The industry was committed and worked hard to meet the January 3, 2018 deadline for the go-live of Mifid II. It is evident now that market participants need to analyse the potential impact across firms in terms of resources and budget to be compliant ahead of SFTR transaction reporting go-live in towards the end of 2019. At the current stage, many firms are considering whether to continue deployment of resources till completion of Mifid II or begin reallocating resources to build and implement operation models and infrastructure for SFTR. This uncertainty might have a detrimental effect on the success of the aforementioned regulation. It is quite evident that SFTR is more than a simple trade reporting practice and impacts a wide-range of investment firms in areas such as businesses processes, controls, operations, IT systems and compliance. It is noteworthy that effort and costs will vary depending on the extent of system integration, the size of the firm and the transaction volumes. Further, challenges impacting the business model are the UTI generation, the reporting obligation to the trade repositories and, finally, the reconciliation process. Therefore, the industry needs to be prepared to tackle this objective rather than take a “wait-and-see” approach.
Following in the footsteps of Emir
From a technical standpoint, similar to Emir (European Market Infrastructure Regulation), SFTR includes two-sided reporting. This will affect both financial and non-financial institutions engaging in SFTs and will require them to report details of their transactions. This requirement will be phased-in with investment firms and credit institutions reporting from day 1. CCPs and CSDs will follow after three months in phase 2. Phase 3 will see insurance firms, pension funds, AIFs and UCITS reporting six months after while non-financial counterparties will bring up the rear after nine months in phase four of the reporting timeline.
Although the industry is currently focused on SFTR transaction reporting, the regulation does include two other significant cornerstones in addition to transaction reporting which are disclosure of information and reuse of collateral.
Disclosure of information
Pursuing to Article 13 of SFTR, UCITS and AIFs are obliged to inform investors on the use they make of SFTs and TRS on a periodic basis, i.e. annual (UCITS and AIFs) and half-yearly (UCITS only). The following information must be included in the reports and should be provided to the regulator as a snapshot:
- Global data, to provide the amount of securities and commodities on loan as a proportion of total lendable assets and the amount of assets engaged in in each type of SFTs and TRs
- Concentration data, to point out the top largest collateral issuers and top 10 counterparties across all SFTs and TRS
- Aggregate transaction data, to provide all the information available regarding the collateral, eg type and quality
- Data on reuse of collateral, to determine which share of collateral received is reused
- Safekeeping of collateral received, to provide number and names of custodians and amount of collateral assets safe-kept by each custodian
- Safekeeping of collateral granted, to determine the proportion of collateral held in segregated accounts, pooled accounts or any other accounts
- Data return and cost, to determine the percentage of overall returns generated by that type of SFTs and TRS
Reuse of collateral
The counterparties involved in SFTR have the right to reuse financial instruments received as collateral if certain conditions are satisfied including reuse in accordance with terms, express consent, duly informed in writing and transfer from account.
On the reporting side, the regulation is structurally identical to Emir. They both require counterparties to report the details of any lifecycle event on a T+1 and s+1 basis timely fashion. Nevertheless, counterparties to an SFT will be required to keep record of the transactions that have concluded, been modified or terminated for at least five years following the termination of the trade, as is currently required under Emir.
Trade repositories will apply a 2-way key (LEI and UTI) regardless of whether both counterparties to each SFTR contract have reported to the given trade repository. In terms of reporting format, in 2017, ESMA released the SFTR final report, specifying the format and frequency of the report. The novelty is represented by requirement also on the counterparties’ side to report to trade repositories using the ISO 20022 standard. The final target is to provide to the industry a single standardisation approach which will ensure open and transparent market’s practices.
What sets SFTR apart from other regulations?
What is very interesting from a regulatory perspective is the introduction for the first time of the extraterritoriality reporting requirement. The proposed regulation would cover SFTs conducted by any firm established in the EU, regardless of where the individual branch is. Furthermore, SFTR represents a significant move towards enhanced transparency in securities lending market and risk reduction from shadow banking. However, from a regulatory standpoint, the market participants will face the following challenges once the regulation is going-live:
1. The collateral re-use practice can lead to complex collateral chains, especially referring to situations where: (i) there is an extensive rehypothecation, so the same collateral will need to be reported several times; (ii) where pools of collateral are used against multiple trades, there will be difficulty allocating each element of the collateral against a specific transaction; (iii) Finally, a default on one transaction can cause a domino effect with other counterparties defaulting on their respective SFTs if the same collateral has been used in all of these.
2. Reconciliation: the process requires both counterparties of the trade to provide a UTI if they are in scope. However, in some cases such as CCPs, the industry is wondering who will generate the UTI for cleared trades considering that CCPs will enter into SFTR just in Phase 2. In addition, further clarity is required in situations whereby after reporting to CCPs, the transaction is subsequently novated. The industry is keen to know whether the different UTIs should be reported to the CCP by the counterparties.
3. Counterparties in scope: SFTR will cover EU counterparties, non-EU branches of EU firms and EU branches of third country firms. The market participants have concerns regarding the involvement of non-EU counterparties in the reporting chain. Indeed, those may be impacted when they trade in STFs, as the reporting entities will require certain information to fulfil their reporting obligations, for instance, the LEI of their counterparty and matching UTIs.
Following the implementation of Emir, lessons were learned. Before the go-live of Emir many market participants decided to take a wait and see approach and, as result, most of them were not prepared. This turned into additional compliance and operational costs.
In addition, the most important lesson learned from Emir relates to the industry preparation to deal with continuously changing regulatory requirements and new reporting regimes. For instance, Emir has been amended several times since its introduction in 2012. During this evolutionary period, new regulations, such as Benchmark, Short-selling and Mifid II transaction reporting entered into force. Preparing for the new reporting regime will provide a huge benefit not only from the regulatory standpoint in terms of transparency but also efficiency and cost-minimisation. Indeed, the industry will get the chance to have access to a more data granularity and business intelligence. The regulators hope that this will dramatically improve the decision-making process resulting in better business outcomes and risk management practices. The SFTR text is just one step in a continuously changing regulatory landscape and it is essential that the industry integrates the rules prescribed by the Regulator to increase transparency and integrity of the market.
In conclusion, the nuances of SFTR highlights the need to pick a trade repository with advanced data quality tools as regulators will be looking at rejection and matching rates. The onus is on firms to start putting their SFTR delivery team in place in other to fully assess the project requirement ahead of time. Firms with Mifir and Emir reporting obligations can leverage their existing infrastructure and vendor experience. Finally, the industry is in the information gathering stage therefore, firms can benefit from being part of industry groups, attending industry events and joining SFTR conversations.