The 鈥榦ther鈥� supervisory drivers the EU鈥檚 SFT market in 2018 and beyond
09 January 2018
Michael Huertas, of Baker McKenzie, offers an overview of the challenges and opportunities ahead for the eurozone securities financing community
Image: Shutterstock
With all the commentary on the second Markets in Financial Instruments Directive/Regulation (MiFID II/MiFIR) many market participants in the securities financing transaction (SFT) space would be forgiven for focusing on just that. It is certainly a game changer and one that has caused a number of concerns along with vocal debate on further tweaks and views on the interaction between it and a host of other regulatory acronyms.
Moreover, the failure by a majority of EU member states in transposing, such as, implementing MiFID II into national legal frameworks fully (if at all) and the infringement proceedings that were initiated have not helped. Nor has the lack of relevant compliant infrastructure that exists as a result of the tardy or faulty transposition or the granting of last minute waivers or reprieves by national competent authorities (NCAs) in more compliant jurisdictions which effectively causes the very fragmentation and uneven playing field that these reforms are supposed to fix.
Last minute tweaks to an already delayed directive and regulation have not been well received by those covered by these rule changes that take effect a decade after the Great Financial Crisis. Add to that the fact that resourcing issues and protracted administrative timelines across certain NCAs post-MiFID II will mean that, going forward, things are likely to look rather taut. In practical terms, this means firms may need to retain resources on MiFID II/MiFIR post-implementation monitoring for a little longer than they may have anticipated.
It is now up to the European Securities and Markets Authority (ESMA) along with the other EU-level super-regulators to keep NCAs in check and to ensure these rule changes deliver on their objectives. That also means balancing the tomes of material, including the breadth of Q&As, FAQs, guidelines and opinions that have been published are fit for purpose and fully complementary to the primary and statutory EU-level instruments. All of this fits into the European System of Financial Supervisions鈥� (ESFS) continuing overarching goal to ensure that the single rulebook for financial services actually is applied in a way that policymakers have promised to make it more 鈥榮ingle鈥�. In many ways this all seems to be eerily familiar to how the first MiFID made its market debut. Also, at a policymaking level, it raises the wider-reaching question that is being asked (yet again) on whether this might have been better dealt with in the form of an EU regulation only, taking uniform direct effect, leaving less room less national options and discretions?
So plus 莽a change鈥�? How is this time any different?
So while MiFID II/MiFIR will remain a moving beast for 2018 and beyond, regulatory reform and the relevant implementation challenges however will not just stop there. Other acronyms and rules, a number of which have been developed independently of MiFID II/MiFIR and the Securities Financing Transactions Regulation (SFTR), will shape how SFTs are structured, executed, booked, custodied, reported, documented and supervised. Some of these apply to the entire EU, while others apply to the Eurozone and its Banking Union only. This distinction matters, in particular鈥攁s in the Banking Union鈥攊t is the European Central Bank (ECB) that sets the tone both when wearing its monetary policy and collateral operations with a single central banking hat as well as when wearing its single supervisory mechanism (SSM) hat.
Nevertheless, 2018 is also a year of change for resourcing at the ECB, including at central bank presidency, vice presidency and supervisory chair level. Equally, ESMA will remain faced with a heavy workload, the European Banking Authority will start relocating from London to Paris and the NCAs will, just as their EU-level counterparts in the ESFS, have more firms and more rules to police. In practical terms, given these 鈥榢nown knowns鈥� along with the 鈥榢nown unknowns鈥� facing the EU (other than Brexit) supervised firms will need to factor in much longer administrative timelines and a changing tone in the supervisory engagement process.
Yet, it is not all bad news. Despite a choppy 2017 and with 2018 set to be no calmer politically and economically, the set of reforms entering into force do offer some monetisable opportunities for those that plan ahead. One positive is that the EU鈥檚 desired end-state on financial services: completion of the Capital Markets Union and Banking Union reform are now far clearer, especially when looking ahead to 2019 and 2025.
So too is the policy agenda in harmonising the regulation and supervision of FinTech, cryptocurrency and other digital assets as well as the identification, mitigation and management of cyber-risks. Also, policymakers have communicated that they, along with EU and NCA supervisors, now have the right rules and tools in the toolbox to prevent a d茅j脿 vu of the deluge that started a decade ago. Some of those statements will likely be put through their paces.
The forgotten ones
So what does this mean for SFT market participants and what SFT-specific rule changes are at risk of being overlooked?
For affected financial market participants, in particular those with a large base of operations in the UK, the immediate planning impact will require meeting both, EU and eurozone compliance obligations as well as earmarking how certain aspects may, following the UK鈥檚 departure from the EU, be tailored for certain UK domestic-only transactions. This is premised on the assumption that the UK, as currently expected, introduces certain exemptions and could thus create an 鈥楨U-lite鈥� regime. The exact details of any such possible framework still remain open to resolution. However, this should not stop firms from planning, preparing and embedding their compliance arrangements.
In the interim, the following ECB and EU workstreams will prompt a number of market participants to consider whether they might require new or have to re-document certain contractual arrangements but equally compliance frameworks.
BMR and replacement rates
Benchmark rates and indices matter. They also play a key role for SFTs. In response to the issues around benchmark rates, the EU finalised reforms which fully entered into force in the form of the EU鈥檚 Benchmarks Regulation (Regulation (EU) 2016/1011 (the BMR) on 1 January 2018. The BMR will have transformative effects across markets, asset classes and transaction types. It will also delineate between activity that is regulated and supervised in the EU and such activity that takes place outside the EU, such as, in a third country which will need to be 鈥榩ermissioned鈥� for access into the EU or for use by those entities that鈥攁s per the BMR鈥攓ualify as an 鈥楨U-supervised entity鈥�. This will be of particular importance once the UK leaves the EU and becomes a third country.
In terms of impact, these rules go very much beyond cleaning-up Ibors, meaning the interbank bid and/or offer rates that shot to prominence in the Libor and Euribor fixing scandals and that caused policymakers, as well as private sector market participants, to search for replacement rates. The ECB began creating a replacement to Euribor. In the fourth quarter of 2017, it announced the launch of a new working group and a methodology for an overnight benchmark rate. This rate would serve as a central bank-led 鈥渂ackstop to private sector benchmark rates鈥�. The current working title thereof is the 鈥榚uro unsecured overnight interest rate鈥� (Euoir). Both the ECB鈥檚 consultation process and the submission date to join the working group closed on 12 January 2018 and a further consultation on Euoir is set to follow.
EGMA and EGAM
The ECB has also been quite active in finalising rules on how to supervise the assessment of internal models used by banks in calculating their counterparty credit risk exposures that arise in SFTs and over-the-counter derivative transactions. Those models also factor into the regulatory capital levels that the ECB, in its supervisory role, sets vis-脿-vis those banks it supervises directly in the Banking Union. As a result, firms will want to consider how these new ECB-specific rules will influence their documentation and their model governance arrangements while the ECB鈥檚 supervisory scrutiny steps-up on preventing bank鈥檚 models from behaving badly.
ECB鈥檚 pension fund statistics regulation
The ECB has also, together with the European Institutional and Occupational Pensions Authority (EIOPA), been active in mapping how pension funds engage in financial markets and its impact on resilience and systemic risk. In 2017, the ECB published, consulted on and held a public hearing on a draft regulation on statistical reporting requirements for pension funds (the ECB PF Regulation). Once finalised, this will prompt reporting requirement that start during the first quarter of 2019.
The rules are clear and far reaching. They seek to capture asset-level data on a quarterly and annual basis. They call for submitting of granular data on securities borrowing against cash collateral, claims under reverse repo, any form of lending (including securities lending), cash collateral received in exchange for securities lending and similar transactions.
However, what the ECB PF Regulation, at least in its current form, does not do, is interlink with defined terms that already exist in SFTR and/or the MiFID II/MiFIR framework. Given that most in-scope pension funds are likely to expect their dealer entities, including on the SFT side of things, to take the lead on preparing regulatory reporting to fulfil the ECB PF Regulation鈥檚 obligations, this could cause both conceptual and practical problems for buy- and sell-side participants unless preparatory action is taken on both sides.
ECB-led market infrastructure changes
The ECB as the gatekeeper of the eurosystem鈥檚 settlement systems (Target2 and Target2-Securities (T2S)) has since their inception undertaken a number of consultations and initiatives to improve their functioning and efficiency. In 2016, the ECB put together a 鈥淭ask Force on the Future of RTGS Services鈥� and, in 2017, that group made large strides in its mandate to deliver the T2 and T2S consolidation project. This project is set to advance further along four distinct workstreams, which are:
Technical consolidation of the eurosystem market infrastructure with an aim to provide more cost-efficient and resilient services to users
Consolidated and harmonised connectivity solutions across the Eurosystem market infrastructure services
Functional convergence and sharing of common services between Target2 and T2S both in terms of payment and user interface (multi-currency services, additional payment fields and collateral options)
Introduction of new real-time gross settlement services, such as the Targets Instant Payment Settlement (TIPS) solution
In addition, the ECB coordinated Advisory Group on Market Infrastructure for Securities and Collateral (AMI-SeCo) will finalise the remaining 24 鈥榩riority one鈥� and 鈥榩riority two鈥� activities. These deliverables aim to improve the harmonisation and efficiency of the T2S environment as well as the interaction with CSDs for cross-CSD settlement and the provision of ancillary services. A further update will be released in the 鈥楨ighth T2S Harmonisation Progress Report鈥� in first quarter 2018.
Brexit and dispute resolution venues
The uncertainty of Brexit has also raised questions on governing law and jurisdiction. As a result, some industry associations have begun to explore how to replicate English law governed master agreement documentation suites used across an array of financial transactions and subject them to the laws of other EU member states. Concurrently, a number of these EU 鈥榗hallenger financial centres鈥� have begun to amend existing venues or build new dedicated dispute resolution venues that embed English as the lingua franca in resolving their disputes. This is welcome in many ways, but does not displace the use case for English law in financial market transactions post-Brexit.
Even if the UK is leaving the EU, the enthusiasm for English law as the governing law for financial market transactions and as the use of English as the language for dispute resolution has not diminished. Even the European Court of Auditors found in its report that the Court of Justice of the European Union ought to consider adding English as a procedural language.
Those market participants affected the question on how to 鈥楤rexit-proof鈥� their documentation and dispute resolution options may want to consider the range of challenger venues that are being set-up in Paris, Amsterdam, Brussels or Frankfurt. With some of these new bespoke or anglicised venues starting their operations in 2018 through 2020, the race is on to find an alternative to the Courts of England & Wales. Those that are able to evidence sufficient 鈥榖ench strength鈥� and cost efficiencies will score first-mover advantage.
Outlook towards 2019
So while the above may paint a picture of piecemeal progress, especially if the EU鈥檚 continued plan is to have financial markets that are as integrated and liquid as those of its favourite North American benchmarks, the EU and the eurozone have come on leaps and bounds in a short period of time and in many ways have not, in the words of Winston Churchill, and as espoused by Rahm Emmanuel, 鈥� 鈥� never let a good crisis go to waste鈥�
Moreover, the failure by a majority of EU member states in transposing, such as, implementing MiFID II into national legal frameworks fully (if at all) and the infringement proceedings that were initiated have not helped. Nor has the lack of relevant compliant infrastructure that exists as a result of the tardy or faulty transposition or the granting of last minute waivers or reprieves by national competent authorities (NCAs) in more compliant jurisdictions which effectively causes the very fragmentation and uneven playing field that these reforms are supposed to fix.
Last minute tweaks to an already delayed directive and regulation have not been well received by those covered by these rule changes that take effect a decade after the Great Financial Crisis. Add to that the fact that resourcing issues and protracted administrative timelines across certain NCAs post-MiFID II will mean that, going forward, things are likely to look rather taut. In practical terms, this means firms may need to retain resources on MiFID II/MiFIR post-implementation monitoring for a little longer than they may have anticipated.
It is now up to the European Securities and Markets Authority (ESMA) along with the other EU-level super-regulators to keep NCAs in check and to ensure these rule changes deliver on their objectives. That also means balancing the tomes of material, including the breadth of Q&As, FAQs, guidelines and opinions that have been published are fit for purpose and fully complementary to the primary and statutory EU-level instruments. All of this fits into the European System of Financial Supervisions鈥� (ESFS) continuing overarching goal to ensure that the single rulebook for financial services actually is applied in a way that policymakers have promised to make it more 鈥榮ingle鈥�. In many ways this all seems to be eerily familiar to how the first MiFID made its market debut. Also, at a policymaking level, it raises the wider-reaching question that is being asked (yet again) on whether this might have been better dealt with in the form of an EU regulation only, taking uniform direct effect, leaving less room less national options and discretions?
So plus 莽a change鈥�? How is this time any different?
So while MiFID II/MiFIR will remain a moving beast for 2018 and beyond, regulatory reform and the relevant implementation challenges however will not just stop there. Other acronyms and rules, a number of which have been developed independently of MiFID II/MiFIR and the Securities Financing Transactions Regulation (SFTR), will shape how SFTs are structured, executed, booked, custodied, reported, documented and supervised. Some of these apply to the entire EU, while others apply to the Eurozone and its Banking Union only. This distinction matters, in particular鈥攁s in the Banking Union鈥攊t is the European Central Bank (ECB) that sets the tone both when wearing its monetary policy and collateral operations with a single central banking hat as well as when wearing its single supervisory mechanism (SSM) hat.
Nevertheless, 2018 is also a year of change for resourcing at the ECB, including at central bank presidency, vice presidency and supervisory chair level. Equally, ESMA will remain faced with a heavy workload, the European Banking Authority will start relocating from London to Paris and the NCAs will, just as their EU-level counterparts in the ESFS, have more firms and more rules to police. In practical terms, given these 鈥榢nown knowns鈥� along with the 鈥榢nown unknowns鈥� facing the EU (other than Brexit) supervised firms will need to factor in much longer administrative timelines and a changing tone in the supervisory engagement process.
Yet, it is not all bad news. Despite a choppy 2017 and with 2018 set to be no calmer politically and economically, the set of reforms entering into force do offer some monetisable opportunities for those that plan ahead. One positive is that the EU鈥檚 desired end-state on financial services: completion of the Capital Markets Union and Banking Union reform are now far clearer, especially when looking ahead to 2019 and 2025.
So too is the policy agenda in harmonising the regulation and supervision of FinTech, cryptocurrency and other digital assets as well as the identification, mitigation and management of cyber-risks. Also, policymakers have communicated that they, along with EU and NCA supervisors, now have the right rules and tools in the toolbox to prevent a d茅j脿 vu of the deluge that started a decade ago. Some of those statements will likely be put through their paces.
The forgotten ones
So what does this mean for SFT market participants and what SFT-specific rule changes are at risk of being overlooked?
For affected financial market participants, in particular those with a large base of operations in the UK, the immediate planning impact will require meeting both, EU and eurozone compliance obligations as well as earmarking how certain aspects may, following the UK鈥檚 departure from the EU, be tailored for certain UK domestic-only transactions. This is premised on the assumption that the UK, as currently expected, introduces certain exemptions and could thus create an 鈥楨U-lite鈥� regime. The exact details of any such possible framework still remain open to resolution. However, this should not stop firms from planning, preparing and embedding their compliance arrangements.
In the interim, the following ECB and EU workstreams will prompt a number of market participants to consider whether they might require new or have to re-document certain contractual arrangements but equally compliance frameworks.
BMR and replacement rates
Benchmark rates and indices matter. They also play a key role for SFTs. In response to the issues around benchmark rates, the EU finalised reforms which fully entered into force in the form of the EU鈥檚 Benchmarks Regulation (Regulation (EU) 2016/1011 (the BMR) on 1 January 2018. The BMR will have transformative effects across markets, asset classes and transaction types. It will also delineate between activity that is regulated and supervised in the EU and such activity that takes place outside the EU, such as, in a third country which will need to be 鈥榩ermissioned鈥� for access into the EU or for use by those entities that鈥攁s per the BMR鈥攓ualify as an 鈥楨U-supervised entity鈥�. This will be of particular importance once the UK leaves the EU and becomes a third country.
In terms of impact, these rules go very much beyond cleaning-up Ibors, meaning the interbank bid and/or offer rates that shot to prominence in the Libor and Euribor fixing scandals and that caused policymakers, as well as private sector market participants, to search for replacement rates. The ECB began creating a replacement to Euribor. In the fourth quarter of 2017, it announced the launch of a new working group and a methodology for an overnight benchmark rate. This rate would serve as a central bank-led 鈥渂ackstop to private sector benchmark rates鈥�. The current working title thereof is the 鈥榚uro unsecured overnight interest rate鈥� (Euoir). Both the ECB鈥檚 consultation process and the submission date to join the working group closed on 12 January 2018 and a further consultation on Euoir is set to follow.
EGMA and EGAM
The ECB has also been quite active in finalising rules on how to supervise the assessment of internal models used by banks in calculating their counterparty credit risk exposures that arise in SFTs and over-the-counter derivative transactions. Those models also factor into the regulatory capital levels that the ECB, in its supervisory role, sets vis-脿-vis those banks it supervises directly in the Banking Union. As a result, firms will want to consider how these new ECB-specific rules will influence their documentation and their model governance arrangements while the ECB鈥檚 supervisory scrutiny steps-up on preventing bank鈥檚 models from behaving badly.
ECB鈥檚 pension fund statistics regulation
The ECB has also, together with the European Institutional and Occupational Pensions Authority (EIOPA), been active in mapping how pension funds engage in financial markets and its impact on resilience and systemic risk. In 2017, the ECB published, consulted on and held a public hearing on a draft regulation on statistical reporting requirements for pension funds (the ECB PF Regulation). Once finalised, this will prompt reporting requirement that start during the first quarter of 2019.
The rules are clear and far reaching. They seek to capture asset-level data on a quarterly and annual basis. They call for submitting of granular data on securities borrowing against cash collateral, claims under reverse repo, any form of lending (including securities lending), cash collateral received in exchange for securities lending and similar transactions.
However, what the ECB PF Regulation, at least in its current form, does not do, is interlink with defined terms that already exist in SFTR and/or the MiFID II/MiFIR framework. Given that most in-scope pension funds are likely to expect their dealer entities, including on the SFT side of things, to take the lead on preparing regulatory reporting to fulfil the ECB PF Regulation鈥檚 obligations, this could cause both conceptual and practical problems for buy- and sell-side participants unless preparatory action is taken on both sides.
ECB-led market infrastructure changes
The ECB as the gatekeeper of the eurosystem鈥檚 settlement systems (Target2 and Target2-Securities (T2S)) has since their inception undertaken a number of consultations and initiatives to improve their functioning and efficiency. In 2016, the ECB put together a 鈥淭ask Force on the Future of RTGS Services鈥� and, in 2017, that group made large strides in its mandate to deliver the T2 and T2S consolidation project. This project is set to advance further along four distinct workstreams, which are:
Technical consolidation of the eurosystem market infrastructure with an aim to provide more cost-efficient and resilient services to users
Consolidated and harmonised connectivity solutions across the Eurosystem market infrastructure services
Functional convergence and sharing of common services between Target2 and T2S both in terms of payment and user interface (multi-currency services, additional payment fields and collateral options)
Introduction of new real-time gross settlement services, such as the Targets Instant Payment Settlement (TIPS) solution
In addition, the ECB coordinated Advisory Group on Market Infrastructure for Securities and Collateral (AMI-SeCo) will finalise the remaining 24 鈥榩riority one鈥� and 鈥榩riority two鈥� activities. These deliverables aim to improve the harmonisation and efficiency of the T2S environment as well as the interaction with CSDs for cross-CSD settlement and the provision of ancillary services. A further update will be released in the 鈥楨ighth T2S Harmonisation Progress Report鈥� in first quarter 2018.
Brexit and dispute resolution venues
The uncertainty of Brexit has also raised questions on governing law and jurisdiction. As a result, some industry associations have begun to explore how to replicate English law governed master agreement documentation suites used across an array of financial transactions and subject them to the laws of other EU member states. Concurrently, a number of these EU 鈥榗hallenger financial centres鈥� have begun to amend existing venues or build new dedicated dispute resolution venues that embed English as the lingua franca in resolving their disputes. This is welcome in many ways, but does not displace the use case for English law in financial market transactions post-Brexit.
Even if the UK is leaving the EU, the enthusiasm for English law as the governing law for financial market transactions and as the use of English as the language for dispute resolution has not diminished. Even the European Court of Auditors found in its report that the Court of Justice of the European Union ought to consider adding English as a procedural language.
Those market participants affected the question on how to 鈥楤rexit-proof鈥� their documentation and dispute resolution options may want to consider the range of challenger venues that are being set-up in Paris, Amsterdam, Brussels or Frankfurt. With some of these new bespoke or anglicised venues starting their operations in 2018 through 2020, the race is on to find an alternative to the Courts of England & Wales. Those that are able to evidence sufficient 鈥榖ench strength鈥� and cost efficiencies will score first-mover advantage.
Outlook towards 2019
So while the above may paint a picture of piecemeal progress, especially if the EU鈥檚 continued plan is to have financial markets that are as integrated and liquid as those of its favourite North American benchmarks, the EU and the eurozone have come on leaps and bounds in a short period of time and in many ways have not, in the words of Winston Churchill, and as espoused by Rahm Emmanuel, 鈥� 鈥� never let a good crisis go to waste鈥�
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