Just under two weeks into the new decade and financial regulators have already released several publications impacting asset managers. One significant release, especially for firms that do business in Europe, was the Securities and Market Authority’s (ESMA’s) publication of the final Securities Financing Transaction Regulation (SFTR) rules on January 6.
As a reminder, SFTR is designed to improve the transparency and monitoring of Securities Financing Transactions (SFTs), defined as securities lending, repurchase agreements, and margin lending. SFTR reporting, as we have flagged before, is a major undertaking, requiring firms participating in securities finance activity to report up to 155 data fields on a next day basis for their SFTs.
Of particular concern in this regard was the availability of legal entity identifier numbers (LEIs) for issuers of non-EU securities involved in securities financing transactions. ESMA has taken the position that an LEI must be available for all such securities because the LEI will associate the issuer with the responsible supervisor of the issuer in their home market. LEIs are 20-character alpha-numeric codes which uniquely identify entities and are fast becoming ubiquitous for issuers and for market participants involved in financial transactions. In Europe, the practice of using LEIs originated from MiFID II and is relatively well-established, but many issuers based in the US and Asia do not have an LEI as they have never had a compelling reason to have one – they do now!
Throughout the back half of 2019, the industry conjectured about a possible delay to the SFTR reporting requirements. Publication of the final guidelines put those thoughts to bed, confirming that the reporting regime will go live on April 13 for banks and brokers, July for CSDs and CCPs, and October for asset managers. The final publication also included a welcome reprieve by granting a one-year grace period to reporting of third-country securities under SFTR. If the rules stood as initially proposed, many believed they would have resulted in a significant reduction in the ability to lend non-European securities. The adjustment delays the need for an LEI for non-EU issuers whose securities are involved in reportable transactions.
Absence of an issuer LEI under securities financing transactions would have resulted in the possibility of trades being rejected by the trade repository and ultimately sanctions for failure to properly and fully report transactions under SFTR. Without the extension, this could have created widespread liquidity and collateral issues globally. Impairment of a securities financing market representing daily transactions totaling approximately $2 trillion could have resulted in wider systemic market issues. Securities lending is often referred to as the oil upon which the engines of financial markets rely since the ability to sell short and cover trade fails disappears, which in turn means no market making, hedging, or true price discovery, which are all factors that could lead to less efficient and more volatile markets.
To mitigate against these negative wider market impacts, ESMA granted a 12-month reprieve to market participants to provide an LEI for a security, loan or collateral, issued from a third-country (non-EU) when reporting their transactions under SFTR. The reporting reprieve only relates to non-EU issued securities. Securities finance market participants required to report under SFTR must still ensure that for EU securities their reports contain LEIs.
Interestingly, while LEI coverage is pretty good in Europe, ESMA’s own report shows that even in its own regulatory domain, coverage is far from complete. This report indicates that on average, 88% of instruments from EU issuers have an LEI, compared to an average of 30% from non-EU jurisdictions. EU issuers that do not yet have LEIs will not enjoy the extension that applies to non-EU issuers and so will have to acquire an LEI by the original April 2020 deadline. As part of the relief, ESMA requires asset managers, lenders, and agents make the non-EU issuers aware that this is a temporary reprieve and they must start the process of applying for LEIs so that they are adequately prepared for the new deadline in April 2021.
It is important to note that the temporary reprieve covers only security LEIs. All other LEIs such as lender, borrower, and lending agent are required on the first day the reporting regime goes into effect.
ESMA hopes the adjustment will “ensure the smooth introduction of the SFTR reporting regime.” This issue once more shows the extra territorial impact that EU regulation can have in today’s highly interconnected global capital markets. It also shows that ESMA will show pragmatism in approach if there are genuine practical reasons to delay or defer an implementation. Even though temporary, this is a welcome regulatory reprieve to asset managers engaged in securities lending transactions.
The article was authored in conjunction with BBH Senior Vice President Tom Poppey.