This primer was first published in March 2020 and has been updated to reflect recent developments
The Securities Financing Transactions Regulation (SFTR) is the EU’s answer to the Financial Stability Board’s policy framework for addressing shadow banking risks in securities lending and repo. The regulation is centred largely on transaction reporting, and impacts firms in the EU and beyond.
What is SFTR?
First proposed in 2014, SFTR came as a response to the Financial Stability Board’s (FSB) review of shadow banking following the 2007-8 crisis. Its goal is to enhance transparency and keep track of the risks associated with the securities market – the “last bastion standing” of the financial industry.
Partly in force since January 2016, the regime introduces extensive transaction reporting requirements for SFTs (securities financing transactions). All details related to an SFT and its lifecycle – including its conclusion, as well as any modifications or termination – are to be reported to a trade repository (TR) no later than the next working day. The TR is then responsible for validating and reconciling the data and making it available to the regulator. There are only four European Securities and Markets Authority (ESMA) approved TRs for now: DTCC, Regis-TR, UnaVista and KDPW.
If the reported SFT involves funds, these have to meet disclosure requirements relating to the use of SFTs and to total return swaps in pre-investment documentation. They are also required to regularly report to their investors. In addition, all in-scope firms have to report on a daily basis collateral market values, collateral reuse and margins.
According to the International Capital Market Association (Icma), “the regulation introduces extremely granular daily reporting requirements for repos and other types of SFTs, which pose a significant challenge for the industry”.
SFTR sets out 155 reporting fields, most of which require the data from both sides of the trade to match with no or very limited tolerance.
“The introduction of reporting for SFTs is significant,” says Pauline Ashall, capital markets partner at Linklaters.
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The SFTR regime is equivalent to derivatives reporting introduced under the European Market Infrastructure Regulation (Emir) in 2012. There was no prior requirement to report these transactions. “It covers a very broad range,” adds Ashall. This includes securities lending, repurchase agreements (repos), and collateralised operations that consist of a transfer of ownership.
Who does it apply to?
SFTR applies to any counterparty and all its branches, irrespective of their location, to an SFT established in the EU. It also applies to counterparties to a third country SFT if the transaction is concluded in the course of the operation of an EU-based branch.
The regime also applies to management companies of undertakings for the collective investment in transferable securities (Ucits), as well as to authorised managers of alternative investment funds (AIFs).
Finally, it applies to any counterparty engaging in a collateral reuse established either in the EU or in a third country, if the reuse is completed in the course of the operation of an EU-based branch.
Non-EU parties are also subject to the regulation if any part of the transaction involves work within an EU branch or using a financial instrument in the EU.
“SFTR is unique in that it introduces big changes around systems and controls,” says Catherine Talks, product manager at UnaVista, referencing the transparency requirements for investor protection. “SFTR requires firms to report in an accurate, complete way.”
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As noted in Article 13 of the regulation, Ucits management companies, Ucits investment companies and AIFMs are obliged to inform investors on their use of SFTs and total return swaps. Information to be included in the Ucits prospectus and AIF disclosure to investors includes a general description of the SFTs and total return swaps used by the collective investment undertaking and the rationale for their use, as well as the overall data to be reported for each type of SFT and total return swaps.
How will this impact the market?
Ashall warns that, at present, the regime’s scope is grey around the edges, with questions remaining for commodity lending and margin loans in particular.
“Reporting requires an enormous system-build with a lot of repapering and documentation to agree on, as it’s not always clear who is responsible for what – for example, generating the unique transaction identifier (UTI),” she says.
Regardless, Ashall does not think the legislation will change what people are doing significantly in terms of driving market practice. “It’s more of a cost issue,” she adds, speculating that at the margin, the costs could push some smaller participants out of the market.
Effectively, firms will have to provide reports on a daily basis during the life of the transaction as changes occur, and adjust to 155 reporting fields,” she says.
UnaVista’s Talks thinks data is the biggest issue. “SFTR is written in a way that you won’t just need to know what you’re doing but also what your counterparty is doing,” she says. “It means that, in a number of circumstances, firms will have to reach out to counterparties and understand what they are doing. This ranges from UTI generation and dissemination to backloading techniques.”
What is the industry doing?
“I think the industry has evolved quite quickly,” says Talks, who adds that ESMA has been explicit about reporting action but not delegation, which although not ideal, does mean that firms have been able to adapt infrastructure to prepare for the reporting involved.
“In Emir we saw firms delegating to their counterparties – they may have eight or nine counterparties reporting to numerous trade repositories,” she says. “Oversight of that data held in so many different places can be complex. I’ve found that firms aren’t talking about electing to delegate their reporting for SFTR as they do not want to add additional fragmentation.”
There’s a general feeling that these rules are cumbersome. Jonathan Lee, senior regulatory reporting specialist in SFTR at Kaizen Reporting, pointed out that firms are genuinely doing their best but have been repeatedly frustrated by rules that don’t reflect how the market functions and a lack of clarity and instruction about how to report certain transactions and lifecycle events.
What have been the key challenges for firms?
Market participants largely reported a smooth implementation process for phases one and two of the regime’s go-live. However, challenges remain, and some argue that certain elements will become fully visible only when all firms have begun reporting. “What we saw in phases one and two is that best practices really came into play,” said Sunil Daswani, senior securities lending and repo consultant at MarketAxess. “Engaging with industry groups and adopting best practices early on helped to fade potential grey areas and drove better statistics.”
While there is good engagement on behalf of hedge funds and asset managers, pension funds and insurance companies are yet to get actively involved, Daswani added.
“Pairing and matching remain challenging, but this was anticipated given the complexity of the reporting rules and their late finalisation,” said Alexander Westphal, director of market practice and regulatory policy at Icma. “There are also inherent issues beyond the control of reporting firms, such as the inability for trade repositories to identify counterparties that haven’t yet started reporting. These issues still create significant noise in the reconciliation data, which makes it hard for us to understand where we are, and challenging for firms to focus on the resolution of actual breaks.”
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Due to the inherent complexity of the reporting rules, some market participants expect other issues to crop up over time. “Beyond the TRs, we have no idea of the quality of the data or how complete it is,” said Richard Comotto, repo consultant and member of Icma’s SFTR taskforce. “Some firms seem to have done really well, but others are asking surprising questions at this stage. Given the incomplete and challenging nature of the reporting rules, there will clearly be problems.”
The quality of the reported data is also expected to improve as firms become more familiar with the rules. “The SFTR go-live is the culmination of several years of intensive cross-industry discussions and preparations,” Icma said in a statement. “The implementation of this highly complex reporting regime will be an iterative process as not all aspects have been finalised. The quality and consistency of the reported data should gradually improve over time, [and] discussions…will continue as firms learn the lessons from the first weeks of reporting.”
What are the different phases of the regime?
Collateral reuse rules began applying as soon as July 2016. The following year, disclosures required by funds on the use of SFTs were implemented, and in April 2019, technical standards in relation to reporting requirements and requirements for TRs entered into force. This year, however, is by far the most important as it brings all financial counterparties subject to the regime into scope.
Since July, all banks and investment firms (phase one), as well as central counterparty clearinghouses (CCPs) and central securities depositories (CSDs) (phase two) have begun reporting. Originally scheduled for April 13, the phase one go-live date was pushed back to match phase two in the aftermath of Covid-19.
“Esma made the bold decision to postpone the original SFTR deadlines for reporting obligations in response to the adverse developments resulting from the coronavirus outbreak,” said Linda Coffman, executive vice-president at SmartStream. “Despite having an additional three-month window to prepare, we found that many firms needed extra help to get them across the finish line.”
October 13 saw phase three firms, including asset managers, hedge funds, Ucits and AIFs, as well as pension funds and insurance companies, come into scope. While the Covid-19-related delay has helped sellside firms be better prepared, some market participants argue it has had the opposite effect for the buyside.
“The phase one reporting delay basically compressed the time available to the sellside to develop delegated solutions, which means clients haven’t always been able to get the answers they need to prepare themselves,” said Adam Jacobs-Dean, global head of markets, governance and innovation at the Alternative Investment Management Association (Aima).
“Although there’s still time to work things out, there would have been some merit in delaying phase three to maintain the appropriate sequencing.”
While the onus is now on the buyside to get ready in time, the sellside still has a role to play. “The regulatory delay has created an ambitious timeline for sellside firms to assist those buyside firms who have opted for delegated reporting models, as several outstanding issues – such as the reporting of collateral reuse – remain,” said Val Wotton, managing director of product and development strategy at DTCC. “Sellside market participants are now turning their attention to finalising their operations to be able to support buyside clients.”
Phase four, which came into effect on January 11 of this year, brings Non-Financial companies (NFCs) into the regulation’s reach. There is not too much crossover between NFC and FC transactions when it comes to SFTR reporting, and as a result, this change is not expected to have a huge impact on financial services
How has Brexit impacted things?
Although some parts of the regime require further work and clarification, preparations for the earlier go-lives are now complete and both buyside and sellside firms can move on. “The focus is now to make sure firms have ascertained how and where their trades are reported: either to a UK or EU trade repository (TR)," said DTCC’s Wotton.
While DTCC does not anticipate regulatory divergence on SFTR between the EU and UK, Brexit will still have an impact on firms’ reporting and compliance efforts. “Some trades that were previously assigned to an EU TR may now have to be transferred to a UK TR or vice-versa, which in turn will impact some of the matching and pairing,” she added. “As for TRs, they have to go through a process of migrating certain transactions, with some of them potentially having to review their business model.”
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To operate in the EU and handle EU transactions, a TR needs to have an established presence there. For some entities, this could indeed be synonymous with cutting off some operations if activity isn’t core in the region. DTCC, for instance, has set up a new entity in Dublin. “We’re working to ensure there’s a smooth product delivery on reporting, both for SFTR and Emir [European Market Infrastructure Regulation],” added Wotton. “TRs need to be domiciled in both jurisdictions if they were to provide services in both places.”
Some firms may also have to do dual reporting – meaning transactions could need to be reported in both jurisdictions. “This is a complication that banks could have done without,” said David Field, senior adviser at Delta Capita. “The UK was a strong contributor to the drafting of SFTR, and although it does believe that securities transactions need to be reported – it doesn’t necessarily believe it to the degree to which Esma has pushed the regulation.
