New EU Financial Markets Legislative Proposals: Liikanen Report Leads to More Regulatory Roll-out
On 29 January 2014, on the back of the Liikanen report, the EC published two provisional legislative proposals, intended to be adopted by June 2015, one on structural measures improving the resilience of EU credit institutions (the "Structural Reforms Proposal" or "SRP") and the other on reporting and transparency of securities financing transactions (the "Reporting and Transparency Proposal" or "RTP"). This alerter summarises each in turn.
1. The Structural Reforms Proposal
The SRP is aimed at EU banks that are deemed to be too big to fail i.e. that are of global systemic importance or that exceed certain specified asset and liability thresholds (i.e. for three consecutive years (a) total assets exceed EUR 30 billion and (b) total trading assets and liabilities exceed EUR 70 billion or 10% of total assets). These thresholds do not prevent a Member State or its relevant competent authority from imposing structural reforms on smaller banks. The SRP extends beyond EU banks to their parent, subsidiaries and branches, including those located in third countries, and also to branches and subsidiaries in the EU of banks established in third countries - subject to exemptions if equivalent local rules apply. For those banks that fall within the scope of the SRP, the EC proposes to introduce:
a ban on proprietary trading, intended to take effect on 1 January 2017
a power for supervisors to require banks to separate trading and deposit-taking activities, intended to take effect on 1 July 2018 (subject to derogation for banks covered by national legislation that has an equivalent effect, provided that the relevant legislation was adopted before 29 January 20141).
The SRP is therefore similar in scope to the US "Volcker rule" and contains parallels to the UK Vickers report. It requires publication of technical standards to follow in due course. It additionally requires Member States to confer on competent authorities various powers and sanctions in the event of non-compliance as well as a whistle-blower's charter.
Ban on Proprietary Trading
The ban extends to proprietary i.e. own account, for-profit trading in financial instruments and commodities. It additionally prohibits ownership or sponsorship of hedge funds that engage in proprietary trading, but this prohibition contains a carve-out for a finite list of funds including closed-ended and unleveraged AIFs and European venture capital, social entrepreneurship and long term investment funds. The buying and selling of money market instruments for the purposes of prudent cash management and trading in EU government bonds are also exempted.
Separation of Trading Activities
The SRP permits banks to engage in "trading activities" (other than proprietary trading) at the discretion of their competent authority. Trading activities are broadly defined as activities other than guarantee-scheme protected deposit taking, lending and retail payment services - investment banking in other words. Competent authorities (i) will be obliged to review trading activities that exceed certain thresholds and that are considered to be close to proprietary trading, such as market making, or that played a key role during the financial crisis, such as investing in/sponsoring of risky securitisations and trading in complex derivatives; and (ii) must require separation if trading activities exceed certain thresholds and meet certain conditions, unless the relevant bank can persuade the competent authority that the relevant activities do not pose a threat to its stability or to the EU as a whole.
The principle here is that deposit-taking entities within banking groups can only engage in trading activities as long as the competent authority does not decide that they need to be performed within a separate trading body. The SRP recognises in this regard that deposit-taking entities will still be permitted to engage in prudent, own-risk management (using IR, FX and credit derivatives) and may sell to their non-financial, non-banking clients a limited range of hedging products - in each case provided the relevant products are eligible for central counterparty clearing and in each case subject to certain safeguards and controls. It also provides that, where trading activities are to remain within the same banking group, they must be transferred to a separate and ring-fenced entity that is prohibited from taking guarantee-scheme protected deposits and from providing retail payment services - that entity may, however, provide credit. Large exposure limits will also apply intra- and extra-group and the competent authority must provide rules on the economic, legal, governance and operational links between the trading entity and the rest of the group.
2. The Reporting and Transparency Proposal
The RTP is intended to complement the SRP by improving transparency and monitoring of securities financing transactions ("SFTs") in the shadow banking sector. SFTs include transactions involving the lending or borrowing of securities and commodities, repo and reverse repo transactions and buy-sell back and sell-buy back transactions as well as transactions having an equivalent economic effect2. The RTP applies to all EU counterparties in SFT markets, to EU investment funds and to any EU counterparty engaging in rehypothecation3, in all cases with the exception of the BIS and certain state and public bodies, including EU central banks. As with other recent EU regulations, certain provisions of the RTP would have extra-territorial reach.
The RTP sets out three broad requirements:
- periodic reporting of SFTs to trade repositories (akin to the reporting obligation under EMIR)
- periodic disclosure by European investment funds (i.e. UCITS and AIFMs) to fund investors on the use of SFTs
- prior consent to the reyhpothecation of loaned/repo'd assets.
The first two requirements are self-explanatory. In relation to the third, the RTP provides that a counterparty may only rehypothecate assets received as collateral where (i) the providing counterparty is informed in writing by the receiving counterparty of the risks in granting consent to rehypothecation, in particular the risks in the event that the receiving counterparty defaults; (ii) the providing counterparty grants consent in writing; (iii) rehypothecation takes place in accordance with the terms of the agreement referred to in (ii); and (iv) the assets received as collateral are first transferred to an account in the name of the receiving counterparty. These requirements are to be read in conjunction with the Financial Collateral Directive and MiFID and are stated to be without prejudice to stricter sectoral legislation such as the AIFMD and the UCITS Directive – although precisely what is intended here is unclear. It is worth mentioning additionally that the RTP has much in common with the Financial Stability Board's "Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos" published on 29 August 2013.
As with the SRP, the RTP requires publication of technical standards to follow in due course. It additionally requires Member States to confer on competent authorities various powers and sanctions in the event of non-compliance as well as a whistle-blower's charter. Finally, the RTP is subject to a review three years after entry into force which may result in the adoption of a revised proposal.
1. Such as the UK’s Financial Services (Banking Reform) Act 2013, which received Royal Assent on 18 December 2013. While the Act serves as a framework and requires secondary legislation to bring it to life, it is to be expected that the relevant secondary legislation will align the Act closely to the SRP.
3. The term rehypothecation here is used in the broadest sense of the word and captures any re-use by the receiving counterparty of the assets that it receives, whether as a secured party or under a title transfer arrangement.