Reporting for scrutiny
14 October 2014
Although there is little indication of if or when the European Commission鈥檚 newest regulations for securities finance transactions will come into force, keeping informed remains half the battle
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Following the Financial Stability Board鈥檚 (FSB) work on shadow banking, which the board estimated to be worth approximately 鈧�51 trillion in 2011, the European Commission set about identifying and adopting measures that could protect what it has deemed to be systematically important to Europe鈥檚 financial system.
In January of this year, the European Commission adopted a regulatory proposal that requires all counterparties doing business within the EU to report trades, including repo and securities lending and borrowing transactions. This, it has said, is essential to be able to monitor risks in an effective manner and intervene when necessary.
In order to enter into force, the proposed securities finance transaction reporting regulation must be passed by the European Parliament and adopted by the Council of the EU. The political process to achieve this has begun.
The rules would apply to all EU entities as well as to those third country entities that rehypothecate financial instruments provided by an EU entity. The rules would also cover any collateral arrangement under the Financial Collateral Directive, ie, title transfer collateral arrangement or security interest collateral arrangement.
The commission states: 鈥淭his proposal provides a set of measures aiming to enhance regulators鈥� and investors鈥� understanding of securities financing transactions (STFs). These transactions have been a source of contagion, leverage and pro-cyclicality during the financial crisis and they have been identified in the commission鈥檚 Communication on Shadow Banking as needing better monitoring.鈥�
SFTs are used by fund managers to earn additional returns or to secure additional funding. For example, repo transactions are often used to raise cash for additional investments. At the same time, SFTs create new risks, according to the European Commission, such as counterparty risk and liquidity risks that materialise if the counterparty to the transaction defaults.
Generally, only a part of the additional earnings is attributed to the fund, but the entire counterparty risk is borne by the fund鈥檚 investors. Therefore, the use of SFTs may lead to a significant alteration of the risk-reward profile of the fund. The commission says that 鈥渕anagers鈥� motivation to use SFTs may not necessarily be aligned with the interests of the investors鈥�. It adds: 鈥淔or instance, revenues might not be fully shared with fund investors鈥�.
As a result, the proposed regulation will require all transactions to be reported to a central database. This would allow supervisors to better identify the links between banks and shadow banking entities and is designed to shed more light on some of their funding operations. As a consequence, supervisors would be able to monitor the exposures to and risks associated with SFTs and, if necessary, take better-targeted and timelier actions.
The regulation is also intended to improve transparency towards investors on the practices of investment funds engaged in SFTs and other equivalent financing structures by requiring detailed reporting on these operations, both in the regular reports of funds and in pre-investment documents. The commission has said that this would ideally 鈥渓ead to better-informed investment decisions by investors鈥�.
Finally, the commission claims that this proposal would improve the transparency of rehypothecation (any pre-default use of collateral by the collateral taker for its own purposes) of financial instruments 鈥渂y setting minimum conditions to be met by the parties involved, including written agreement and prior consent鈥�. This would ensure that clients or counterparties have to give their consent before rehypothecation can take place and that they make that decision based on clear information on the risks that it might entail.
At the European Beneficial Owners鈥� Securities Lending Conference in London, the commission鈥檚 Martin Mitov intimated that these proposed regulations would not adversely affect the industry.
Mitov said the commission鈥檚 proposal 鈥渋s all about transparency鈥攊t doesn鈥檛 restrict the transactions themselves鈥�.
鈥淭his proposal does not restrict market practice. It鈥檚 an important step in understanding and reducing risk.鈥�
In the European Central Bank鈥檚 official opinion, it has confirms that it 鈥渂roadly welcomes the proposed regulation鈥�, while the UK government has also pledged its support to the objective of increasing transparency of the shadow banking sector. Minutes from a parliamentary committee meeting on the proposed regulation confirmed that, 鈥渁s the proposal is taken forward, [the UK government] will look for reassurance on these issues and seek to amend the draft regulation if it deems it necessary鈥�.
In January of this year, the European Commission adopted a regulatory proposal that requires all counterparties doing business within the EU to report trades, including repo and securities lending and borrowing transactions. This, it has said, is essential to be able to monitor risks in an effective manner and intervene when necessary.
In order to enter into force, the proposed securities finance transaction reporting regulation must be passed by the European Parliament and adopted by the Council of the EU. The political process to achieve this has begun.
The rules would apply to all EU entities as well as to those third country entities that rehypothecate financial instruments provided by an EU entity. The rules would also cover any collateral arrangement under the Financial Collateral Directive, ie, title transfer collateral arrangement or security interest collateral arrangement.
The commission states: 鈥淭his proposal provides a set of measures aiming to enhance regulators鈥� and investors鈥� understanding of securities financing transactions (STFs). These transactions have been a source of contagion, leverage and pro-cyclicality during the financial crisis and they have been identified in the commission鈥檚 Communication on Shadow Banking as needing better monitoring.鈥�
SFTs are used by fund managers to earn additional returns or to secure additional funding. For example, repo transactions are often used to raise cash for additional investments. At the same time, SFTs create new risks, according to the European Commission, such as counterparty risk and liquidity risks that materialise if the counterparty to the transaction defaults.
Generally, only a part of the additional earnings is attributed to the fund, but the entire counterparty risk is borne by the fund鈥檚 investors. Therefore, the use of SFTs may lead to a significant alteration of the risk-reward profile of the fund. The commission says that 鈥渕anagers鈥� motivation to use SFTs may not necessarily be aligned with the interests of the investors鈥�. It adds: 鈥淔or instance, revenues might not be fully shared with fund investors鈥�.
As a result, the proposed regulation will require all transactions to be reported to a central database. This would allow supervisors to better identify the links between banks and shadow banking entities and is designed to shed more light on some of their funding operations. As a consequence, supervisors would be able to monitor the exposures to and risks associated with SFTs and, if necessary, take better-targeted and timelier actions.
The regulation is also intended to improve transparency towards investors on the practices of investment funds engaged in SFTs and other equivalent financing structures by requiring detailed reporting on these operations, both in the regular reports of funds and in pre-investment documents. The commission has said that this would ideally 鈥渓ead to better-informed investment decisions by investors鈥�.
Finally, the commission claims that this proposal would improve the transparency of rehypothecation (any pre-default use of collateral by the collateral taker for its own purposes) of financial instruments 鈥渂y setting minimum conditions to be met by the parties involved, including written agreement and prior consent鈥�. This would ensure that clients or counterparties have to give their consent before rehypothecation can take place and that they make that decision based on clear information on the risks that it might entail.
At the European Beneficial Owners鈥� Securities Lending Conference in London, the commission鈥檚 Martin Mitov intimated that these proposed regulations would not adversely affect the industry.
Mitov said the commission鈥檚 proposal 鈥渋s all about transparency鈥攊t doesn鈥檛 restrict the transactions themselves鈥�.
鈥淭his proposal does not restrict market practice. It鈥檚 an important step in understanding and reducing risk.鈥�
In the European Central Bank鈥檚 official opinion, it has confirms that it 鈥渂roadly welcomes the proposed regulation鈥�, while the UK government has also pledged its support to the objective of increasing transparency of the shadow banking sector. Minutes from a parliamentary committee meeting on the proposed regulation confirmed that, 鈥渁s the proposal is taken forward, [the UK government] will look for reassurance on these issues and seek to amend the draft regulation if it deems it necessary鈥�.
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