SFTR – A Necessary Challenge
Monday 9 July 2018
Since the financial crisis in 2007, there has been considerable focus from regulators on establishing reporting regimes designed to create more honest and transparent financial markets for all. In the EU, regulation has been introduced to achieve this aim - EMIR covers the reporting of OTC derivative transactions, whilst MiFID (now MiFID II) covers reporting of a wide variety of transaction types (including Equity and Commodities transactions), largely dealt on exchange. These two pillars of the transaction reporting world have arguably been successful in achieving their overarching goal of making these once murky markets much clearer. However, despite the wide net these regulations cast over the markets, there are still several transaction types falling outside of the scope of EMIR and MiFID II. One such transaction type is, “Securities Financing Transactions” which currently operate in an opaque corner of the market, and which fell under scrutiny during the crash. The European Securities and Markets Authority (ESMA) have since announced that Securities Financing Transaction Regulation (SFTR) will be implemented in 2019, legally requiring firms to report all Securities Financial Transactions. With everyone’s eyes having been trained squarely on MiFID II in January 2018, the industry will now need to turn their attention towards SFTR as it aims to close, “a regulatory gap” and bring an even higher level of transparency to the EU financial sector. 
What is a Securities Financing Transaction?
Securities Financing Transactions (“SFTs”) are any transaction where securities are used to borrow cash, or vice versa. This mostly includes repurchase agreements (repos), securities lending activities, and sell/buy-back transactions. The most commonly traded of these types is the repo - a generic name for “repurchase agreement”, meaning a sale and repurchase of securities. It is an agreement in which one party sells securities to a counterparty, and simultaneously commits to repurchase the same or similar securities from the counterparty, at an agreed future date, at a repurchase price equal to the original sale price plus a return on the use of the sale proceeds during the life of the repo.
SFTs and the Financial Crisis
Until now, SFTs have gone largely under the radar. The problem with this, and the main reason SFTs get a bad reputation in connection with the crisis, is that regulators are blind to the “hidden leverage and interconnectedness” these deals create between firms.  Due to this and a mixture of other factors, a catastrophic domino effect of defaulting financial giants occurred. We now commonly refer to this domino effect as the financial crash of 2007/08. Lehman Brothers’ downfall is a key example of the damage SFTs were able to deal out. Due to extremely poor records of deals, i.e. lack of details such as counterparties involved, collateral linking to which deals, and even a lack of details of the amounts borrowed, meant that “the market experienced extreme difficulty in unwinding the bank’s SFT book.”  Having held over $630 billion in assets and $619 billion in debts, and such poor records kept of their dealings (including SFTs) it isn’t too hard to see how this single domino could have caused so much devastation.  So why is this potentially destructive market still largely unmonitored, and why are we only seeing SFTR being implemented over 10 years after the crash?
Well, despite the lack of SFT regulation, ESMA have not been sitting still since the financial crash. There have of course been massive steps made in regulating other large portions of the markets. With MiFID covering a much wider variety of deals than SFTR covers, and EMIR shining light on the dark corners of the OTC derivative world, perhaps ESMA were prioritising regulation they believed would bring the most transparency. Indeed, Warren Buffett himself famously stated his feelings for derivatives calling them, “weapons of mass destruction”.  Industry opinions such as this, coupled with the evidently destructive powers of OTC derivatives during the crisis, i.e. Credit Default Swaps, are likely to have had a strong influence on decisions of prioritising made by the European Commission, and ultimately, ESMA. With heavy focus being put on implementing these regulations along with some massive amendments to them (MiFID II/EMIR Level 3), it is perhaps not so hard to see how SFTR has been slow to come to the table. It is also worthwhile noting that whilst it may not come into effect for firms until 2019, SFTR has been a work in progress for regulators for several years, with the initial release previously scheduled for 2018, but was delayed.  Now that everything is set to go live in 2019, there is understandably some uncertainty surrounding how firms will deal with the new regime.
ESMA aims and Industry challenges ahead…
One of the most used terms you will hear when discussing transaction reporting/regulation is “transparency.” The reason for this being that if you were to distil down the aims and objectives of every piece of financial regulation, you are left with transparency as the desired end-product. With the successful implementation of EMIR and MiFID over the last 10 years, the level of transparency has indeed increased dramatically with all transactions now requiring to be reported (correctly) to a trade repository where regulatory authorities can monitor reports. Similarly, with SFTR, the overall aim remains the same – Transparency.
Of course, to achieve this transparency there are several challenges for those subject to the regulation, with the two most pressing challenges likely to be time and cost. Implementing brand-new systems to create, test, and eventually run/maintain the procedures necessary to report all transaction data is a massive task to undertake. As it stands with current regulation, there is also a small cost incurred for every transaction record sent to trade repositories, so it is literally costing firms money to obey the law and send each required report. The time and resources being spent on creating these procedures within firms could also be spent elsewhere on tasks that will make the company money rather than cost them it. Despite the time and cost involved, there is of course a very good reason for having these regulations in place. Without the regulation the ‘cost’ would likely be infinitely greater to the economy overall, with far greater potential for another financial crisis. Furthermore, firms should also keep in mind the potential for massive fines for non-compliance with the regulation. For example, the £34.5 million fine faced by Merrill Lynch in the UK for not reporting over 60 million derivative trades in 2017.  Whether or not these fines are really an effective deterrent to firms is another discussion altogether.
Despite the mentioned challenges, there are ways in which firms can work to help themselves to manage these challenges more effectively. For example, as noted by the London Stock Exchange Group (“LSEG”) there are several striking similarities between EMIR and SFTR, the most striking of which is the requirement to report trades to a trade repository (set out under Article 4 of SFTR). Stemming from this, there is also the same granularity of reporting, similar counterparty classification, and confidentiality restrictions not being applicable during reconciliation between trade repositories.  It would seem therefore that firms have a major opportunity to reduce the time and cost of creating and sustaining their new SFTR practices by utilising existing EMIR practices where possible. This may include areas such as use of the same trade repository, pairing and matching techniques at trade repository level, and making use of staff familiar with the granular EMIR reporting fields. Regulators themselves may also be able to take a leaf out of the USA’s book, where they have in place 3 benchmark rates for repo transactions, “in a bid to increase transparency in that market.”  A similar approach in the EU (perhaps in an amendment to SFTR) may help them overcome their own challenge of creating transparency in the market. Moreover, regulators have an opportunity with SFTR to roll out improvements to pairing and matching principles which have proven to be an issue with EMIR. Pairing and matching involves reconciling all reporting details between counterparties on every trade, such as trade identifiers, price, maturity date etc. With not enough guidance being given by ESMA on creating robust strategies to deal with this massive task, there have been less than desired results in terms of total percentages of paired trades under EMIR. With the mentioned similarities in reporting style between EMIR and SFTR, this is a challenge which ESMA should look to overcome with this new regulation in order to better meet their aim of transparency.
Where does FinTrU fit in?
As a current provider of both EMIR and MiFID II transaction reporting for our tier 1 investment clients, FinTrU has proven its ability to perform in this area of expertise. As mentioned previously, utilising existing EMIR systems and knowledge to overcome the challenges they face is a good way for firms to prepare for SFTR. However, FinTrU provides firms with a viable substitute to this by acting as a reliable, experienced, and low-cost alternative to managing these tasks in house. This also has the added benefit for firms of overcoming another obstacle mentioned previously - freeing up time and resources of their own to focus on other strategic areas of their business. With 2019 fast approaching, FinTrU could become a very desirable asset for firms affected by the upcoming changes.
Jordan Allen joined FinTrU in 2016 through our fourth Financial Services Academy after graduating from Queen’s University with a BSc in Business Management.
Since joining FinTrU, Jordan has worked as a member of the Transaction Reporting team covering EMIR and MiFID II regulations for a Global Investment Bank. He is responsible for performing a variety of daily checks to ensure the bank is correctly reporting their trades to the trade repository and working to correct any discrepancies in reporting. He is also responsible for creating metrics for senior management.
While at FinTrU Jordan has completed all 3 modules of his Investment Operations Certificate, with the CISI, studying an Introduction to Securities and Investments, UK Financial Regulation, and Derivative Operations.