By Tariq McFadzean, director and James Langlois, senior manager, Quorsus

Back in 2015, the Securities Financing Transactions Regulation (SFTR) was first published in the Official Journal of the European Union. Since then, the European Securities and Markets Authority (ESMA), supported by the various National Competent Authorities in Europe and the UK financial services supervisory community, have worked diligently in implementing a regulation that is aimed at enhancing the transparency of the securities financing markets and consequently the financial system overall.

But unlike previous regulatory reporting regimes such as the European Market Infrastructure Regulation (EMIR), SFTR suffered unique implementation challenges such as the COVID-19 global pandemic and Brexit. Here, we will be reviewing the impact of such challenges and highlighting what’s next for those caught by this regulation.

ESMA’s unprecedented delay to SFTR

If it were not for the COVID-19 Pandemic, we’d have been writing this SFTR anniversary piece in April. As it so happened, it was this time last year that ESMA relaxed the rules and its regulatory timeline in what was an unprecedented move by a major regulator. Interestingly, the reason for this delay was in response to an influence originating wholly outside of the financial markets — ICMA’s and ISLA’s joint industry letter, which highlighted the substantial pressure that the financial services sector felt, to simultaneously comply with the impending SFTR reporting regime while reeling from the impact of the pandemic.

ESMA listened, and subsequently delayed the first phase of SFTR reporting requirements by three months to 13 July 2020 allowing the first two ‘phases’ to go-live simultaneously (phase I: credit institutions and other investment. firms; phase II: CCP & CSD). As the lynchpins of the flow of information, the Trade Repositories (TRs) were also considered, as the regulator no longer required them to register ahead of 13 April 2020, thereby allowing TRs to ensure that their focus could be directed to their other regulatory and market-enabling obligations. Phases III (buy-side firms) and Phase IV (non-financial counterparties) were to receive no such extensions, so compliance deadlines fell on time in October and January 2021, respectively, as originally planned.

Covid-related deadline delays were of course just one element that impacted this piece of Europe-wide regulation. Another unprecedented event was also unfolding in tandem.

Pandemic problems, but Brexit in the background

Another unprecedented event affected SFTR and other pan-European regulations; the UK Financial Conduct Authority (FCA) and the Bank of England rang in the new year with Brexit and with it, new self-governing powers. In a demonstration of its new authority, the FCA would no longer require Non-Financial Counterparties to report, essentially eliminating the aforementioned SFTR Phase IV for the UK market.

Comparatively, the Central Securities Depository Regulation (CSDR) fared less well and was axed completely – perhaps some held out hope that the SFTR would fall the same way, but with the market already reporting in Europe, to completely drop SFTR in the UK after all that work would surely mean a cruel waste for many. Maybe there are more tweaks and changes to come from the British supervisors, but we think there is a ‘stick with it and see’ mentality; with a preference to leave ‘as is’, as altering or removing obligations could become difficult to reverse or reinstate.

Nevertheless, Brexit has impacted the City’s firms more than SFTR. Financial services were almost entirely omitted from the Brexit agreement between London and Brussels. When the UK’s Brexit transition agreement with the EU expired in January 2021, over €6 billion of daily trading in Euro denominated stocks shifted overnight from London to Frankfurt, Paris, Amsterdam, etc.

Is this simply the first step on a path to more volumes and services departing to the continent, and if so, what reaction can we expect from the UK regulators? There are two possible approaches they could follow. The first, staying closely allied to the EU regulatory model with the hope they will be granted equivalence - aka will be permitted some access. The second, more free-market capitalist approach is that they could exploit their new capacity to make their own rules and regulations and attract trade organically. One thing’s for certain: we will be keeping a close eye on how this all plays out.

Despite the delay, is ESMA’s implementation of SFTR a success?

It is generally understood that ESMA is pleased with the smooth transition to SFTR compliance. In its EMIR and SFTR data quality report 2020, ESMA stated, “While the TR rejection rate has been elevated in the initial weeks of reporting, it declined significantly since then indicating that TRs and counterparties have settled into the new reporting regime.” ESMA further stated that “The overall rejection rate peaked at 9% in July 2020 and declined to below 2% in January 2021.”

While this statement looks very positive, it is worth digging a little deeper. It does not address missed submissions (for example, a TR can’t reject a report that isn’t sent), nor does it account for submission correctness, as trades with valid data will pass validation rules, but unless trades are paired and matched, it’s impossible to say who’s actually reflecting the details of the trade accurately. We look forward to ESMA’s full year reports which are expected in autumn 2021, where “ESMA will provide more extensive data quality assessment in future iterations of this report.” Although this will only cover EU reporting, we anticipate that the FCA will certainly produce their own review of SFTR data quality.

Looking outside of the Eurozone, it’s easy to see areas where the global reach of a local regulation start to rub. Issuer LEIs were a mandatory field in the original SFTR guidelines, despite the Financial Stability Board’s Thematic Review on Implementation of the Legal Entity Identifier dated May 2019, which found that 88% of instruments issued by EU issuers had an LEI, but only 30% of non-EU issuers had one.

The result is that SFT trades using collateral issued by entities without a LEI can’t be correctly reported. ESMA provided a solution in January 2020 by agreeing to a twelve-month easing of the validation rules for non-EU issued securities. As such, collateral issuer fields for SLEBs and REPOs (fields 2.54 and 2.93) will be accepted without a LEI if the issuer is from a non-EEA country. With this due to expire in January 2021, another 11th hour concession from ESMA was granted, further extending the easing to April 2022. Despite the G20 financial authorities’ goal to harmonise global regulatory reporting, it was clear that ESMA’s SFTR regime needed these delays, so that firms could report.

What’s next for SFTR?

Looking towards the future, the focus of both supervisors and reporting firms will naturally move towards reconciliation accuracy as rejection rates are still very low and have been since the commencement of reporting. However, it should be noted that the single largest category of rejections remains report sequencing with rejections occurring for valuations and collateral updates being reported without a position establishing a new report.

As buy-side reporting has now started, many breaks that were due to buy-side non reporting will dissipate from the reconciliation report. Adding to this, if most of the dealers start reporting on a T+1 (instead of some on T+0 and some on T+1), the ability to navigate the complex reconciliation reports to focus resource on actual breaks will become easier.

A question worth asking now that detailed collateral reporting has been established as a workable solution for securities lending, is how long will it be before other regimes are updated to include full collateral reporting? This may well be the start of a wider overhaul of all firms’ collateral processes and systems, including more accurate collateral allocations from tri-party collateral firms where the detailed, more accurate and timely information may be useful to feed into firms existing credit processes, supplanting the old Agent Lending Data (“ALD”) flow of data.

A costly regulation on an already squeezed market

Quorsus estimates that SFTR has been a billion Euro initiative, or in excess thereof: hundreds of major firms with multi-million Euro project budgets, thousands of smaller market participants with hundreds of thousands spent on operational and IT consulting and legal advice and an industry-wide regulatory offering from several third-party software providers to the platform solutions that charge for connection and ongoing licencing as well as per submission lifecycle reporting costs. 

Five full years of planning since the endorsement of SFTR in 2015 and one year of phasing in the players has finally delivered: all in-scope countries and market participants now registered with their chosen TRs are reporting. A significant amount of money is being spent by a market that is already under pressure to become more cost-effective, adding additional complexity to the business model, and restricting counterparty selection where reporting capability must be considered. Some smaller firms have simply pulled out of European markets all together as the overall burden of reporting outweighs the return.

Continued attention on SFTR

Against the backdrop of a global pandemic and a major market shift like Brexit, it’s extremely difficult to see how successful the implementation of SFTR has been. Perhaps it is best to expect that its success can only be measured when SFTR reporting is fully implemented for a considerable length of time, especially given the significant costs that have been expended by the market in its execution.

Additionally, it is highly likely that a ‘SFTR II’ will be drafted before too long and there will be closer scrutiny of the current reporting as the teething problems are fixed.  Therefore, firms shouldn’t reduce their attention on SFTR data quality and reconciliation until further notice.