SFTR is built on three pillarsi viz.:
- Transaction Reporting. Requirements for counterparties to SFTs to report all SFTs to central trade repositories;
- Client Disclosure requirements for investment funds to disclose the use of SFTs to investors in their regular reports and pre-contractual documents;
- Minimum transparency conditions for the reuse of collateral received in a SFT (rehypothecation), such as the disclosure of the resulting risks and consequences as well as prior consent by the counterparty providing collateral.
SFTR Pillar I
The gross amount of outstanding repos (one type of SFT) by EU counterparties alone is estimated at €5.5tn. SFTs lead to the build-up of leverage.ii This is difficult to assess due to a lack of granular data (e.g. the volume of margin lending transactions, data on the reinvestment and reuse of collateral) and the potentially different purposes for which SFTs are undertaken.
The transaction-level reporting obligation introduced with SFTR will enable authorities to better analyse the implications of SFTs in terms of creating leverage.iii These data will also allow authorities to implement appropriate qualitive standards for the calculation of haircuts and numerical haircut floors, thereby fulfilling outstanding FSB recommendations 12-18.iv [haircuts refers to a reduction applied to the value of an asset. It is expressed as a percentage. Loans are typically overcollateralised, i.e. a €1 million loan may demand €1.2 million in collateral, thereby mitigating market risk as the collateral could potentially lose value, thereby exposing the lender to credit risk. More information here.v]
SFTR Pillar II
The use of SFTs and total return swaps (TRSs) could increase the general risk profile of the collective investment undertaking whereas their use is not properly disclosed to investors. It is crucial to ensure that investors in such collective investment undertakings are able to make informed choices and to assess the overall risk and reward profile of collective investment undertakings.
Investments made on the basis of incomplete or inaccurate information as regards a collective investment undertaking’s investment strategy can result in significant investor losses. It is therefore essential that collective investment undertakings disclose all relevant detailed information linked to their use of SFTs and TRSs.vi
SFTR Pillar III
Reuse of collateral provides liquidity and enables counterparties to reduce funding costs. However, it tends to create complex collateral chains between traditional banking and shadow banking, giving rise to financial stability risks. The lack of transparency on the extent to which financial instruments provided as collateral have been reused and the respective risks in the case of bankruptcy can undermine confidence in counterparties and magnify risks to financial stability.vii In short, unchecked collateral rehypothecation represents systemic risk.
Pillar I Transaction Reporting will commence:
- 12 months after the level II RTS/ITS appear in the Official Journal for MiFID II Investment Firms and CRD IV Credit Institutions (+ third-country equivalents);viii[approximately Q2 2019]
- 15 months for EMIR ‘central counterparties’, CSDs (+ third-country equivalents);
- 18 months for UCITS, AIFMs (+ third country equivalents); ix
- 21 months for NFC (+ third-country equivalents). x
Pillars II and III are already in force.
Industry awaits the Commission’s adoption of ESMA level two RTSs/ITSs contained in its Final Report. Thereafter these require approval by the Parliament and Council.
The Commission has drafted delegated regulation governing Trade Repository fees, per its empowerment under Article 11(2) of SFTR. These must be adopted and appear in the Official Journal.
i Commission SFTR Article 29(3) Report p.7
ii Refer to ESMA’s Report on securities financing transactions and leverage in the EU.; ESMA/2016/1415
iii Commission SFTR Article 29(3) p.5
iv Commission SFTR Article 29(3) p.9
vi SFTR Recital 15.16
vii SFTR Recital 21
viii SFTR Article 33(2)(a)(i)
ix SFTR Article 33(2)(a)(iii)
x SFTR Article 33(2)(a)(iv)