Securities Financing Transactions Regulation – implications for UCITS and AIFs
The Securities Financing Transactions Regulation (EU Regulation No. 2015/2365) (the "SFTR") is part of the EU's legislative package to improve transparency and monitoring, not only in the traditional banking sector but also in areas where bank-like intermediation, known as shadow banking, takes place. The SFTR is directly applicable to a wide range of financial and non-financial counterparties, including UCITS and AIFs (themselves defined as financial), and came into force on 12 January 2016 subject to various transitional provisions.
Securities Financing Transactions ("SFTs") are defined to include repo or reverse repo, securities or commodities lending/borrowing transactions, buy/sell-backs or sell/buy-backs and margin lending transactions1. Certain provisions of the SFTR apply additionally to collateral arrangements and, for UCITS and AIFs, to total return swaps.
This summary focusses on the SFTR as it applies to UCITS and AIFs. The key point for these entities is that certain obligations apply immediately and that others come into effect soon - six to eighteen months from now - so current awareness is imperative.
The SFTR contains three key requirements:
(i) Obligations in relation to reuse under collateral arrangements – Article 15 SFTR
Entities within scope of the SFTR (including UCITS and AIFs) reusing financial instruments received under a collateral arrangement (which includes both title transfer and security interest collateral arrangements falling within the Financial Collateral Directive2) must first disclose3 the risks and consequences to, and obtain written consent4 to reuse from, their counterparty.
The exercise of the right to reuse must be in accordance with the collateral arrangement's terms and the relevant financial instruments have to be transferred from the providing counterparty's account.
Where it is the UCITS fund or AIF that is the provider of the collateral, its counterparty will be subject to the same requirements.
The rules overlap with provisions on reuse contained within the UCITS Directive, ESMA Guidelines5 and the AIFMD. These latter provisions prevail if they impose stricter obligations.
(ii) Disclosure to investors – Articles 13 and 14 SFTR
UCITS managers and AIFMs must disclose their use of SFTs and total return swaps to investors in their half-yearly and annual reports and in their prospectus and pre-contractual disclosure documents. The information to be provided is detailed and is set out in Sections A and B of the Annex to the SFTR.
Again this is additional to the information that a UCITS must already disclose as required by the UCITS Directive and applicable ESMA Guidelines.
(iii) Reporting obligations and record-keeping – Article 4 SFTR
Both6 counterparties to an SFT must, on a T+1 basis, report the SFT's details7 to a trade repository upon its conclusion, modification or termination and must keep records of the SFT for at least five years following its termination. UCITS managers and AIFMs must report on behalf of the funds that they manage but may delegate the reporting to a third party. In the same way as is provided for under EMIR, reporting under the SFTR will not infringe EU confidentiality restrictions or give rise to reporter liability, although waivers may be required if third country law is applicable.
Implementation and transitional provisions
The record-keeping requirement and the pre-contractual disclosure obligation in respect of new funds came into force on 12 January 2016.
The remaining obligations are subject to phased implementation as follows:
- The reuse requirements apply six months post-entry into force of the SFTR, but then apply not only to new collateral arrangements but also to collateral arrangements existing on that date – Article 15 SFTR;
- The disclosure requirements apply between twelve and eighteen months post-entry into force of the SFTR to, respectively, new periodic reports and prospectuses/pre-contractual disclosure documents8 in respect of funds constituted9 before entry into force of the SFTR – Article 33(2)(b)&(c) SFTR; and
- For UCITS and AIFs, the trade repository reporting obligations apply eighteen months after the corresponding regulatory technical standards have been adopted10 - Article 33(2)(a)(iii) SFTR. They apply only to new trades entered into after that date (save for trades which still have 180 days to run (or are left open for 180 days) after that date, which also have to be reported).
One area of uncertainty is whether new sub-funds of existing umbrella funds will benefit from the transitional period set out in Article 33(2) SFTR or will, on launch, be burdened with an immediate compliance obligation. The FCA's current position is that the transitional period will not apply but it is considering the matter further and is consulting interested parties accordingly.
The SFTR applies to UCITS and their management companies and to AIFMs authorised or registered under the AIFMD regardless of where they or their AIFs are established. There is, however, uncertainty as to the application of the reporting requirements where a non-EU AIF is managed by an EU AIFM.
The SFTR also applies to any other EU entities, EU branches of non-EU entities and, as regards reuse, any non-EU entities who receive collateral from a UCITS and AIF or another EU entity or EU branch.
Non-compliance with the SFTR will not affect the validity or enforceability of a transaction. It may, however, lead to fines, public censure, temporary bans and withdrawal or suspension of authorisations and, at Member State discretion, criminal sanction.
In the case of breaches of the investor disclosure obligations, the UCITS Directive and the AIFMD provide the applicable sanctions.
Once in-scope entities have been identified, various documents – collateral, SFT master agreements, prime brokerage documentation etc. – will need to be reviewed to ensure that they comply with the reuse requirement. In practice it is more likely that a separate disclosure statement will be used to achieve compliance.
Procedures and processes will need additionally to be implemented to generate relevant disclosures and to ensure adherence to applicable reporting, record-keeping and other compliance obligations. Like EMIR, compliance under the SFTR will be an on-going rather than a one-off exercise.
1 The recitals to the SFTR make clear that SFTs do not include any derivatives contract as defined in EMIR (EU Regulation No. 648/2012) but, subject to that exception, include liquidity and collateral swaps.
2 This is wider than just securities financing and would include, for example, prime brokerage and futures margining arrangements as well as CSAs.
3 Various industry associations are currently working on standard disclosure language for incorporation into relevant collateral arrangements.
4 Most industry standard documentation for title transfer collateral is likely to satisfy this requirement already. Bespoke documentation may benefit from review and, if necessary, amendment.
5 Guidelines on ETFs and other UCITS issues – ESMA/2014/937 and Guidelines on repurchase and reverse repurchase agreements – ESMA/2012/722.
6 Or one only if the other is not subject to the reporting obligation (e.g. because it is exempt or non-EU based).
7 The precise details to be reported will be specified pursuant to a delegated act under the SFTR which will be finalised by 13 January 2017. 8 It is suggested that the obligation to bring prospectuses into line will in practice apply on the date of the next relevant update.
9 It is not clear from the SFTR what "constituted" means. One reasonable interpretation might be "in existence but not necessarily launched".
10 Under the SFTR, ESMA is required to develop RTS in relation to the reporting obligation and has the option to develop RTS in relation to the disclosure obligation.