Alongside its proposed EU banking sector structural reforms, the European Commission (EC) has issued a proposal regarding the reporting and transparency of securities financing transactions (SFTs). This blog post provides a high-level overview of certain aspects of the EC’s SFT proposal.
EC’s Stated Rationale for the SFT Proposal: The EC stated that “[t]o prevent banks from shifting parts of their activity to the less-regulated shadow banking sector, it is important that any structural separation measure [such as the EC’s proposed banking sector structural reforms] is accompanied by measures improving the transparency of shadow banking.” According to the EC, transparency helps ensure that authorities and market participants have an appropriate understanding of how the markets work and the magnitude and nature of any potential risks. The EC also noted that transparency “provides the information necessary to develop effective and efficient policy tools to prevent systemic risks.”
SFTs: The EC described an SFT as any transaction that uses assets belonging to the counterparty to generate financing. The EC noted that, in practice, SFTs mostly include lending or borrowing of securities and commodities, repurchase or reverse repurchase transactions, or buy-sell back or sell-buy back transactions.
Scope of Application: The EC noted that its SFT proposal would apply to all EU entities as well as to those third country entities that rehypothecate financial instruments provided by an EU entity.
Key Aspects of the SFT Proposal: According to the EC, its proposal aims to improve the transparency of SFTs in the following three ways:
- Reporting of SFTs to Trade Repositories: The proposal would generally create a framework under which financial or non-financial counterparties to an SFT will report the details of the transaction to trade repositories. This information will be centrally stored and directly accessible by the relevant EU authorities. According to the EC, this aspect of its proposal would allow supervisors to monitor the exposures to and risks associated with SFTs and, if necessary, take better-targeted and timelier actions.
- Transparency Towards Investors: In order to enable investors to become aware of the potential risks associated with the use of SFTs and other financing structures, fund managers would generally be required to include detailed information on any recourse they have to these techniques in regular reporting intervals.
- Transparency Regarding Rehypothecation: The SFT proposal generally provides for the following requirements with respect to rehypothecation: (1) the client or the counterparty would need to give its consent for its assets to be rehypothecated; (2) the entity wishing to engage in rehypothecation would need to disclose the potential risks, e.g., those in the event of default; (3) the rehypothecation must be pursuant to the terms of a written agreement; and (4) the financial instruments must be transferred to the account of the entity that uses them for its own purposes (i.e., the rehypothecation could not take place on the client’s or counterparty’s own account).
Increasing Regulatory Focus on SFTs: The EC’s SFT proposal is the latest in a number of recent regulatory developments relating to SFTs, shadow banking and short-term wholesale funding.
- In August 2013, the Financial Stability Board (FSB) published a set of policy recommendations and reports designed to strengthen the oversight and regulation of the shadow banking system. Our earlier blog post on the FSB’s proposed regulatory framework for minimum haircuts on SFTs is available here.
- A number of senior U.S. regulatory officials have also discussed the possibility of introducing capital, liquidity and other policy measures to address certain risks relating to short-term wholesale funding in the form of SFTs. See e.g., our earlier blog posts on Federal Reserve Board Governor Jeremy C. Stein’s November 2013 speech (available here) and Federal Reserve Board Governor Daniel K. Tarullo’s November 2013 speech (available here).
Giving Effect to Certain FSB Recommendations: In August 2013, the FSB made 11 recommendations regarding SFTs. According to the EC, its SFT proposal is consistent with a number of these recommendations because it would provide for: granular and frequent reporting of SFTs to trade repositories (FSB recommendations 1 and 2); enhanced disclosure of the use of SFTs to fund investors (FSB recommendation 5); and requirements relating to rehypothecation (FSB recommendation 7).
Materials: European Commission, Proposal for a Regulation of the European Parliament and of the Council on Reporting and Transparency of Securities Financing Transactions (Jan. 29, 2014) available here: http://ec.europa.eu/internal_market/finances/docs/shadow-banking/140129_proposal_en.pdf.