April 2014 - Luxembourg
FSO Alert: EU to regulate securities financing transactions
Repos, securities lending and rehypothecation
In January 2014, the European Commission issued a Proposal for a Regulation on reporting and transparency of securities financing transactions (SFTs). The proposed regulation lays down:
- EMIR-like rules on the reporting of SFTs to trade repositories
- Additional transparency requirements the use of SFTs by investment funds
- Minimum conditions to be met when financial instruments are rehypothecated
The proposal will impact the securities financing activities of EU counterparties, EU branches of non-EU counterparties, management companies, and AIFM.
The Financial Stability Board (FSB) and the European Systemic Risk Board (ESRB) have been working to identify the key risks of the shadow banking system, including securities financing transactions (SFTs).
In this context, in August 2013, the FSB adopted a policy framework to address shadow banking risks in securities lending and repos; the report was endorsed in September 2013 by the G20 leaders.
In light of this work, the European Commission considers it necessary and appropriate to ensure the transparency of market activities including SFTs and rehypothecation, and to enable the monitoring and identification of the corresponding risks to financial stability.
The proposal covers the SFTs of:
- EU counterparties (such as banks, brokers, funds, insurance companies, pension funds, other financing companies and non-financial companies) and their branches, wherever they are located
- EU branches of non-EU counterparties
- Management companies of UCITS and UCITS investment companies
- Alternative investment fund managers (AIFMs) and internally managed AIFs subject to the Alternative Investment Fund Managers Directive (AIFMD)
- Repurchase transactions1 (repos) and reverse repurchase transactions (reverse repos)
- Securities or commodities lending2 and securities or commodities borrowing
- Any transaction having an equivalent economic effect and posing similar risks, in particular a buy-sell back or sell-back transaction
The proposal also covers counterparties engaging in rehypothecation:
- EU counterparties and their branches, wherever they are located
- EU branches of non-EU counterparty
- Non-EU counterparties that rehypothecate financial instruments provided as collateral by an EU counterparty or an EU branch of a non-EU counterparty
Transparency on SFTs
The reporting of securities financing transactions (SFTs) would be based on the existing reporting framework for derivative contracts established by the European Market Infrastructure Regulation (EMIR), and would operate in a similar way.
Counterparty to SFTs would have to report the details of these transactions to a trade repository. The reporting obligation will apply to SFTs which:
- Were concluded before the date of application of the requirements on transparency of SFTs, and remained outstanding on that date
- Are concluded after the date of application of the requirements on transparency of SFTs
Where a trade repository is not available to record the details of SFTs, counterparties will be required to report the details of the SFTs to the European Securities and Markets Authority (ESMA).
ESMA is required to develop draft regulatory technical standards specifying the detail of the different types of SFTs to be reported, which should include at least:
- The parties to the SFT and, where different, any beneficiary of the rights and obligations arising from it
- The principal amount, currency, type, quality and value of collateral, the method used to provide collateral, where it is available for rehypothecation, if it has been rehypothecated, any substitution of the collateral, the repurchase rate or lending fee, counterparty, haircut, value date, maturity date and first callable date
ESMA is also required to draft implementing technical standards specifying the format and frequency of the SFT reporting.
The date of application of the requirements on transparency of SFTs will be 18 months after the date of entry into force of the Regulation.
A counterparty which is subject to the reporting obligation may delegate the reporting of the details of SFTs.
Counterparties must keep a record of any SFT that they have concluded, modified or terminated for at least ten years following the termination of the transaction.
Eligible trade repositories for SFT reporting
To become eligible for the reporting of SFTs, trade repositories must comply with requirements of EMIR and submit an application for registration to ESMA.
A third country trade repository may also be eligible for the reporting of SFTs if it is recognized by ESMA.
Transparency for investors on the SFT activities of investment funds
The proposed Regulation also aims to enable investment fund investors to better understand the risks and returns linked to the use of the SFT transactions by the investment fund, management company, AIFM or internally managed AIF, and create incentives for managers to act in the interests of investors in relation to the use of SFTs.
Management companies, investment companies and AIFM will be required to provide investors with all relevant data regarding the use of SFT by the fund in a concise and aggregate manner:
- In the prospectus or issuing document made available to investors before they invest:
- General description of the SFTs and other financing structure used by the fund and the rationale for their use
- Types of assets that can be subject to SFT
- Maximum and expected proportion of assets under management (AuM) that can be subject to SFT
- Criteria used to select counterparties
- Description of acceptable collateral
- Information on collateral valuation methodology
- Description of the risks linked to SFT, as well as risks linked to collateral management, such as operational, liquidity, counterparty, custody and legal risks
- Specification of how assets lent out and collateral received are safe-kept
- Policy on sharing of return generated by SFT that are returned to the fund, to the manager or retained by third parties
- In the regular reports of funds:
- Global data:
- Amount of securities and commodities on loan as a proportion of total lendable assets
- Amount of assets engaged in each type of SFT expressed as an absolute amount and as a proportion of the fund’s AuM
- Concentration data:
- Top 10 collateral securities and commodities received per issuer
- Top 10 counterparties of each type of SFTs separately
- Global data:
- Aggregate transaction data for each type of SFT separately broken down by:
- Type and quality of collateral
- Maturity tenor of the collateral broken down into maturity buckets
- Currency of the collateral
- Maturity tenor broken down in maturity buckets
- Country of domicile of counterparties
- Settlement and clearing (e.g., tri-party, Central Counterparty, bilateral)
- Data on re-use and rehypothecation of cash collateral:
- Share of collateral received rehypothecated, compared to the maximum amount specified in the prospectus or in the disclosure to investors
- Information on any restrictions on type of securities and commodities subject to rehypothecation
- Cash collateral reinvestment returns to the fund
- Number of custodians and the amount of collateral assets safe-kept by each
- The proportion of collateral granted by the fund as part of SFTs held in segregated accounts or in pooled accounts
- Data on return and cost for each type of SFTs broken down between the fund, fund manager and agent lender
Requirements on rehypothecation
The draft Regulation lays down the requirements to be met when financial instruments are rehypothecated:
- The providing counterparty must give its prior consent for its instruments to be rehypothecated
- The providing counterparty must have been duly informed of the potential risks involved, including those in the event of default of the receiving counterparty
- There must be a written agreement
- The financial instruments received as collateral must be transferred to an account opened in the name of the receiving counterparty
Competent authorities will have the power to impose administrative sanctions and measures in relation to:
- Breach of the reporting obligation and safeguarding in respect of SFTs
- Breach of requirements on rehypothecation
Potential sanctions and measures available to competent authorities will include:
- An order requiring the person responsible for the breach to cease the conduct and to desist from a repetition of that conduct
- The disgorgement of the profits gained or losses avoided due to the breach
- A public warning which indicates the person responsible and the nature of the breach
- Withdrawal or suspension of the authorization
- A ban against managers or persons deemed responsible, from exercising management functions and/or dealing on own account
- Pecuniary sanctions of at least three times the amount of the profits gained or lossesavoided because of the breach
- Fines of:
- For a natural person, at least €5 million
- Legal entities: at least 10% of the total annual turnover of the entity
In order to enter into force, the proposed Regulation must be passed by the European Parliament and adopted by the Council of the European Union. The political process to achieve this has begun.
Download the FSO alert (pdf, 2mb).
1 “Repurchase transaction” means any transaction governed by a repurchase agreement or a reverse repurchase agreement.
2 “Securities or commodities lending” means any transaction in which a counterparty transfers securities or commodities subject to a commitment that the borrower will return equivalent at some future date or when requested to do so by the transferor.