SFTR – the latest regulation on the block

Oct 16, 2018 | Articles, Practice - Risk & Regulation

By Principal Consultant Aditya Oak

Data, analytics and machine learning may be the hottest topics at the moment, but that doesn’t mean that regulation can be ignored. With the compliance deadlines for the General Data Protection Act (GDPR) and Markets in Financial Instruments Directive (MiFID II) behind us, the regulatory focus now is on the Securities Financing Transactions Regulation (SFTR).

Aimed at improving transparency around securities lending and repos or Securities Financing Transactions (SFTs), as well as addressing the inherent risk in transactions entering ‘shadow banking’ areas, SFTR was published by the European Commission in January 2016. The deadline for compliance is the second half of 2019.

Tighter controls

SFTs are effectively collateralised short-term cash loan transactions that facilitate the ownership of securities and include the lending or borrowing of securities and commodities, including buy-sell and sell-buy back transactions, margin-lending transactions, and total return swaps (investor disclosure only). SFTs make up a large part of the alternative lending mechanism in the banking system and it is no surprise that the European Securities and Markets Authority (ESMA) is keen to establish tighter controls.

Recommended by the Financial Stability Board (FSB) and European Systemic Risk Board (ESRB), SFTR applies to EU financial institutions and non-EU branches of EU firms which transact with SFTs, including banks, asset or investment managers, insurance companies, pension funds or clearing institutions and repositories.

Enhance transparency

Amongst other things, SFTR aims to enhance transparency and enable regulators to better monitor risks by:

  • introducing reporting requirements for SFTs (similar to those for qualifying derivatives under the second European Market Infrastructure Regulation (EMIR II) whereby any event on SFT must be reported to a trade repository), and
  • limiting the reuse of collateral across all transactions (not just SFTs).

Changes will also need to be made to existing reporting systems as there is a degree of similarity with the reporting obligations already applicable to derivatives transactions under the Markets in Financial Instruments Regulation (MiFIR). Specific counterparty pairing rules will need to be applied across their different jurisdictions and regions to deliver the reporting to a centralised repository.

In the same way as the EMIR guidelines, SFTR requires two-sided T+1 reporting. In addition, the counterparty classifications and requirements for counterparties to send one report containing the complete data set to ESMA are also similar. This leads to a specific data challenge, namely that reporting entities require Legal Entity Identifiers (LEIs) and matching instrument static for the two-sided reporting to the repository.

Furthermore, counterparties subject to SFTR are required to keep a record of any SFT that they have concluded, modified or terminated for at least five years following the termination of the relevant transaction.

Challenges

From a regulatory standpoint, SFTs are challenging because the rehypothecation of collateral securities in other SFTs can lead to complex collateral chains. Default on one transaction can cause a domino effect, with other counterparties defaulting on their respective SFTs if the same collateral is used again.

Finally, the new legislation also aims to introduce minimum standards for collateral valuation and eliminate the possibility of SFTs obscuring potential weaknesses in financial institutions’ balance sheets which in turn has an impact on the tier 1 leverage ratio as well as the business as a whole.

Meeting the Deadline

In order to meet the compliance deadline of the second half of 2019, firms should be completing their infrastructure design and build plans now. There are four distinct areas to transition into the new state for banks and agents alike.

  • Industry Change:

SFTR is still taking shape and it is a major shift for the SFT industry itself. It is imperative for the business to guide the regulation to ensure the desired results of data accuracy, timeliness and transparency are achieved with the most efficient execution.

  • New Target Operating Models:

The new reporting standards, collateral re-use and valuation requires a change in operating model, with the impact on internal booking and valuation processes, interaction between counterparties, agents and tri-parties and impact on responsibilities within different functions yet to be assessed. The regulation requires more than 150 fields to be reported to the central repository. It will need more stringent processes and controls to ensure the fields are captured accurately and in a timely manner.

  • Technology Changes:

As it stands, the markets are relying on third-party providers for a part or full solution. The required operating model needs to drive the solution, with the technology changes to in-house applications ensuring compliance and helping drive efficiency.

  • Opportunity for improvement/optimisation:

SFTR will have industry-wide implications, with changes in processes, data gathering and management, as well as changes to the business model. It also provides all the participants with an opportunity to improve a variety of processes, including internal reporting, streamlining collateral management, deal booking and reconciliation processes, calculating risk metrics and monitoring return on capital/equity and day-to-day exposure.

At Brickendon we are helping firms meet the requirements of SFTR by leveraging our extensive network of existing transaction reporting projects, capital markets expertise and innovative data capabilities. We offer a number of solutions for the reporting, data management and operating model challenges, as well as IT system rationalisation and vendor selection, and can provide programme governance to the change team.

We are an award-winning transformational consultancy with the drive, skills, knowledge and experience to help you change your business for the better. Let us show you what we can do.

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