The SFTR in a nutshell and how it will impact Shadow Banking

The practice of using financial instruments to borrow funds is known only to a small circle in the industry, though it has a turnover of trillion dollars each day. Following the Global Financial Crisis of 2007/2008, regulators around the world started to tackle the part of the shadow banking known as Securities Financing Transactions, but even though the European rules have been in place for more than three years, the impact in practical terms has been limited – the reporting rules that recently came into force aim to change that. Time to have a closer look at the SFTR and how its rules might change one of the most lucrative activities in finance.

This week, the European Securities and Markets Authority (ESMA) published a consultation on draft guidelines on how to report securities financing transactions under the Securities Financing Transactions Regulation (SFTR). It is the latest act in a long line of documents that seek to bring a part of the shadow banking industry into the light. Following the Global Financial Crisis of 2007/2008, international bodies like the Financial Stability Board (FSB) and European Systemic Risk Board (ESRB) identified large holes in the regulatory framework of the financial system and highlighted the need to improve transparency in the traditional banking sector and the shadow banking sector that had grown to enormous proportions. One of the key elements responsible for the Crisis, shadow banking has its origins in the 1970s, but became only in the early 2000s an important aspect in providing credit across the global financial system. For the former head of the Fed, Ben Bernanke, “shadow banking comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies”.

While exact numbers are hard to come by in a sector that is traditionally extremely murky and opaque, the global Repo market is estimated to account for a daily turnover of about EUR 3 trillion.Now, consider that these numbers are significantly lower than pre-crisis plus that the repos are only one instrument used for securities financing transactions (SFTs) and you begin to have an idea of the size of the market we are talking about.

Securities financing transactions (SFTs) are transactions where securities are used to borrow cash (or other higher investment-grade securities), or vice versa to secure funding for their activities. As such, other than repos or repurchase transaction, i.e. the practice of selling an asset with the promise to buy it back at some point in the future for the same amount plus a fee similar to interest, it includes securities lending, margin lending transaction, a buy-sell back transactions or basically any form of pledging a security for funding as only the sky seems to be the limit of imagination of financial innovation.
In late 2012, the FSB started a consultation Shadow Banking Risks in Securities Lending and Repos, which led to a report published in August 2013 that called for action to make these markets more transparent. Around the same time and as a consequence of these analysis, the European Commission started a process that resulted in the adoption of the securities financing transactions regulation (SFTR) to increase the transparency of SFTs by requiring:

– all SFTs, except those concluded with central banks, to be reported to central databases known as trade repositories

– information on the use of SFTs by investment funds to be disclosed to investors in the regular reports and pre-investment documents issued by the funds

– minimum transparency conditions to be met when collateral is reused, such as disclosure of the risks and the obligation to acquire prior consent.

In January 2016, the SFTR entered into force and since then additional regulatory acts have been published to further define the new framework. Already not exactly a straightforward process, institutions like the Commission and ESMA disagreed on a number of aspects, which led to lengthy delays in finalising the reporting provisions and a large amount of frustration of market participants with Brexit just adding to the mix.

In any case, the key objective of the SFTR was to establish that both parties to an SFT would report a new, modified or terminated SFTs to a trade repository (TR) and the consultation on the ESMA guidelines aims to get the views of stakeholders on key elements before it publishes its final report towards the end of the year.

It will be another piece in an ambitious undertaking to increase both transparency of transactions and consistency to post-trade processing. Considering the incurring costs but also the increased complexity of transactions will likely make shadow banking less attractive and further reduce the market size. But that doesn’t need to be a bad thing.

Lavanya Rathnam

Lavanya Rathnam is an experienced technology, finance, and compliance writer. She combines her keen understanding of regulatory frameworks and industry best practices with exemplary writing skills to communicate complex concepts of Governance, Risk, and Compliance (GRC) in clear and accessible language. Lavanya specializes in creating informative and engaging content that educates and empowers readers to make informed decisions. She also works with different companies in the Web 3.0, blockchain, fintech, and EV industries to assess their products’ compliance with evolving regulations and standards.

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