Repo Comes Under the Microscope

Introduction

On 29 January 2014, the EU Commission published a legislative proposal for a regulation on reporting and transparency of securities financing transactions[1] (SFTs) and associated FAQ document.

The EU Commission is concerned that efforts to reform the structure of EU banks (in the form of the Liikanen proposals – see this blog post for more detail) could drive a substantial subset of ‘traditional’ banking activities towards the shadow banking sector.  In light of this, transparency and reporting requirements for SFTs are regarded as necessary in order to avoid regulatory arbitrage, identify vulnerabilities in the shadow-banking system and avoid undermining the principals of Liikanen.[2]  The regulation itself introduces transparency in three main areas:

  • the monitoring of the build-up of systemic risks related to SFTs;
  • the disclosure of information to investors whose assets are employed in SFTs; and
  • rehypothecation activities.

Scope

The proposed regulation applies to:

  • a counterparty to an SFT that is established:
    • in the EU (including all of its branches irrespective of where they are located); or
    • in a third country (if the SFT is executed by an EU branch);
    • management companies of UCITS and UCITS investment companies;
    • managers of alternative investment funds (AIFMs);
    • a counterparty to an SFT engaging in rehypothecation that is established:
      • in the EU (including all of its branches irrespective of where they are located); or
      • in a third country, if:
        • the rehypothecation is effected in the course of the operations of an EU branch; or
        • the rehypothecation concerns financial instruments[3] provided as collateral by an EU counterparty or an EU branch of a non-EU counterparty.[4]

SFT Reporting

The regulation requires all in-scope counterparties to an SFT which was concluded:

  • before the ‘Reporting Date’[5] and which remains outstanding on that date; or
  • after the ‘Reporting Date’

to report the details of the SFT to a registered or recognised trade repository no later than the working day following the conclusion, modification or termination of the SFT.  Within 12 months of the publication of the regulation, ESMA is to develop draft regulatory technical standards further specifying the format, frequency and contents of reports.  At least the following information is to be reported:

  • Parties to the SFT;
  • Beneficiary of the rights and obligations arising from the SFT (if different to the parties);
  • Principal amount;
  • Currency;
  • Type;
  • Composition of the underlying collateral;
  • Quality and value of collateral;
  • Method used to provide collateral;
  • Availability of collateral for rehypothecation;
  • Whether collateral has been rehypothecated;
  • Whether collateral has been substituted;
  • Repurchase rate or lending fee;
  • Haircuts;
  • Value date;
  • Maturity date;
  • First callable date. [6]

As is the case under EMIR, delegation of reporting is permissible.[7]  Reported data can also be made available to regulators in non-EU jurisdictions which have executed cooperation agreements with the EU Commission.[8]

Investor Disclosure

UCITS, their management companies and AIFMs must inform investors on their use of SFTs and other financing structures within their half-yearly[9] and annual reports.[10]  The information to be provided is detailed in Section A of the Annex to the regulation.[11]  Furthermore, any UCITS prospectus and the AIFM disclosure document[12] must also provide the information detailed within Section B of the Annex.[13]

Transparency of Rehypothecation Activities

Once the regulation enters into force, any rehypothecation of securities underlying an SFT can only take place if the following conditions are satisfied:

  • the counterparty providing the securities (the “provider”) has been informed in writing by the receiving counterparty (the “receiver”) of the risks involved in granting consent to rehypothecation (in particular the potential risks in the event of the default of the receiver);
  • the provider has granted its prior express consent in a written agreement or an equivalent alternative mechanism;[14]
  • rehypothecation is undertaken in accordance with the terms specified in the written agreement; and
  • the financial instruments received as collateral are transferred to an account opened in the name of the receiver.[15]

Conclusion

Since the Lehman collapse in 2008, transparency and the promotion of a ‘culture of data’ have been the order of the day across financial markets.  Whilst eminently reasonable in principal, the investor disclosure and rehypothecation requirements of the proposed regulation will have significant resource implications as firms once again revisit client documentation in order to identify areas of non-compliance.

However, even though (or perhaps because) the SFT reporting regime is designed to mimic the mechanics of EMIR transaction reporting, the sense is that SFT reporting will represent the greatest challenge to the industry.  Whilst largely consistent with the requirements of other regimes, such as asset encumbrance reporting, the amount of effort required to create an ability to properly analyse underlying collateral and the use to which it has been put should not be underestimated.  Moreover, as firms without the infrastructure or the tradition of generating data on the scale of banks, UCITS and AIFMs will find the detailed reporting requirements in Section A – which demands wholly new views of data to be created and maintained – particularly burdensome.

The SFT rules are not final, but precedents for SFT reporting regimes exist (warts and all) and the direction of travel is clear.  Granted, the future regime is likely to be burdensome.  However, on the plus side future surprises are unlikely.  As such, firms should keep at least one eye on the requirements of SFT reporting as they continue to build out their EMIR reporting capabilities.  It won’t be plain sailing, but with early awareness, a considered strategy and a flexible approach it should be possible to avoid many of EMIR’s reporting bear traps.


[1] Defined in Article 3(6) as including repos, securities and commodities lending/borrowing or any transaction having an equivalent economic effect and posting similar risks, in particular a buy-sell back transaction

[2] Recital 5

[3] As defined in Section C of Annex 1 of MiFID (Directive 2004/39/EC)

[4] Article 2(1)

[5] Being the date which occurs 18 months after the regulation enters into force (see Article 28(2)(a))

[6] Recital 8 and Article 4(7)

[7] Article 4(1)

[8] Article 19(8)

[9] UCITS and their management companies only

[10] Article 13(1)

[11] Article 13(2)

[12] See Directive 2011/61/EU, Article 23

[13] Article 14

[14] Article 15(1)

[15] Article 15(2)