Securities lending: A brief reprieve on new rule

Securities Services, Regulation

Securities lending: A brief reprieve on new rule

May 2020

As treasurers continue to grapple with Covid-19-related funding challenges, the Securities Finance Transaction Regulation has prompted some to adopt an outsourced agency solution for their repo trades in preparation for new reporting requirements. flow analyses the impact of the regulation on the buyside and how it has catalysed - or could be the stimulus for - beneficial change

The postponement of significant financial regulatory change has been at the forefront of governments’ and regulators’ arsenals in response to the Covid-19 pandemic. A recent flow article titled Covid-19: Financial regulatory responses captured how securities industry participants were granted a temporary reprieve from regulations such as the EU’s Securities Finance Transaction Regulation (SFTR) to enable them to focus on operational challenges triggered by the pandemic.

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In March, the European Securities and Markets Authority (ESMA) postponed the reporting of securities lending transactions in line with detailed phase 1 reporting requirements of SFTR, which were due 13 April 2020, until June 13, 20201.  However, ESMA has informed trade repositories (TRs) that it expects them to be fully registered ahead of the new deadline – a task completed by four TRs as of 6 May.

 

Drivers behind the reprieve

Given the degree of market volatility, significantly increased transaction volumes and widespread changes in working practices, the delay is a welcome respite for financial institutions during these unprecedented market conditions. Industry-wide preparations for delivery of SFTR reporting were well advanced as the seriousness of Covid-19 became apparent. The grace period provided by the ESMA decision will enable the industry to thoroughly test and remediate any shortcomings across the reporting chain ahead of the updated June deadline.

 

Understanding SFTR

Born out of the 2008 global financial crisis, SFTR follows regulatory calls for greater accountability and transparency into the US$54 trillion2 shadow banking market. Both were lacking because there was a general lack of understanding and insight into how certain types of collateral were being used in multi-layered transaction chains3. In many cases, the same piece of collateral was being utilised or re-hypothecated many times over in transaction chains leading to heightened leverage and build-ups of systemic risk.4

In response to this, the European Commission introduced SFTR, a piece of regulation which will apply to banks, alternative and Undertakings Collective Investment in Transferable Securities (UCITS) asset managers, central counterparty clearing houses (CCPs), central securities depositories (CSDs) and other third party entities. The rules are also highly extraterritorial insofar as they apply to any third country counterparty where the securities financing transaction takes place at one of their subsidiaries inside the EU.

 

Getting SFTR reporting right

SFTR mandates financial institutions to disclose information about their securities financing transactions (SFTs), amongst other in-scope trading activities, to trade repositories5 that fall under the regulatory remit. Reportable transactions will include activities like repurchase, or repo agreements, margin lending trades, total return swaps, buy-sell backs, sell-buy backs plus securities lending and securities borrowing and commodities lending and commodities borrowing.

The reporting template, which firms must provide to repositories on either T+1 for SFTs or S+1 for the underlying collateral constituents, contains 155 different data fields split into four criteria, namely counterparty data, loan and collateral data, margin data, and re-use, cash reinvestment and funding sources data.6 Managers will be asked to disclose information on the terms of any repos; collateral composition; re-use of collateral and details about any haircuts7. All of this data must be reported by firms to trade repositories using the ISO 20022 messaging standard.8

 

Managing the operational challenges of reporting

Moreover, financial institutions must report information about their SFTs on a dual-sided basis, although this process can be delegated to third party service providers such as brokers or securities lending agents. Regardless of whether a financial institution harnesses a delegate reporting framework, as principal, they retain the regulatory responsibility for the accuracy and timing of the requisite filings. In this context counterparties should validate beforehand that any transactional data they are sharing with their trade repositories is aligned and accurate; otherwise it risks being rejected. Once reported, trade repositories will then validate and reconcile the data, before making the information accessible to the relevant regulatory body, which will evaluate it in order to identify developing systemic exposures of note.9

Additionally, affected organisations should provide a unique transaction identifier (UTI) for each reported trade and a legal entity identifier (LEI) for counterparts to the trades. Trade repositories have been instructed to reject any reported information without an LEI. However, ESMA announced back in January 2020 that it would give firms a one year LEI extension, amid growing regulatory concerns about the absence of proper global LEI coverage, especially for SFTs issued out of the US and Asia-Pacific (APAC).10 The International Securities Lending Association (ISLA), for example, said reported that 34% of assets held by custodian banks are missing an issuer LEI.11

Many financial institutions and investment funds have already been carrying out identical reporting requirements for exchange traded derivatives (ETDs) and over-the-counter (OTC) derivatives under the European Market Infrastructure Regulation (EMIR). However, SFTs can be quite complex trades as they are heavily intermediated and often reliant on manual processing. This, argue some industry experts, could make the SFTR reporting and compliance requirements much harder than the EMIR rules. However, firms should benefit from some of the experiences they picked up from EMIR.

In addition to the mandatory reporting to trade repositories, SFTR also requires that investment managers make periodic disclosures about their SFTs and total return swaps for UCITS funds and alternative investment funds once every six or 12 months, respectively. The rules also impose strict restrictions on collateral re-use, namely that counterparties must provide consent to any collateral re-use activities and be fully notified about the potential risks.

 

Committed to delivery

ESMA’s deferral of the phase 1 reporting requirements has provided some breathing space to facilitate greater postsubmission testing to ensure data integrity. However, with less than a month to go before the initial implementation date was due, lending agents such as Deutsche Bank were already committed to the delivery of the requisite reporting for the April date and have proceeded with their submissions on the original timetable.

At a minimum, investment firms need to ensure their data quality is robust and that they have streamlined connectivity channels with their counterparties ahead of the reporting deadline.

 

Catalysing change – what benefits has SFTR brought?

As industry participants prepare for the SFTR reporting requirements, it is important that they look beyond the initial technical burden that surrounds the implementation of the regulation and harness the longer-term benefits that standardised data and greater transparency can deliver.

 

Strengthening governance

The reporting obligations for UCITS and alternative investment funds (AIFs), which entered into force in 2016, have to date provided investors, fund boards and the wider public with access to detailed reporting on key exposure measures and the commercial outcomes that characterise securities lending programmes, whether they are managed by affiliates or third parties. This heightened transparency has strengthened governance practices and enables stakeholders to examine comparative risk-adjusted returns against peer fund offerings, often delivering better return outcomes for investors.

 

Enhancing policy interventions

SFTR supports greater regulatory transparency in a timely manner and with a granularity of content not previously achievable. Such improved accessibility to loan transaction and related collateral information should underpin enhanced analytical frameworks within regulatory authorities and support more informed responses to various market conditions. For example, the data could be applied to evaluate the implementation and subsequent tapering of various monetary policy liquidity measures, or to provide a rich empirical backdrop to consider adjustments to short sale regulations during times of market strain. This may be the catalyst for greater regional harmonisation of responses to market volatility triggered by the 2008 financial crisis or Covid-19.

 

Driving greater automation and standardisation

Industry-wide standardisation and collective engagement across industry practitioners will underpin further digitisation of securities finance activity, while protecting against inherent risk and realising operational efficiencies.

The securities lending industry has a longstanding history of collaboration to create a harmonised operating framework in areas such as legal opinions that support the Global Master Securities Lending Agreement (GMSLA) and across working groups on regulation, tax and ESG within the International Securities Lending Association and its peer associations. SFTR has garnered industry-wide momentum towards further standardisation. For example, the regulation’s reporting requirements catalysed the need for a collaborative approach where much of the requisite work to create standardisation is already being undertaken.

This collaborative approach has also epitomised the partnership between an initial community of six financial institutions and securities lending data provider IHS Markit to design and develop a solution to address SFTR reporting in 2017.12

Leveraging the standardisation accomplished under SFTR, ISLA and other industry associations are examining the application of a common domain model within securities finance markets to achieve greater automation and standardisation of documentation, trading and transaction management.

 

Move toward outsourcing

Within the current uncertain economic environment, the treasury teams at companies and financial institutions have been focused on delivering sustainable liquidity to meet varying business and market exposure requirements with Repo transactions being a cornerstone of many Treasury solutions. The Treasury teams at these buy side firms are increasingly opting for an outsourced repo agency solution, which has long been the domain of traditional securities finance product offerings. Considerations in the buy side evaluation of such outsourcing models have been the resources and planning required to deliver SFTR reporting for internally managed repo trading operations. The -delegated reporting model available through outsourced repo is seen as a positive by-product of adopting such a third party agency solution.

“We expect to see a continued widening of such partnership frameworks to include securities lending alongside liquidity management solutions,” says Maurice Leo, Director, Agency Securities Lending, Deutsche Bank.

 

Enabling further performance analytics

The industry has well-established performance measurement and benchmarking solutions based upon substantive loan transaction data sets. A number of these data vendors are offering regulatory reporting solutions to meet SFTR requirements. Consequently beneficial owners will be able to elect to merge the SFTR collateral data alongside the established loan transaction data set they submit to a data vendor, in order to deliver more insightful performance attribution reporting. Diagnostics based upon a consolidated loan and collateral data set would highlight the importance of specific collateral types, term or margining practices in optimising the value of certain lendable assets or the importance of collateralisation under pledge or title transfer arrangements in managing capital constraints. These insights offer data users a more informed basis upon which to frame their operating parameters.

 

Selecting counterparties with new evaluation criteria

Since 2005 borrowers and agent lenders have adopted the Agent Lending Disclosure (ALD) framework to support the measurement of exposures to the underlying principals in the loan transaction. Regulatory developments in the intervening years have heightened borrower sensitivity to the Risk Weighted Assets (RWA) burden of sourcing supply from particular lender types. Established ALD practices have struggled to deliver timely data to borrower credit teams to optimise RWA impacts on certain lower margin transaction types. SFTR has been a catalyst for institutions to review the current ALD process and it is possible that firms will dispense with the legacy ALD trading information as SFTR data represents a more-timely and standardised set of evaluation criteria including adoption of legal entity identifiers that have been successfully used in other collateralised transaction types.

 

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Sources

1 See ESMA (March 19, 2020) ESMA sets out approach to SFTR implementation
2 See CNBC (April 11, 2019) Shadow banking is now a $52 trillion industry posing a big risk to the financial system
3 See Bloomberg (October 3, 2018) Say hello to SFTR
4 See Bloomberg (October 3, 2018) Say hello to SFTR
5 See FCA (January 7, 2019) Trade Repositories
6 See Regis-TR – Securities Financing Transaction Regulation
7 See Global Custodian – The SFTR Clock is ticking – implications and solutions for those carrying out securities financing transactions
8 See Broadridge – SFTR Reporting
9 See ESMA – SFTR Reporting
10 See Global Custodian (January 7, 2020) ESMA grants one year reprieve for key SFTR requirement
11 See ISLA – The LEI and Securities Financing Transaction Regulation
12 See https://bit.ly/3eooair at news.ihsmarkit.com

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