On 12 January 2016 Regulation (EU) 2015/2365 of the European Parliament and of the Council of 25 November 2015 on transparency of securities financing transactions and of reuse (the "Regulation") entered into force. Many of the obligations set forth in the Regulation will however not immediately apply, but will be phased in and become applicable over time. The Regulation, which is intended to limit the risks arising from shadow banking, lays down rules relating to the transparency of securities financing transactions ("SFTs") and the reuse of collateral received under a financial collateral arrangement ("FCA"). According to EU lawmakers, the Regulation is expected to enhance the transparency of the securities financing markets.
The scope of the Regulation is not limited to parties established in the EU, but also has extraterritorial effect. Specifically, it applies to:
- a counterparty to an SFT where that counterparty is established:
- in the EU, including all its branches irrespective of where they are located; or
- in a third country, if the SFT is concluded in the course of the operations of an EU branch of that counterparty;
- a counterparty that reuses financial instruments received as collateral under an FCA, where that counterparty is established:
- in the EU, including all its branches irrespective of where they are located; or
- in a third country, where either (x) the reuse is effected in the course of the operations of an EU branch of that counterparty, or (y) the reuse concerns financial instruments provided under a collateral arrangement by a counterparty established in the EU or by an EU branch of a counterparty established in a third country;
- authorised managers of undertakings for collective investment in transferable securities ("UCITS"); and
- authorised managers of alternative investment funds ("AIFs").
The Regulation distinguishes two types of "counterparties": financial counterparties (in short: authorised financial undertakings established in the EU or similar financial undertakings established in a third country) and non-financial counterparties (in short: undertakings that do not constitute financial counterparties).
- WHAT ARE SFTs?
As stated above, the Regulation contains rules on the transparency of SFTs. The Regulation defines an SFT to mean:
- a repurchase transaction;
- securities or commodities lending and securities or commodities borrowing;
- a buy-sell back transaction or sell-buy back transaction; and
- a margin lending transaction.
Except in the case of margin lending transactions, an SFT is a transaction whereby certain assets, such as securities, commodities or precious metals, are transferred by one party (Party X) to another party (Party Y) at a specified price (as security or the purchase price) and whereby Party Y undertakes to retransfer the same or equivalent assets to Party X at a specified price on a future date. In a margin lending transaction a party extends credit to another party 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).
- REPORTING OBLIGATION IN RESPECT OF SFTs
The Regulation requires counterparties to SFTs (see section 1, under 1) to report certain details about any SFT they have concluded, as well as any modification or termination thereof, to a trade repository. This must be done no later than the working day following the transaction's conclusion, modification or termination. The European Markets Infrastructure Regulation ("EMIR") already imposes a similar obligation on counterparties to a derivative transaction.
A counterparty is in principle entitled to delegate the reporting obligation to a third party. A similar right is regularly exercised by non-financial counterparties and small financial counterparties under EMIR. However, the Regulation states that where a financial counterparty concludes an SFT with a mid-sized non-financial counterparty, the financial counterparty is responsible for reporting on behalf of both counterparties. By contrast, EMIR does not include a comparable rule.
The Regulation also provides that where the counterparty is a UCITS or AIF, its manager is responsible for reporting on its behalf. Delegation of the reporting obligation is therefore unnecessary.
The Regulation sets out the minimum details that must be reported. These relate to the core elements of a transaction, such as the counterparties, the principal amount and the collateral. Pursuant to the Regulation, the European Securities and Markets Authority (ESMA) must draw up further rules (regulatory technical standards) to be adopted by the European Commission. The deadline for the submission of a draft set of standards to the European Commission is 13 January 2017.
Counterparties are required to keep a record of any SFT that they have concluded, modified or terminated for at least five years following the termination of the transaction.
The reporting obligation does not apply to members of the European System of Central Banks (ESCB), or transactions in which a member of the ESCB is a counterparty. Other EU public bodies charged with, or intervening in, the management of the public debt (such as the Dutch State Treasury Agency) and the Bank for International Settlements (BIS) are also exempt from the reporting obligation, but the same is not true for their counterparties.
- TRANSPARENCY TOWARDS INVESTORS BY MANAGERS OF UCITS AND AIFs
The manager of a UCITS or AIF is required under the Regulation to inform investors about its use of SFTs and total return swaps (i.e. derivative contracts in which one party is required to transfer the total economic performance of a reference obligation to another party). For UCITS this information must be provided in the half-yearly and annual reports and for AIFs in the annual report.
In addition, the manager of a UCITS or AIF is required to specify in the pre-contractual documentation – the prospectus of a UCITS or certain disclosures to investors of an AIF – which SFTs and total return swaps it is authorised to use and include a clear statement that those transactions and instruments are being used.
The annex to the Regulation lists the information that must be included in the reports (section A) and the pre- contractual documentation (section B). The European Commission may adopt rules further specifying the content of the annex.
- TRANSPARENCY OF REUSE
The Regulation is not limited to SFTs but also contains rules applicable to other FCAs insofar as the recipient, under an FCA, of collateral in the form of financial instruments (such as securities) is entitled to reuse those instruments.
The FCA was introduced by Directive 2002/47/EC on financial collateral arrangements. The Regulation refers to the Directive for the relevant definitions (and thus not to the implementation legislation of the respective EU member states).
There are two types of FCAs: title transfer FCAs and security FCAs (creating a security interest, e.g. a pledge). A title transfer FCA is an arrangement under which cash, securities or credit claims are transferred for the purpose of securing the performance of an obligation. A security FCA is an arrangement under which a (limited) security right is granted over cash, securities or credit claims for the same purpose, but where the ownership of the collateral in principle remains with the collateral provider. In order for an arrangement to constitute an FCA, at least one of the parties must be a financial market party.
Examples of customary FCAs are the standard master agreements for documenting SFTs (the MRA, MSLA, GMRA or GMSLA) and the collateral arrangements in connection with derivative transactions under an ISDA Master Agreement (the CSA or CSD). The security documentation for prime brokerage clients often constitutes an FCA as well.
As stated above, the Regulation limits itself to FCAs under which financial instruments are received as collateral. This applies both for title transfer FCAs and security FCAs.
Under a title transfer FCA, the collateral taker acquires ownership of the assets transferred as collateral. As owner of the collateral, the collateral taker then has full discretion to dispose of the assets as it deems fit. The same does not apply by definition in the case of a security FCA. In most European jurisdictions a (limited) security right provided pursuant to a security FCA is extinguished if the collateral taker ceases to have power and control over the collateral. This is also the case under Netherlands law. However, it can be agreed in a security FCA that the collateral taker may use or sell the collateral (with the exception of credit claims) and retain the resulting proceeds or assets. Upon exercising this right of reuse, the collateral taker thereby incurs an obligation to return equivalent assets to the collateral provider and obtains a (limited) security right over those assets by operation of law.
In practice collateral is often reused, as this provides liquidity and enables parties to reduce funding costs.
Under the Regulation "reuse" includes the transfer of ownership of the collateral under a title transfer FCA.
Rules regarding reuse
According to the Regulation, the right of reuse is controversial because of the lack of transparency on the extent to which collateral has been reused and the risks arising from this in the event of bankruptcy. This can undermine confidence in counterparties and increase the risks to financial stability. The Regulation therefore provides that the right to reuse financial instruments received as collateral is subject to at least both of the following conditions:
- the collateral provider has been duly informed in writing by the collateral taker of the risks and consequences that may be involved in one of the following:
- granting consent to a right of use of collateral provided under a security FCA;
- concluding a title transfer FCA;
- the collateral provider has granted its prior express consent, as evidenced by a signature, in writing or in a legally equivalent manner, to a security FCA, the terms of which provide a right of use, or has expressly agreed to provide collateral by way of a title transfer FCA.
With regard to point 1 the collateral provider must, at a minimum, be informed in writing of the risks and consequences that may arise in the event of the default of the collateral taker.
With regard to point 2, the prevailing view in the market is that, for example, the customary master agreements for the documentation of SFTs (the MRA, MSLA, GMRA or GMSLA) or the collateral arrangements in the case of derivative transactions under an ISDA Master Agreement (the CSA or CSD) already satisfy these conditions.
The exercise of a right of reuse is subject to the following conditions:
- the reuse can only be undertaken in accordance with the terms specified in the FCA; and
- the financial instruments received must be transferred from the collateral provider’s account (where such collateral provider is established in a third country and the account is maintained in such third country and subject to the law of such third country, the exercise of the right of reuse may be evidenced by other appropriate means)
The rationale for the condition set out in point 2 is that the exercise of a right of reuse should be reflected in the securities account of the collateral provider. The systems used by securities depositories may have to be adapted to enable the collateral taker to comply with this condition.
The Regulation explicitly provides that the above rules regarding reuse are without prejudice to stricter EU sectoral rules (such as those laid down in or deriving from the UCITS Directive, the AIFMD or MiFID) or national legislation providing a higher standard of protection to collateral providers in the event of reuse.
Like the reporting obligation of SFT counterparties (see section 3), the above rules regarding reuse do not apply to members of the ESCB, the BIS and other EU public bodies charged with, or intervening in, the management of the public debt. Their counterparties to an FCA in which the collateral consists of financial instruments must, however, comply with these rules.
It is noteworthy that the rules regarding reuse apply only to FCAs under which financial instruments received as collateral may be reused by the collateral taker. Apparently, they do not apply to a transaction in which financial instruments are transferred but a different type of asset (such as cash) is received under an FCA as collateral. That is the case in, for example, a securities lending transaction (an SFT). Consequently, market parties may wish to consider structuring transactions in which an FCA serves as the security document (such as an SFT) in such a way that assets other than financial instruments are used as collateral in connection with that transaction.
- CONSEQUENCES OF INFRINGEMENTS
The Regulation requires EU member states to ensure that competent authorities have the power to impose administrative sanctions and other measures for, at a minimum, infringements of the reporting obligation and the rules regarding reuse. The Regulation also addresses the effect of an infringement of the reporting obligation and the reuse-related rules on the SFT and the transaction, respectively.
According to the Regulation, an infringement of the reporting obligation has no effect on the validity of the terms of an SFT or the possibility of the parties to enforce those terms. In addition, such an infringement does not give rise to rights to compensation from a party to the SFT.
When it comes to the effect of an infringement of the rules regarding reuse, the Regulation is unfortunately less explicit. Article 15 of the Regulation – which sets out those rules – states that its provisions do not affect national law concerning a transaction's validity or effect. The legislative intent would seem to be that an infringement of the rules regarding reuse does not affect the validity or effect of a transaction. However, it would have been clearer if this had been formulated in those terms. Under Netherlands law, for example, there is now a lack of clarity over the possible consequences of Section 3:40 of the Netherlands Civil Code, under which an infringement of an EU obligation can result in a transaction being null and void or subject to nullification. Furthermore, in some cases the effect of an infringement of the Regulation must be determined not under the law applicable to the FCA but the law applicable to the transfer of the financial instruments under the FCA.
It is therefore desirable that the Netherlands legislator removes the above ambiguity by explicitly providing, whether in implementing legislation or otherwise, that an infringement of the rules in the Regulation regarding reuse does not affect the validity or effect of the relevant transaction.
- PHASED INTRODUCTION
As stated above, the Regulation entered into force on 12 January 2016 but many of its provisions will not apply until a later date.
The reporting obligation will be phased in so that counterparties have enough time to make the necessary preparations. For each type of counterparty a different phase-in period applies. These periods start to run on the date on which the regulatory technical standards (see section 3) will be adopted by the European Commission. This period is 12 months for investment institutions and banks; 15 months for central securities depositories; 18 months for insurers, reinsurers, UCITS, AIFs and pension funds; and 21 months for non- financial counterparties.
The applicability of the reporting obligation is not limited to SFTs concluded on or after the date on which the obligation becomes applicable. It also applies, as from that date, to existing SFTs that are still outstanding if:
- the remaining maturity of those SFTs on that date exceeds 180 days; or
- those SFTs have an open maturity and remain outstanding 180 days after that date.
Such SFTs must be reported within 190 days of the relevant date of application.
A counterparty's obligation to keep a five-year record of SFTs following their termination applies since 12 January 2016.
Transparency by managers ofUCITS andAIFs towards investors
The obligation for managers of UCITS and AIFs to inform investors, in the periodic reports of the relevant institution, about the use made of SFTs and total return swaps will apply from 13 January 2017.
For UCITS and AIFs in existence before 12 January 2016, the obligation for managers to specify in the pre- contractual documentation which SFTs and total return swaps they are authorised to use will apply from 13 July 2017. For UCITS and AIFs formed after 12 January 2016 the obligation applies since that date.
The rules regarding reuse will apply from 13 July 2016, including to FCAs in existence on that date. It is advisable for counterparties to existing FCAs under which the collateral consists of financial instruments and which provide for a right of reuse (which is inherent to title transfer FCAs, but must be agreed explicitly for security FCSs) to already start preparing to modify these FCAs to the extent necessary.