Introduction The Regulation on Transparency of Securities Financing Transactions (SFTR) was published in the Official Journal on 23 December 2015 and entered into force on 12 January 2016.
At first glance it might appear that the SFTR which focuses on ‘securities financing’ would have little impact on the commodity markets. However, the scope of the SFTR is much broader than securities financing and many players in the commodities industry will find their transactions will be within scope of the requirements and obligations of the SFTR. This client alert discusses those obligations and their effect.
In particular, SFTR:
- Sets new reporting obligations that will apply to commodity repos and some related commodity financing techniques
- Sets new requirements relating to collateral arrangements commodity players may use
- Amends one of EMIR’s more troubling definitions which has had adverse consequences for users of non-EU exchanges (and the exchanges themselves)
Background Like EMIR1, the SFTR is part of a suite of regulations drafted in response to the 2007-2008 financial crisis. In August 2013, the Financial Stability Board (FSB) adopted a policy framework, “Strengthening Oversight and Regulation of Shadow Banking”, to address the risks stemming from securities lending and repurchase transactions and the overall need to improve regulation of ‘shadow banking’. The policy framework, which includes 11 recommendations, was endorsed by the members of the G20 in September 2013 and the SFTR was proposed by the European Commission in January 2014. The European Parliament voted overwhelmingly in favour of adopting the draft text of the SFTR on 29 October 2015 and a draft was published and passed by the council in November 2015.
As a response to the 2008 financial crisis, the SFTR “responds to the need to enhance the transparency of securities financing markets and thus of the financial system” by increasing the transparency of “securities financing transactions” (SFTs) through a phased-in reporting regime and disclosure obligations for those market participants involved in such arrangements. These obligations apply to repurchase agreements, securities lending/borrowing, commodities lending/borrowing, buy/sell back and sell/buy back transactions as well as the ‘reuse’ of collateral. The SFTR will apply to all new arrangements that qualify as SFTs as well as all qualifying existing arrangements.
Types of arrangements within scope
What is an SFT? The ‘securities financing transaction’ or SFT is the key concept defining the scope of the SFTR.
A SFT is defined by Article 3(11) of the SFTR to include ‘repurchase transactions’; ‘securities or commodities lending and securities or commodities borrowing’; buy-sell back transactions or sell-buy back transactions and ‘margin lending transactions’. Table 1 below sets out the definition of each of these terms as included in Article 3 of the SFTR. Under the SFTR a ‘commodity’ is defined to be “any goods of a fungible nature that are capable of being delivered, including metals and their ores and alloys, agricultural products, and energy such as electricity”.2
The scope of the SFTR does not include derivative contracts as included under the definition of EMIR.
Definition of arrangements included within the SFTR
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Based on these definitions, some common arrangements within the commodities industry such as commodity repo agreements and loans of gold or other precious metals where title to commodities is transferred will be caught as SFTs. But common types of trade finance deal in which the lender provides finance to a borrower and is granted security over commodities is unlikely to be caught.
In addition, as discussed further below, outright collateral transfers (such as those under the ISDA Credit Support Annex (English law)) will also be within scope of the disclosure obligations regarding the reuse of collateral. As these arrangements are common market practice for the broader commodity industry, the SFTR will bring all counterparties to them within scope of its obligations.
Which entities are caught? The SFTR applies to any EU counterparty to an SFT and any third-country (i.e. non-EU) counterparty where the SFT is concluded in the course of operations of an EU branch of that counterparty. All branches3of an EU entity, no matter where they are located, will be within scope of the SFTR where they are counterparty to an SFT.
‘Counterparty’ is defined by Article 3(2) to include both ‘financial counterparties’ and ‘non-financial counterparties’. The definition of ‘financial counterparty’ in Article 3(3) of the SFTR originates from Article 2(1) of EMIR and includes, among others:
- Investment firms authorised in accordance with MiFID II
- Credit institutions authorised in accordance with CRD IV
- Central counterparties (CCP) authorised in accordance with EMIR
- Third-country (i.e., non-EU) entities which would require authorisation or registration if established in the EU
Non-financial counterparties are undertakings ‘established’ in the EU other than financial counterparties.4 An undertaking is considered to be ‘established’ in the EU where the counterparty has its head office (if a natural person) or registered office (if a legal person) in the EU.5
The scope of the SFTR does not contain exemptions for producers or users of commodities. Accordingly, any commodities producer or trader that is a ‘counterparty’ and makes use of arrangements classified as SFTs will need to put procedures in place to facilitate the reporting of these arrangements as well as meeting other obligations under the SFTR.
Reporting obligation under Article 4
Obligation to report The SFTR introduces a phased-in reporting obligation for counterparties to SFTs. Reports of the details of any SFT concluded, modified or terminated will need to be submitted to a trade repository (which has been registered under Article 5 of the SFTR or recognised in accordance with Article 19 of the SFTR) no later than the following working day following the SFT’s conclusion, modification or termination (T+1). If a trade repository is not available, or in the event no repository has been registered or recognised in time for the start of reporting, counterparties are to report directly to ESMA.
Reports will need to be submitted when an SFT is concluded, modified or terminated and counterparties may delegate reporting of SFTs to another entity. The draft regulatory technical standards for reporting process will be developed by ESMA and are required to be submitted to the Commission by 13 January 2017.
Where an SFT is arranged between a financial counterparty and a non-financial counterparty (as defined by Article 3(3) and (4) of the SFTR), the financial counterparty is responsible for reporting for both parties if the undertaking does not exceed more than one of the thresholds below:
- Balance sheet total of EUR 20m
- Net turnover of EUR 40m
- Average of 250 employees during the financial year
Record keeping Regardless of whether a counterparty satisfies the reporting obligation itself or whether it delegates the obligation to another entity, that counterparty must keep a record of any SFT concluded, modified or terminated for at least five years following termination of the transaction.
Timing of phase-in The date of the application of the reporting obligation is determined based on the counterparty type. The reporting obligation will apply to:
- EU and non-EU investment firms and credit institutions (Article 3(3)(a) and (b)), starting 12 months after the date of entry into force of the Commission delegated act on reporting.
- EU and non-EU CCPs and central securities depositories (CSDs) (Article 3 (3)(g) and (h)), starting 15 months after the date of entry into force of the Commission delegated act on reporting.
- EU and non-EU insurance undertakings, AIFs, UCITS and institutions for occupational retirement provisions (article 3(3)(c) to (f)), starting 18 months after the date of entry into force of the Commission delegated act on reporting.
- Non-financial counterparties (Article 3(4)), starting 21 months after the date of entry into force of the Commission delegated act on reporting.
The Regulation does not indicate which start date will apply when the parties to an SFT fall within two different categories. We expect this to be clarified in the draft implementing technical standards.
Backloading requirement The SFTR includes a ‘backloading’ requirement so that all SFTs concluded before the date of application of the reporting obligation (as it applies to the counterparty) and which remain outstanding on that date must be reported to a trade repository if:
- The remaining maturity of the SFT on the date of application of the reporting obligation exceeds 180 days, or
- The SFT has an open maturity and remain outstanding 180 days after the date of application
Such outstanding SFTs will need to be reported to a trade repository within 190 days of the date of application of the reporting obligation to that counterparty.
What will industry participants have to do? Industry participants will need to review the agreements in place and the arrangements typically used to determine which of those will qualify as SFTs (e.g., commodity repos etc.). Reporting mechanisms will need to be established, procedures developed and relationships set up with an appropriate trade repository.
Market impact For traders and financiers who use the popular commodity repo product as an off-balance sheet financing tool, the introduction of reporting requirements will be a further regulatory hurdle which may encourage some to consider moving such financing operations offshore and outside the EU (where the majority of traders involved in commodity repo transactions now operate). Market participants have some time to digest the implications but planning will have to start soon.
New disclosure rules on ‘reuse’ of collateral under Article 15
What is meant by ‘reuse’ of collateral? ‘Reuse’ is defined under Article 3(12) of the SFTR as the use by a receiving counterparty, in its own name and on its own account or on the account of another counterparty, including any natural person, of financial instruments received under a collateral arrangement. Under this definition, ‘reuse’ includes transfer of title or exercise of a right of use in accordance with Article 5 of the Collateral Directive6 but does not include “the liquidation of a financial instrument in the event of default of the providing counterparty”.
‘Financial instruments’ is defined in accordance with MiFID II and thus includes government and corporate bonds, shares, derivatives and emissions allowances.
Requirements on the right of reuse Where the receiving counterparty wishes to exercise a right to reuse financial instruments received by it as collateral, the right of reuse is conditional on the following two points.
- The providing counterparty must be notified in writing by the receiving counterparty of the risks and consequences involved in: (i) granting consent to a right of use of collateral and/or (ii) concluding a title transfer agreement. The notification will have to include at least the risks and consequences that may arise in the event of the default of the receiving counterparty.
- The providing counterparty has granted prior express consent, evidenced by a signature, in writing or legally equivalent manner, to a security collateral arrangement which provides for a right of reuse (in accordance with Article 5 of the Collateral Directive) or has expressly agreed to provide collateral by way of a title transfer agreement.
Where the right of reuse is exercised, the reuse must (1) be undertaken in accordance with the prior written agreement between the parties and (2) the financial instruments received under the collateral arrangement must be transferred from the account of the providing counterparty.
Less stringent approach for non-EU counterparties In the event that a counterparty is established outside of the EU and providing the counterparty’s account is maintained in and subject to a the law of a non-EU jurisdiction, point 2 above will not apply and the reuse will be evidenced either by a transfer from the account of the providing counterparty or other means as appropriate. This reflects that third country laws may conflict with the Collateral Directive.
Article 15 will apply from 13 July 2016, including for those collateral arrangements existing on that date. This means that parties to existing outright transfer collateral arrangements and security collateral arrangements containing a right of reuse will need to ensure that they meet these requirements from that date.
Next steps Industry participants will review their current process and documentation to determine compliance with the new regulations. As the SFTR applies to those arrangements in place at the time of application of Article 15 (i.e., 13 July 2016) as well as all new arrangements put into place on or after that date, counterparties will need to ensure reuse under current arrangements and all future rearrangements is in compliance.
ISDA has established a working group looking at, among other things, potential documentation solutions with regard to the disclosure obligations under Article 15.
Reporting of breaches and sanctions for breaches As a regulation, the SFTR will be directly applicable in each EU member state. However, the SFTR has granted the competent authorities of member states the power to establish reporting procedures for both actual and potential infringements of Article 4 (reporting) and Article 15 (right of reuse). Counterparties to an SFT will need to have appropriate internal procedures in place for their employees to report actual and potential infringements of Articles 4 and 15 in accordance with the requirements of their competent authority.
Additionally, for breaches of Articles 4 or 15, competent authorities will have the power to apply administrative sanctions as included in Article 22(4)(a) to (h) of the SFTR. These include a cease and desist order, a public warning and a temporary or permanent ban against anyone who is deemed responsible. Member states may also elect to impose criminal sanctions. A breach of Article 4 will not affect the validity of the terms of an SFT. However, no additional statement has been included with regards to breaches of Article 15.
Addressing the third country exchange issue under EMIR – amendments to EMIR Article 2(7) At present all derivatives trades executed on non-EU markets (e.g., NYMEX, CME, ICE US) are treated under EMIR as OTC trades, partly because of legal issues with the power of the Commission to treat them otherwise. As a result, such trades are currently included in clearing threshold calculations and thus such trades can cause firms to be classified as NFC+ (an NFC above the clearing threshold) and subject to additional obligations.
SFTR sets out a new legal basis for excluding trades on third country exchanges from clearing threshold calculations. Article 32 of SFTR amends the definition of “OTC Derivative Contract” under EMIR to include all derivatives not traded on either an EU regulated market or a third country market which is deemed equivalent to a regulated market under a new Article 2a of EMIR (also put in place by Article 32 of SFTR). Article 2a provides for the Commission to make an equivalence determination and sets out the criteria for that determination.
This change is very important for users of third country exchanges, and those exchanges themselves, since it offers hope that major U.S. and other non-EU exchanges will be determined as equivalent and trades on them will no longer count towards the clearing threshold calculation, thus dealing with one of the most troubling aspects of EMIR for the market.