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Impact Assessment – Commission Proposals on Reporting and Transparency of Securities Financing Transactions
Title of EU proposal:Regulation of the European Parliament and of the Council on reporting and transparency of securities financing transactions
Lead dept/agency: HM Treasury
Other depts/agencies with an interest: Bank of England, Prudential Regulation Authority, Financial Conduct Authority, Department of Business, Innovation and Skills, Foreign and Commonwealth Office, Cabinet Office.
Date: 21 February 2014 / Lead policy official:
Maura Cravero
020 7270 5374
Lead lawyer:
Malcolm Smith
020 7270 5725
Lead economist:
Ali Uppal
020 7270 1609
Lead UKRep desk officer:
Jack Middleton
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What are the potential impacts of the Commission proposal on the UK?
BACKGROUNDThe recent crisis exposed risks in the area of non-bank credit activity, called shadow banking. The shadow banking system can broadly be described as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. This includes entities which perform maturity and/or liquidity transformation, allow credit risk transfer, use direct or indirect leverage or raise funding with deposit-like characteristics.
On 29 January 2014, the European Commission adopted aproposal for a regulationaimed at increasing transparency of certain transactions outside the regulated banking sector (the “Securities Financing Transactions Proposal”).
It provides a set of measures aiming to enhance regulators’ and investors’ understanding of securities financing transactions (“SFTs”). These transactions have been a source of contagion, leverage and procyclicality during the financial crisis and they have been identified in theCommission’s Communication on Shadow Banking, published on 4 September 2013, as needing better monitoring.
AFFECTED GROUPS
The sector most likely to be affect by the Securities Financing Transactions Proposal is the financial sector, in particular the shadow banking sector. Whilst the size of the sector has been falling (shadow banking assets have decreased slightly since the onset of the financial crisis), the global figure at the end of 2012 was €53 trillion. In the UK, shadow banking assets are just under 13% of the global figure i.e. around €6.7 trillion[1].
The Securities Financing Transactions Proposal relates to transparency around SFTs. According to the Financial Stability Board (“FSB”) definition, SFTs are considered a shadow banking activity irrespective of the entity that is performing such a SFT activity. Specifically, the proposed regulation applies to all counterparties in SFT markets, investment funds as defined by Directives 2009/65/EC and 2011/61/EU and any counterparty engaging in rehypothecation[2]. It also covers all financial instruments provided as collateral as listed in Annex I Section C of Directive 2004/39/EC (MiFID).
Given that the Securities Financing Transactions Proposal applies to all entities that use SFTs rather than just the shadow banking sector, measuring the scale of those affected becomes far more complicated. However, it is likely that the majority of SFT users will exist within the financial sector, therefore a useful proxy for the total size of those affected is the contribution of the Financial and Insurance industry (as defined by the ONS). This industry contributed £234.2 billion to the UK economy in 2011[3] i.e. the gross value added of the Financial and Insurance industry was just under 8.4% of GDP. Furthermore, whilst it is difficult to give an exact breakdown of these companies by size, the financial sector will include many SMEs. However, as is evidenced in the European Commission impact assessment, the requirement to report SFTs to trade repositories is not expected to have a material impact on SMEs as they tend not participate in SFT markets.
COSTS & BENEFITS
SFTs consist of any transaction that uses assets belonging to the counterparty to generate financing means (e.g. repurchase agreements also known as repos). SFTs can be conducted in several ways including being centrally cleared, via an agent lender, on a bilateral basis or using a tri-party agent.
As mentioned above, according to the FSB definition, SFTs are considered a shadow banking activity irrespective of the entity that is performing such an SFT activity. Therefore, the following analysis attempts to capture all entities that use SFTs.
The key areas of the proposal are:
· Requirements on reporting to trade repositories or, if that is not possible, directly to regulators;
· Incorporating SFTs and equivalent financing structures reporting into existing ex-post documentation;
· Implementing SFT and equivalent financing structures reporting through ex-ante documentation, in the prospectus or equivalent Alternative Investment Funds (“AIF”) report according to Article 23 of the Alternative Investment Fund Managers Directive (“AIFMD”); and,
· Obligations relating to contractual transparency on rehypothecation.
Benefits
The Requirements on reporting to trade repositories (TRs) or, if that is not possible, directly to regulators is a particularly important area of the proposal. Reporting to TRs will lead to a significant increase in the transparency of SFTs markets as the information will be collected in a central database. This will close current data gaps. Furthermore, by improving regulators' access to the data, it avoids the need to compile individual information from several regulators and therefore allows for an efficient early detection of risks building up in the SFT market as it allows gathering data with a higher level of granularity and frequency. This is a critical benefit of increased transparency as preventing the build up of systemic risks in the SFT market will help to ensure financial stability.
The Undertakings for Collective Investments in Transferable Securities (UCITS) Directive requires UCITS funds to produce annual reports and half-yearly reports. In the same way, the AIFMD requires information on AIFs to be disclosed to investors on an annual basis or more frequently according to the fund rules. As the UCITS and AIF reports already provide some information on the use of SFTs, this ex-post documentation could easily be used to incorporate more detailed regular reporting on the use of SFTs. Similarly, all investment funds (whether a UCITS fund or an AIF) are required to produce a prospectus setting out the fund rules and the rules of incorporation. Typically, these contain all the information related to the investment strategy that the fund intends to pursue. The fund rules represent the “contractual obligation” of the fund manager towards the investor. The supervisory authorities, with the help of the depositary of the fund, are responsible for ensuring that managers do not deviate from the predefined rules. The effect of these provisions is to require managers to also include the use of SFTs in their ex-ante documentation as part of the investment strategy they intend to pursue.
The key benefit from the ex-post and ex-ante documentation is that it will provide investors with an insight into the transactions that the fund has been involved in. It will also have additional benefits on competition as including more detailed data on SFTs will enable investors to gain a more comprehensive understanding of these transactions and in particular their implications on the fund risk and reward profile. This will facilitate the comparison with other similar investment funds thereby promoting competition. An indirect benefit to investors is that the greater transparency will enable investors to increase the pressure on the manager, where appropriate, to rebate a larger part of the revenue from SFTs to the investors. Furthermore, enhanced disclosure of SFTs will also mitigate potential conflict of interests between the fund manager and the fund investors because investors will be reluctant to invest in funds where their interests are neglected.
The last key area relates to specific transparency requirements to be met by contractual agreements on rehypothecation as well as requiring the prior express consent to rehypothecation by the counterparty providing collateral. Furthermore, prior to the actual rehypothecation, the financial instruments received as collateral have to be transferred to an account opened in the name of the receiving counterparty. This would help reduce uncertainty, particularly in times of market instability as it will ensure that investors fully are aware of their rights thereby contributing to financial stability. Moreover, by clarifying that express consent is needed for rehypothecation to take place, these transparency requirements prevent the non-authorised rehypothecation of assets hence ensuring that counterparties are enabled to fully manage their exposure. The requirement that financial instruments received as collateral have to be transferred to an account opened in the name of the receiving counterparty prior to rehypothecation would supplement the Financial Collateral Directive. By preventing excessive rehypothecation and making the rehypothecation chain transparent, these requirements would reduce the risks brought by uncertainty and opacity in times of market instability which in turn would reduce systemic risk and therefore contribute to financial stability.
Costs
In relation to costs, it is plausible that there is an initial cost of creating SFTs trade repositories which could be owned and run either by private entities (e.g. existing TRs) or public bodies. However, by using existing structures such as registered TRs, central counterparties, matching facilities or tri-party agents this cost could be minimised.
In terms of ongoing costs, market participants, including managers, will incur the cost of handling the SFTs reporting processes and computing the relevant information. Whilst it is possible that these costs could be passed on to investors in the form of higher fees, these costs are expected to be small for several reasons.
Firstly, by using existing structures and experiences that have been created through, for example, the existing obligation to report derivative instruments to TRs under the European Market Infrastructure Regulation (EMIR), these costs are likely to be minimised and therefore the impact is likely to be marginal.
Similarly, additional data for ex-post and ex-ante documentation will be reported through existing UCITS and AIF reports. In addition part of those data already has to be disclosed under existing rules applying to UCITS and AIFs and therefore the cost is likely to be further reduced.
Therefore, by building on existing obligations and utilising previous experiences, the additional compliance cost of the proposed regulation is likely to be minimal.
Net Impact
Taken together, these provisions aim to ensure that SFT-related shadow banking activity is properly supervised and regulated. It is important to note that there are no specific restrictions on SFTs but only requirements relating to greater transparency. The result of this is that the SFT market should not experience any structural impacts. Broadly speaking, the impact will be an increase in the reporting costs for the counterparties but this increase should be outweighed by the benefits resulting from a more transparent market which include greater financial stability, improved efficiency and more competition with the direct beneficiaries being clients, investors and competent authorities. Specifically, greater financial stability occurs as a result of improved transparency which reduces the contagion risks brought by uncertainty and opaque markets in times of market instability and reduces the risk of instability by providing supervisors with more information, thereby enabling them to react more promptly. Recent experience has shown how costly financial crises are to the UK economy. The 2007-2009 financial crisis is estimated to have cost the UK economy as much as £140 billion. Therefore, even small improvements in financial stability, as expected from the combined impact of these provisions, can result in material benefits.
Equalities Impact Assessment
The current assessment is that the proposal does not have a specific, significant impact on age, disability, gender reassignment, pregnancy and maternity, race, religion or belief, sex, or sexual orientation.
ENFORCEMENT
The Securities Financing Transactions Proposal defines the rules for designating competent authorities for different purposes. These include authorisation, registration, supervision and enforcement of the measures regarding reporting of SFTs to trade repositories and engaging in rehypothecation. After being notified by Member States, the European Securities and Markets Authority (ESMA) has to publish a list of the competent authorities and update it continuously on its website.
It entrusts the supervision of compliance with rules on investment fund’s transparency to the competent authorities already designated by Member States under Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to UCITS and Directive 2011/61/EU on Alternative Investment Fund Managers (AIFM). The reporting of as well as the compliance with rules on rehypothecation should be supervised by competent authorities designated by Member States according to Article 16 of the proposal.
LEGAL IMPLEMENTATION/COPY-OUT
The proposed Regulation will be directly applicable and, as such, will not require implementing legislation in order to have effect in the UK.
Ministerial sign-off:
I have read the analysis above of the potential impacts of this proposal and I am satisfied that, given the significance of the proposal, the time and evidence available, and the uncertainty of the outcome of negotiations, it represents a proportionate view of possible impacts.
Signed by the responsible Minister: Date:
UNCLASSIFIED
[1] Annex A13 of the European Commission Impact Assessment, 29 January 2014, see http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=SWD:2014:0030(53):FIN:EN:PDF
[2] ‘Rehypothecation’ is an alternative name for ‘re-pledging’. In other words, a party who receives a pledge of collateral pledges the same collateral to a third-party.
[3] Table 2.2 of the United Kingdom National Accounts, The Blue Book, 2013 Edition.