Shedding Light on Shadow Banking: How Firms Can Address the Challenge of SFTR
Although the term sounds sinister, shadow banking is not quite so ominous. Shadow banking involves activities conducted by entities that are not banks but rather perform bank-like functions, such as lending or trading financial instruments. Realizing the extent and scale of shadow banking and its potential impact on the traditional banking system, Securities Finance Transactions Regulation (SFTR) was introduced, which is set to go into effect in a phased approach starting in Q2 2019.
The onset of SFTR, a European Union (EU)-wide framework, brings a brand new set of products and associated challenges with data assimilation and accurate reporting. As the regulatory reporting landscape thickens with broader and more extensive regulations, an increasing number of market participants are moving toward loosely coupled architectures that segregate the reporting pipeline into smaller manageable business modules.
Securities financing transactions
As an intricate cog in the shadow banking system, securities financing transactions (i.e., transactions that see the ownership of securities changing in return for cash or collateral for an agreed period of time and fee) are now brought under the regulatory purview via SFTR. That means repurchase agreements (repos), buy-sell backs, margin lending transactions and securities or commodities lending and borrowing are all in scope for reporting under SFTR. As the draft regulatory technical standards (RTS) and implementing technical standards (ITS) documents will soon be published in the EU official journal, reporting entities and other market participants must start evaluating their technical architectures, reviewing data captured by trade booking systems and planning strategic solutions to enrich the data sets from different sources.
SFTR reporting obligations
Under article 4 of SFTR, counterparties are required to report details on the conclusion, modification and termination of SFTs to a registered trade repository (TR) or the European Securities and Markets Authority (ESMA) no later than one working day following the trade activity. A party may delegate the reporting to the other counterparty or a third party. SFTs systems tend to be fragmented in nature without a single system that provides a complete view of data. Assimilating the data will require interaction with multiple third parties and the reporting entities will have to ensure they capture all updates throughout the term of the SFTs with automated processes in place for data enrichment and validation prior to reporting.
SFTs that involve a non-financial counterparty, which falls below certain balance sheet thresholds set out in Directive 2013/34/EU on annual financial statements, require the financial counterparty to report on behalf of both counterparties. Transactions involving an EU central bank as a counterparty have been exempted from reporting.
For unique identification and linking of transactions, it is mandatory for counterparties to report legal entity identifiers (LEIs), international securities identification numbers (ISINs) and unique transaction identifiers (UTIs) at the party, collateral and trade level, respectively.
Transparency to investors
Undertakings for the Collective Investment of Transferable Securities (UCITS) management companies and alternative investment fund managers (AIFMs) must duly inform investors on their use of SFTs under articles 13 and 14. This includes disclosures via the following:
- Biannual and annual reports
- Prospectus and disclosure documents clearly stating authorization to use respective transactions and instruments
Reporting firms need to analyze the new requirements and carry out impact assessments in terms of operational and legal challenges involved, including the effect of the new disclosure requirements on fund offering documents. ESMA will closely monitor the quality of the reported data for the above requirements to determine if regulatory technical standards are required for proper disclosure. At the current stage, ESMA has decided against publishing RTS for these articles as the requirements are explicit enough.
Collateral reuse arrangements
Article 15 sets out restrictions on the reuse of collateral by counterparties. Any party intending to reuse collateral must take prior consent from the counterparty providing the collateral and inform the latter of any potential risks and consequences that may arise from the arrangement.
The counterparty that undertakes the reuse of a financial instrument or cash as collateral must report details that include, but are not limited to, the type of collateral and the calculated value of the reused collateral via standard calculation logic specified by ESMA or reinvested cash by T+1.
Collateral reuse reporting will pose significant challenges as parties will need to trace the entire chain of collateral reuse across different business lines and accounts, as well as identify new and existing transactions that fall within the reporting scope. Requirements on collateral reuse are not just limited to SFTs, including instance derivative transactions and margin loans. Tracking collateral reuse across these diverse products will necessitate automated processes to source the variables and calculate the value of reused collateral within the tight T+1 reporting timeline.
Impact and challenges
Compliance costs and operational challenges for SFT reporting will need to be controlled and mitigated to ensure it does not deem SFTs as uneconomic and discourage investments in this sector. If the new rules are not approached correctly, repercussions could include liquidity challenges and increased pressure on the entire banking system. Industry participants will need to follow a systematic approach to mitigate risks and ensure a smooth transition to SFTR reporting, including:
- SFT data capture—A sizeable chunk of the reportable fields for SFTs are not currently captured by trading platforms and need to be sourced from multiple venues. Consolidating data reporting in a common central hub will help mitigate fragmentation and operational risk while ensuring accuracy and compliance with reporting timelines.
- Collateral reuse—Evaluating complex collateral chains for collateral reuse reporting encompasses a wider product scope lying outside the SFT definition. This will affect existing financial securities. All participants in a trade must work in tandem to trace collateral chains to get to the value of reused collateral and ensure timely and accurate reporting.
- Data reconciliation by trade repositories (TRs)—The regulation places a significant emphasis on data reconciliation by trade repositories and publishing aggregated reports on a daily basis. The sheer number of fields required to be matched and reconciled with stringent tolerances add to the complexity. To comply with reconciliation requirements, TRs will need to have agile technology platforms and adequate systems and controls in place to establish an automated collection and reporting process.
- LEI reporting—A good fraction of market participants, which includes small unregulated entities, do not have an authorized LEI. Entities in scope of SFTR will need to promptly initiate the LEI issuance process with local operating units (LOUs) ahead of the reporting start date to prevent their trades from being rejected by TRs or ESMA due to missing LEIs.
Going forward, seamless technology is key for business continuity and avoiding compliance breaches. In that respect, moving from monolithic structures built on traditional infrastructure and legacy systems to microservices architectures is a transition worth exploring. A significant advantage of using microservices is breaking down the entire business process into smaller independent components that can be built and managed independently, where any errors or issues can be instantly fixed without affecting the rest of the chain. Since microservices components are built around business capabilities, it is easier to pinpoint and implement changes by business users as the regulations continue to evolve.
Any change in the regulatory requirement or TR reporting specifications can be easily localized, focusing only on the individual affected microservice components with a shorter turnaround time to build, deploy and test changes via automation. Demystifying complex regulations with decentralized, scalable, modular and adaptable applications via microservices is the need of the hour and has tremendous potential to ease a significant portion of the compliance burden and bring in a much-needed simplification to the chaotic regulatory reporting world.
Shruti Prakash is a Senior Business Consultant at Sapient Consulting. Shruti covers the European regulatory landscape for CMRS (Compliance Management Reporting System), an award-winning reporting platform. She is a subject matter expert in financial regulations such as STS securitization, MiFID II, AnaCredit, SFTR and has steered knowledge-sharing discussions and workshops with clients. She is also proficient in software quality assurance, data reconciliation, data analytics, Agile and blockchain. She loves to code and learn new languages in her free time.