SFTR implementation

The exact implementation timeline of the extensive SFTR reporting regime remains uncertain. In latest news, on 24 July, the European Commission notified ESMA that it is planning to make significant amendments to two of the draft RTS and ITS that ESMA had submitted to them back in March 2017 for review. In response, on 5 September, ESMA issued an opinion on the proposed amendments, making it very clear that they disagree with the proposals put forward. The main point of contention is around the process for incorporating into the SFTR any future standards that are being developed at global level, such as UTIs or LEIs for branches, and whether this would require the Commission to be involved. Importantly, it is now up to the Commission to decide whether to adopt the amendments as proposed alongside the other technical standards or whether to make any further changes based on ESMA’s opinion. While this latest development is likely to introduce some further delay, this is probably rather limited. The expectation continues to be that the final technical standards can be published towards the end of Q1 2019, following further scrutiny by Parliament and Council, which would mean that the reporting regime could still go live as soon as Q1 2020 for banks (after a transition period of 12 months following entry into force).

The ERCC’s SFTR Task Force therefore continues to work at full steam with members to prepare the hugely challenging implementation of the rules. The main focus of the SFTR Task Force is to agree common definitions and establish market best practices to facilitate the implementation of SFTR. Given its extensive experience with best practices the ERCC is well placed to do so. The ERCC’s Guide to Best Practice in the European Repo Market is among the most detailed and established best practice documents across all markets. Using the Guide as a framework, the ERCC is looking to develop an Annex with specific recommendations related to SFTR reporting and this work is already well advanced.

Best practices can of course only work effectively if they are based on a broad industry consensus and implemented by all stakeholders. This is reflected in the composition of the SFTR Task Force, which brings together market participants, both sell-side and buy-side, but also includes market infrastructures and other relevant service providers, including vendors and trade repositories (TRs), which will all have an important role to play in this process. Another important aspect remains collaboration with other industry bodies and ultimately of course also regulators. ESMA itself is looking to provide detailed additional guidance for the market in relation to SFTR implementation as part of the so-called Level 3 process. This process will formally kick off once the technical standards have been finalised. However, the ERCC continues to be in close contact with ESMA to ensure that the extensive work done by the Task Force is suitably taken into account.

SFTR will be one of the focus topics at the ERCC’s upcoming General Meeting on 17 October, hosted by Bloomberg in London. This will be a good opportunity for members to learn more about SFTR, the work of the Task Force, but also to continue the dialogue with ESMA who will actively participate in the meeting. For more details on the event and to register please visit the event section of the ICMA website.

Contact: Alexander Westphal alexander.westphal@icmagroup.org

CSDR mandatory buy-ins and SFTs

In October 2018, ICMA published the discussion paper, CSDR Mandatory Buy-Ins and Securities Financing Transactions. This discussion paper is intended to serve as a companion paper to ICMA’s earlier discussion paper, How to Survive in a Mandatory Buy-In World, and seeks to explore and discuss the potential impacts, considerations, and risks specifically in relation to in-scope SFTs (ie SFTs with terms of 30 business days and longer). What becomes clear is that applying the CSDR buy-in (and cash compensation) provisions to SFTs is not straightforward, and there remain a number of questions as to how the Regulation is intended to be implemented, as well as to how market participants can identify and manage their risk.

Buy-ins, mandatory or otherwise, are generally not applied to SFTs, and GMRAs and GMSLAs provide for alternative remedies in the case of settlement fails which are tailored to the underlying characteristics of SFTs, as opposed to outright cash transactions. The ICMA paper attempts to illustrate the potential challenges of applying the CSDR mandatory buy-in framework to SFTs, and the complications and questions that this raises. SFTs are fundamentally different in nature to outright securities purchases and sales, and it is difficult to understand how the architects of the CSDR Level 1 provisions ever expected mandatory buy-ins to apply to SFTs, and to what extent they had evaluated the practicalities and implications. This further raises concerns about the overall market impact of CSDR mandatory buy-ins in terms of liquidity, efficiency, and stability with respect to termed (ie longer-dated) SFTs.

The paper also highlights a number of areas where Level 3 guidance can play a critical role in supporting implementation with respect to SFTs. However, it also supports the broader market view that the CSDR mandatory buy-in regime is highly undesirable and will be far more damaging to the functioning of European financial markets than beneficial. With the regime not set to come into force until September 2020, there is still time for regulators and policy makers to reconsider both its design and application.

More information and resources on CSDR Settlement Discipline can be found on the dedicated ICMA CSDR-SD webpage. Under the umbrella of its Secondary Market Practices Committee, ICMA has also mobilised a CSDR-SD Working Group, focused on the practicalities of implementing the CSDR settlement discipline regime with respect to both bond and repo and collateral markets.

Contact: Andy Hill andy.hill@icmagroup.org

Other regulatory reforms

In January 2018, the European Commission launched a consultation on proposals to change some of the details in the EU liquidity coverage ratio (LCR). Dated 13 July 2018, the Commission has now published its final proposed text for this Delegated Regulation, which shall apply from 18 months after formal publication in the EU’s Official Journal (which, as this proposal is now subject to scrutiny by the European Council and Parliament, will follow in the coming months).

In context of repos and collateral, it should be noted that the second paragraph of section 1.2 of the Explanatory Memorandum states that: “The first, and most important, amendment is the full alignment of the calculation of the expected liquidity outflows and inflows on repurchase agreements (repos), reverse repurchase agreements (reverse repos) and collateral swaps transactions with the international liquidity standard developed by the BCBS. Although the treatment of those transactions in the LCR Delegated Regulation is in line with the treatment contained in the CRR and had not been challenged during the many discussions preceding the adoption of the LCR Delegated Regulation, several stakeholders subsequently asked for the cash outflows calculation to be directly linked to the prolongation rate of the transaction (aligned with the haircut on the collateral provided applied to the cash liability, as in the BCBS standard) rather than to the liquidity value of the underlying collateral. This approach should also be followed for collateral swaps. This change would ensure that outflows and inflows on the same transactions are symmetrical and would thereby facilitate efficient liquidity management, particularly by internationally active credit institutions.”

Related to this, at the start of the second paragraph in the impact assessment section, at 1.3 in the Explanatory Memorandum, it states that: “The impact of the proposed change to outflows and inflows on repos, reverse repos and collateral swaps transactions should be relatively neutral or negligible.”

Among the other changes in this new text it can also be noted that:

(i) the third paragraph of section 1.2 of the Explanatory Memorandum starts: “The second substantive amendment concerns the treatment of certain reserves held with third-country central banks.” With respect to this, the impact assessment states that: “As regards the impact of the treatment of certain reserves with central banks, it should be contained as well since the amount of those reserves is limited. Moreover, the impact would be further limited by the safeguard provided in the proposal, namely that the treatment would be limited to liquid assets used to cover the stressed net liquidity outflows incurred in the corresponding currency.”

(ii) the fifth paragraph of section 1.2 of the Explanatory Memorandum starts: “The fourth substantive amendment relates to the application of the unwind mechanism for the calculation of the liquidity buffer.” With respect to this, the impact assessment states that: “Removing collateral received through derivatives transactions from the unwind mechanism is not expected to have a significant impact on the level of the LCR and the waiver introduced for secured transactions with the ECB or the central bank of a Member State is subject to competent authorities’ decisions. This unwind is only considered for the application of the caps on HQLA in the liquidity buffer.”

A Public Register of Statements of Commitment to the UK Money Markets Code was launched, on 17 September. Following this, on 21 September, the UK Money Markets Code Annual Survey has been launched – and will stay open until 19 October. The survey aims to enable the Money Markets Committee – which owns the Code – to gain a broader and more detailed cross-market perspective on awareness and adherence to the Code, as well as allowing respondents to provide feedback on, for example, specific contents of the Code and application of the Code within their institution. To obtain the broadest possible view across UK money market participants, with all sectors to be represented in the survey results, all relevant firms are invited to take part.

The BCBS met in Basel, on 19-20 September. Among other things, it was reported that:

• a newsletter will be published on leverage ratio window-dressing behaviour around regulatory reporting dates – Pillar 1 (minimum capital requirements) and Pillar 3 (disclosure) measures to prevent this behaviour will be considered;

• clarification of the treatment of “settled-to-market” derivatives in the liquidity standards has been agreed and an FAQ has been published on this topic; and

• the outcome of the BCBS review of the impact of the leverage ratio on client clearing was discussed, as was an associated joint consultation paper by the BCBS, FSB, CPMI and IOSCO on the effects of post-crisis reforms on incentives to CCP clear OTC derivatives – a consultation paper will be published in October to seek the views of stakeholders as to whether the exposure measure should be revised and, if so, on targeted revision options.

Contact: David Hiscock david.hiscock@icmagroup.org

Repo and collateral-related research

Published on 3 August, Repo Market Functioning: The Role of Capital Regulation is a Bank of England staff working paper, which shows that the leverage ratio affects repo intermediation for banks and non-bank financial institutions. The authors exploit a novel regulatory change in the UK to identify an exogenous intensification of the leverage ratio and combine this with supervisory transaction-level data capturing the near-universe of gilt repo trading. Studying adjustments at the dealer-client level and controlling for demand and confounding factors, they find that dealers subject to a more binding leverage ratio reduced liquidity in the repo market. This affected their small but not their large clients.

The authors further document a reduction in frequency of transactions and a worsening of repo pricing, but no adjustment in haircuts or maturities. Finally, they find evidence of market resilience, based on existing, rather than new repo relationships, with foreign, non-constrained dealers stepping in. Overall, their findings help shed light on the impact of Basel III capital regulation on repo markets.

On 10 September, the ESRB published the EU Shadow Banking Monitor 2018, which covers data up to end-2017 and identifies several key risks and vulnerabilities in the EU shadow banking system. Within the overview of risks and vulnerabilities, in section 1.2, it is reported that these include “procyclicality, leverage and liquidity risk created through the use of derivatives and SFTs”.

• “The reuse of collateral creates intermediation chains – these can become channels for spreading funding liquidity shocks among market participants along the chains. Derivatives and SFTs can be used to build up leverage, and procyclicality in collateral requirements can lead to sudden deleveraging during the downswing phase of asset price cycles. In addition to the risks typically associated with leverage, the haircut and margining practices in bilaterally and centrally cleared trades may force market participants to post additional cash or other cash-like collateral. These market dynamics expose counterparties to liquidity risk, which needs to be monitored and managed.”
• “In 2017, the use of non-cash relative to cash collateral increased in the important government bond lending market. This may be a reflection of the growing role of collateral transformation trades in securities lending markets. The haircuts and margins applied to collateral transformation trades determine how much higher quality collateral can be obtained for a given portfolio of lower-quality collateral. Haircuts and margins may increase if prices decline in the underlying lower-quality collateral. Collateral transformation trades can therefore be prone to a sudden repricing of risks in the underlying markets.”

• “In some types of securities lending transactions, lenders may recall the securities lent at any time. This exposes borrowers to liquidity risk as it may be difficult for them to return the securities, which they may have used in other transactions, at short notice. If borrowers are unable to return securities this will also expose lenders to risk, since lenders will need to sell the collateral obtained from borrowers and repurchase the securities lent in the market. More generally, the reuse of cash and non-cash collateral can involve liquidity and maturity transformation, as cash collateral may be reinvested in securities with longer maturities, or in those which are less liquid than the securities lent.”

On 19 September, the EBA published reports on EU banks’ funding plans and asset encumbrance respectively, which aim to provide important information for EU supervisors to assess the sustainability of banks’ main sources of funding. The results of the assessment show that banks plan to match the asset side increase in the forecast years by a growth in client deposits as well as market-based funding. 159 banks submitted their plans for funding over a forecast period of three years (2018 to 2020). According to the plans, total assets are projected to grow, on average, by 6.2% by 2020. The main drivers for asset growth are loans to households and to non-financial corporates.

The asset encumbrance report shows that in December 2017 the overall weighted average asset encumbrance ratio stood at 27.9%, compared to 26.6% in 2016, with the modest increase mostly driven by a reduced volume of total assets as opposed to an increase in encumbered assets. As previously, the report shows a wide dispersion across institutions and countries. Besides repos, covered bonds and OTC derivatives are among the main source of asset encumbrance involving also monetary, fiscal and even structural policies.

The Implications of Removing Repo Assets from the Leverage Ratio is an ECB Macroprudential Bulletin article, published on 2 October, which summarises the key findings from a counterfactual exercise where the effect of removing repo assets from the leverage ratio on banks’ default probabilities is considered. The findings suggest that granting such an exemption may have adverse effects on the stability of the financial system, even when measures are introduced to compensate for the decline in capital required by the leverage ratio framework. Increases in probabilities of default are mainly seen for larger banks which are more active in the repo market. Moreover, it is observed that the predictive power of the model improves when repo assets are included. Overall, the analysis in this article does not support a more lenient treatment of repo assets in the leverage ratio framework, eg by exempting them or allowing for more netting with repo liabilities or against high-quality government bonds.

Contact: David Hiscock david.hiscock@icmagroup.org