.

As a phase-in for reporting has been included in the SFTR, banks and investment firms may need to start reporting trades from mid-2018. Reporting will also apply to SFTs existing at the relevant effective date of the phase-in, provided that they either have (i) a remaining maturity in excess of 180 days or (ii) an open maturity or remain outstanding 180 days after that date.

The Reuse Obligation (Article 15)

The SFTR restricts the instances in which counterparties have the right to reuse “financial instruments” received as collateral under collateral arrangements. Compliance with this obligation for new and existing collateral arrangements became effective on 13 July 2016.

There are two conditions which will need to be satisfied for the collateral taker to reuse collateral.

First, the collateral provider must be notified in writing by the collateral taker of the “risks and consequences” involved in granting consent to reuse of collateral and/or concluding a title transfer agreement. The notification must include the risks and consequences that may arise on a default of the collateral taker. Five industry bodies[5] have jointly published a template “information statement”, which has been widely adopted by the financial services industry, for use by market participants to comply with this notification requirement.

Second, the collateral provider is required to have granted its prior express consent in writing to a security collateral arrangement which provides for a right of reuse[6] 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/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. The template information statement (referred to above) is intended to inform market participants of the general risks and consequences that may be involved in consenting to a right of use of collateral provided under a security collateral arrangement or of concluding a title transfer collateral arrangement. Market participants can tailor the statement to suit their own circumstances.

Any exercise of the right of reuse must also be undertaken in accordance with the prior written agreement between the parties and the “financial instruments” received under the collateral arrangement are to be transferred from the account of the collateral provider.

A safeguard has been included which provides that Article 15 shall not affect national law concerning the validity or effectiveness of any collateral arrangement. This protection means that a breach of the requirements set out above should not invalidate a transfer of collateral. This should also mean that the enforceability of security and/or the operation of close-out netting in related transactions should be unaffected.

Sanctions

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 measures upon notification to ESMA.

The FCA’s Approach

The changes to COLL include guidance on the information to be included on SFTs and TRS

  • in the prospectus or other offering documentation for UCITS, non-UCITS retail schemes (NURS), and qualified investor schemes (QIS); and
  • in annual and half-yearly reports of UCITS, NURS, and QIS.

The FCA’s guidance is set out in COLL 4.2.5AG. In addition, the provisions of the SFTR setting out the relevant disclosure obligations have been copied out into COLL 4.2.5BEU and 4.2.5CEU.

The FCA has detailed transitional provisions which mirror those under the SFTR (as described above). In the FCA’s consultation on proposed Handbook amendments to accommodate the SFTR, the FCA has stated that sub-funds constituted after 12 January 2016 would not benefit from transitional provisions regarding pre-contractual disclosures, even if the umbrella fund of which they are part was formed prior to that date. This position is reflected in the finalised transitional provisions to COLL.

The changes to FUND are similar to those in COLL. However, it should be noted that FUND contains cross-references to COLL, which is unusual since COLL is not applicable to AIFMs of unregulated funds.

Considerations

In view of recent developments, the following should be considered:

  • The written consent requirement is anticipated to be satisfied through the amendment of market-standard documents such as GMRAs, GMSLAs, and ISDAs, however, if this is not possible, alternative agreements should be implemented.
  • Whether particular facts and circumstances relating to market participants necessitate the supplementing of risk disclosures in any information statement.
  • Implementation of reporting obligations may prove onerous for market participants such as pension funds. Therefore, certain institutions may to need to delegate to third parties to report on their behalf.
  • Managers of UCITS and AIFs should prepare to disclose details of their use of SFTs and TRS in fund offering documents and periodic reports to investors.


[1] Shadow banking is considered by the Financial Stability Board to be “a system of credit intermediation that involves entities and activities outside the regular banking system”.

[3] 2002/47/EC

[2] Directive 2002/47/EC

[4] ISO 20022 is a single standardisation approach (methodology, process, and repository) to be used by all financial standards initiatives, and is currently used for other regulatory reporting regimes. ISO 20022 has widespread acceptance in the financial industry.

[5] The Association for Financial Markets in Europe, FIA, the International Capital Market Association, the International Swaps and Derivatives Association Inc., and the International Securities Lending Association.

[6] In accordance with Article 5 of the FCD.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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