This article was first published on Lexis®PSL Financial Services on 3 December 2015. Click for a free trial of Lexis®PSL
1. What is the background to the new regulation?
Shadow banking is non-deposit taking credit activity, undertaken by financial institutions, including but not limited to banks. Shadow banking takes three principal forms, (1) securities lending transactions; (2) sale and repurchase (or repo) agreements (3) securitisations. Given that securitisations have been addressed by the various Capital Requirements Directives, the focus in this Q&A will be on securities financing.
Under both forms, financial institutions may receive from or transfer to counterparties large cash sums, subject to the provision of collateral. However, whilst the mechanics of such trades are similar, the motivations are different.
Under a securities loan, a client participating in the financial markets seeks specific securities from the financial institution to cover an open trading position. The financial institution makes the securities available to the subject to the provision by the client of collateral (including margin). Cash is the most common but by no means only form of collateral. The financial institution will charge the client a stock lending fee but may pay interest on cash received, which it may use for its own purposes.
By contrast, the client in a repo transaction wishes to raise short term finance. The client by return provides the financial institution with collateral (plus margin), usually in the form of bonds or securities. Again, the client will pay a fee comparable to interest charged on a loan.
Such trades have not been the prime focus of prudential regulation and supervision, not least because the participants are generally regulated financial institutions acting in the course of their business. Shadow banking performs an important function in the financial system, by creating alternatives to bank funding and deposits.
The Financial Stability Board (FSB) and the EU are concerned that shadow banking could cause instability in the international financial markets given that such activities and entities remain subject to a lower level of regulation and supervision than the rest of the financial sector and are additionally concerned that further banking regulation could drive a substantial part of banking activities beyond the boundaries of traditional banking and towards shadow banking The Regulation on Transparency of Securities Financing Transactions (“Regulation”) was adopted by the Council of the EU on 16 November 2015.
2. How will the regulation affect firms carrying out securities financing transactions?
The Regulation covers the lending or borrowing of securities, repurchase or reverse repurchase transactions, buy-sell back or sell-buy back transactions, or margin lending transactions (“SFT”).
In future, all market participants, whether they are financial or non-financial entities will be obliged to report details of SFTs, including the composition of the collateral, whether the collateral is available for reuse or has been reused, the substitution of collateral at the end of the day and the haircuts applied.
All SFTs other than those with central banks will need to be reported to trade repositories. This is consistent with the requirements of the European Market Infrastructure Regulation (Regulation (EU) No 648/2012) or “EMIR” in respect of OTC derivatives. Depending on their category, firms will need to start reporting at different stages from 12 to 21 months after the entry into force of the Level 2 regulatory technical standards;
Additionally, investment funds will have to start disclosing information on the use of SFTs and total return swaps to investors in their regular reports and in their pre-contractual documents from the entry into force of the Regulation, while the existing funds will have 18 months to amend them.
Additionally, the Regulation introduces minimum transparency conditions in respect of the reuse of collateral, such as disclosure of the risks and the need to grant prior consent. These will apply 6 months after the entry into force of the Regulation.
3. How will it change the future of shadow banking?
Inevitably, there will be additional costs to operating a securities financing / repo business given the cost of building systems capable of providing regulatory reporting. It is likely that banks operating securities financing / repo businesses will pass on these costs to clients in the form of higher fees. Nonetheless, it is likely that most firms will be able to leverage off the cost of complying with EMIR and should be able to adapt or use similar systems. Additionally, the Regulation provides that the legal framework should be as per EMIR.
4. What are the next steps towards implementation?
The Regulation was formally adopted by the EU Council of Ministers on 16th November 2015 and will technically enter into force will enter into force on the 20th day following its publication in the EU Official Journal. The Regulation will then be published in the Official Journal of the EU. As per the Lamfalussy process used for other major financial sector regulatory initiatives, we would then expect Regulatory Technical Standards to be published by the European Securities and Markets Authority (ESMA) following consultation.
5. How will the new regulation improve transparency?
Regulators should have better access to the dynamics of the shadow banking market and more information as to the inherent risks for participants, in particular on the buy side. How they will use the information available remains to be seen, but we should expect regulators to use this as a tool in their continued campaign against market abuse and manipulation. From a macro perspective, this should also shed further light on a relatively murky world where transactions are executed on a bilateral basis
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