As part of the EU shadow banking initiatives, the EU Securities Financing Transactions Regulation (2015/2365)(1) was adopted by the European Parliament on October 29 2015 and by the European Council on November 16 2015, entering into force on January 12 2016. It builds on the work and policy recommendations made by the Financial Stability Board within the context of its work to curb shadow banking.
The regulation purports to rectify what the European Union identified as a lack of transparency in both the securities financing markets and the financial markets by enhancing transparency through:
- the introduction of reporting of all securities financing transactions (SFTs) (save for those concluded with central banks) to central databases ('trade repositories');
- the obligation for investment funds and managers to start disclosing information on the use of SFTs and total return swaps to investors in their regular reports and pre-contractual documents; and
- the introduction of minimum transparency conditions that should be met regarding the reuse of collateral.
This update looks at the potential impacts of the regulation on traditional securitisations and the issuing special purpose vehicles (other than undertakings for collective investment in transferable securities or other regulated entities) used in those securitisations.
'Traditional securitisations' are defined in the EU Capital Requirements Regulation(2) as securitisations:
"involving the economic transfer of the exposures being securitised. This shall be accomplished by the transfer of ownership of the securitised exposures from the originator institution to an SSPE or through sub-participation by an SSPE. The securities issued do not represent payment obligations of the originator institution."
In this type of securitisation, orphan and bankruptcy remote special purpose vehicles that issue the securities ('issuers') may enter into swap contracts to deal with currency risk. This may be because the securities issued are denominated in a different currency from the currency of the underlying exposures. Issuers may also enter into swap contracts to deal with interest rate risk and/or basis risk. This may be because the interest rate of the securities issued is different from the interest rate of the underlying exposures or the timing of the interest rate of the securities is different from the timing of interest paid on the underlying exposures.
As a result, issuers entering into swap contracts will need to determine whether they need to comply with the regulation, which in turn could potentially lead to an increase in regulatory compliance and related costs by imposing reporting or other transparency obligations.
Reporting to trade repositories
Article 4 of the regulation obliges counterparties to SFTs to report the details of any SFT they have concluded, as well as any modification or termination thereof, to a registered or recognised trade repository. Such reporting must be done no later than the working day following the conclusion, modification or termination of the transaction.
Whether any of these reporting obligations would apply to an issuer in a traditional securitisation depends first on whether any of the swap contracts concluded by the issuer would qualify as an SFT.
Under the regulation, an 'SFT' can be any of the following transactions:
- Repurchase transaction – a transaction governed by an agreement by which a counterparty transfers securities, commodities or guaranteed rights relating to title to securities or commodities where that guarantee is issued by a recognised exchange which holds the rights to the securities or commodities and the agreement does not allow a counterparty to transfer or pledge a particular security or commodity to more than one counterparty at a time, subject to a commitment to repurchase them, or substituted securities or commodities of the same description at a specified price on a future date specified, or to be specified, by the transferor, being a repurchase agreement for the counterparty selling the securities or commodities and a reverse repurchase agreement for the counterparty buying them;
- Securities or commodities lending and securities or commodities borrowing – a transaction by which a counterparty transfers securities or commodities subject to a commitment that the borrower will return equivalent securities or commodities on a future date or when requested to do so by the transferor, that transaction being considered as securities or commodities lending for the counterparty transferring the securities or commodities and being considered as securities or commodities borrowing for the counterparty to which they are transferred;
- Buy-sell back or sell-buy back transactions – a transaction by which a counterparty buys or sells securities, commodities or guaranteed rights relating to title to securities or commodities agreeing, respectively, to sell or to buy back securities, commodities or such guaranteed rights of the same description at a specified price on a future date, that transaction being a buy-sell back transaction for the counterparty buying the securities, commodities or guaranteed rights and a sell-buy back transaction for the counterparty selling them; and such buy-sell back transaction or sell-buy back transaction not being governed by a repurchase agreement or by a reverse-repurchase agreement within the meaning of a repurchase transaction; and
- Margin lending transaction – a transaction in which a counterparty extends credit in connection with the purchase, sale, carrying or trading of securities, but not including other loans that are secured by collateral in the form of securities.
The definition of 'SFT' in the regulation does not include 'derivative contracts' as defined in the European Market Infrastructure Regulation (648/2012) (EMIR), but does include transactions that are commonly referred to as 'liquidity swaps' and 'collateral swaps',(3) which do not fall under the definition of derivative contracts in EMIR.(4)
Given the nature of the swap contracts that an issuer and a swap counterparty may typically enter into, it seems unlikely that they would fall within the definition of an 'SFT' and that the reporting obligation of the regulation would apply.
However, this does not mean that an issuer would not be subject to any swap-related reporting requirements. Swap contracts entered into by issuers in a traditional securitisation typically fall within the definition of a 'derivative contract' as defined in EMIR. Further, under normal circumstances issuers would classify as non-financial counterparties within the meaning of EMIR. As a result, issuers will be subject to trade reporting and compliance with risk mitigation techniques (including portfolio reconciliation, dispute resolution and collateralisation) under EMIR and may, if they fall above the clearing threshold, be subject to the clearing obligations set out in EMIR and its regulatory and implementing standards.
Transparency of reuse Reuse
Article 15 of the regulation sets out transparency requirements relating to the reuse of financial instruments received under a collateral arrangement, applicable from July 13 2016 (including with respect to collateral arrangements already in place on that date). These requirements apply irrespective of whether the collateral arrangement forms part of an SFT.
An issuer will therefore need to consider its hedging arrangements and determine whether:
- the hedging arrangements comprise a collateral arrangement such as an English law credit support annex (CSA), as well as collateral posted by way of security arrangements under a New York law CSA or English law credit support deed (CSD);
- the collateral arrangement includes the potential posting of collateral in the form of financial instruments (not cash only); and
- the collateral arrangement includes or grants a right of reuse to the receiving counterparty (which in the case of an English law CSD will be the case only if expressly so amended).
If an issuer determines that all of the above are satisfied, then the transparency requirements set out in Article 15 will need to be adhered to if the issuer is established in the European Union or, indirectly, if the issuer is dealing with a counterparty established in the European Union (including all of such counterparty's branches, irrespective of where they are located) or in a third country if the rights of reuse are granted by an EU branch.
The minimum transparency requirements set out in the regulation relate to the right of reuse and the exercise of any right of reuse.
Right of reuse In order to have the right of reuse, the receiving party must:
- disclose, in writing, the risks and consequences of entering into such a collateral arrangement; and
- obtain the prior express consent of the collateral provider in the case of a security collateral arrangement. In the case of a title transfer collateral arrangement, such as an English law CSA, the collateral provider must have expressly agreed to provide collateral, with such agreement being evidenced in the CSA itself.
In light of the above, the disclosure requirements are therefore more stringent for security collateral arrangements, such as New York law CSAs or CSDs, than for title transfer collateral arrangements.
Exercise of right of reuse The regulation further determines that the exercise of any right of reuse will be subject to at least both of the following conditions:
- Reuse must be undertaken in accordance with the terms of the collateral agreement; and
- Any financial instruments received under a collateral arrangement must be transferred from the account of the providing counterparty.
Article 15 allows for derogation to the second point above where a counterparty to a collateral arrangement is established in a third country and the account of the collateral provider is maintained in and subject to the law of a third country. In that case the reuse shall be evidenced either by a transfer from the account of the collateral provider or by other appropriate means.
Even though in practice it is unlikely that an issuer would exercise the right of reuse of securities collateral, the issuer would still need to comply with the requirements relating to the right of reuse and may also need to deal with requests from swap counterparties as to the issuer's standard disclosures for reuse of securities collateral.
On April 13 2016, the International Securities Lending Association, together with the Association for Financial Markets in Europe, FIA, the International Capital Market Association and the International Swaps and Derivatives Association, Inc jointly published an information statement on the regulation.(5) Subsequently, on May 13 2016, the information statement was updated to include a new Appendix 3, which sets out the risks and consequences that may arise in connection with the reuse of financial instruments by certain US entities. The updated information statement is intended for use when a transaction involves any such entities and includes alternative disclosures that are applicable in that case.(6)
The information statement is a template for use by market participants to inform their counterparties of the general risks and consequences that may be involved in consenting to a right of use of collateral provided under a security collateral arrangement or of concluding a title transfer collateral arrangement. It is a disclosure document only and does not purport to amend any of the terms of the collateral arrangement entered into between parties.
The information statement could be used for existing transactions where the reuse requirements have not been documented in the actual collateral arrangement (eg, through the inclusion of similar terms as set out in the information statement).
For new transactions, similar terms as set out in the information statement could be included in the agreements governing the collateral arrangement. However, if the terms of the information statement are included in the agreements governing the collateral arrangement, any change to these terms will be considered an amendment to such agreements and will need to follow the procedure and consent requirements for amending transaction documents as set out in the securitisation documentation.
Consequences of non-compliance Transaction documents
Article 15(4) of the regulation clarifies that breaches of the transparency of reuse requirements will not affect the validity or enforceability of the SFT or collateral arrangements as such. However, contrary to what is specified in relation to an infringement of the trade reporting requirements, Article 15(4) does not determine that a breach of the reuse requirements should not give rise to compensation rights so that careful consideration should be given to the swap documentation being entered into by issuers.
Further, a breach of the reuse requirements could potentially affect the securitisation if the issuer has given a representation and warranty in the transaction documents pertaining to the compliance with all applicable laws without any materiality threshold. In such case, unless remedied within the applicable grace period, an event of default or early amortisation event under the securitisation could be triggered following a breach of the reuse requirements.
The regulatory consequences of non-compliance on the issuer will depend on the implementation of the regulation by member states, as they must introduce effective, proportionate and dissuasive administrative sanctions.
Although the European Central Bank recommended wording to the effect that a receiving counterparty could be subject only to administrative sanctions, the regulation still leaves open the possibility for member states to implement criminal penalties in addition to those administrative sanctions (which can include maximum fines of at least 10% of the total annual turnover for legal persons, public statements, withdrawal or suspension of authorisation and temporary bans for those with managerial responsibilities).
While the impact of the regulation on the issuers in traditional securitisations appears to be fairly limited, similar to EMIR, it adds to the regulatory burden imposed on orphan special purpose vehicles such as the issuers and the costs of setting up and maintaining a securitisation transaction.
The question is whether, with respect to issuers under traditional securitisations, such additional regulatory burden is strictly necessary to increase transparency of reuse. As the swap providers under this type of securitisation tend to be sophisticated financial counterparties with sufficient knowledge to assess the risks pertaining to the right of reuse, it appears that the reuse information requirements will become a mere tick-box exercise without achieving the greater transparency desired by the European Union - but one that must be complied with given the number and potentially disproportionately high sanctions for non-compliance.
For further information on this topic please contact Julian Craughan or Michèle Daelemans at Hogan Lovells International LLP by telephone (+44 20 7296 2000) or email (email@example.com or firstname.lastname@example.org). The Hogan Lovells International website can be accessed at www.hoganlovells.com.
(1) Regulation (EU) 2015/2365 of the European Parliament and of the Council of November 25 2015 on transparency of securities financing transactions and of reuse and amending Regulation (EU) 648/2012.
(2) Regulation (EU) 575/2013 of the European Parliament and of the Council of June 26 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) 648/2012 (as amended).
(3) ESMA's consultation paper entitled "Draft RTS and ITS under SFTR and amendments to related EMIR RTS" (ESMA/2016/1409), dated September 30 2016, clarifies that a collateral swap included in the scope of SFT would involve a securities financing transaction, in which a securities loan is collateralised with non-cash collateral.
(4) Recital (7) of the regulation.
(5) The information statement was originally published on April 13 2016. See further www.isda.org/publications/regulatorydocumentation.aspx.
(6) The original information statement that was published on April 13 2016 can still be used in respect of all other types of transactions that do not involve any such entities.
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