Explanatory Memorandum to COM(2014)40 - Reporting and transparency of securities financing transactions - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2014)40 - Reporting and transparency of securities financing transactions . |
|---|---|
| source | COM(2014)40  |
| date | 29-01-2014 |
1. CONTEXT OF THE PROPOSAL
The 2008 global financial crisis revealed important regulatory gaps, ineffective supervision, opaque markets and overly-complex products in the financial system. The EU has adopted a range of measures in order to render the banking system more solid and more stable, including strengthened capital requirements, rules on improved governance and supervision and resolution regimes. The progress made on the establishment of the Banking Union is also decisive in this context.
The proposal regarding structural reforms of the EU banking sector, which is presented in a package with this proposal, is the final piece of the new regulatory framework, ensuring that even the largest banks in the EU become less complex and can be effectively resolved, with minimum implications for tax payers.
However, the crisis highlighted the need to improve transparency and monitoring not only in the traditional banking sector but also in areas where non-bank credit activities took place, called “shadow banking” 1 . In practice, shadow banking entities and activities raise funding with deposit-like characteristics, perform maturity or liquidity transformation, allow credit risk transfer or use direct or indirect leverage. At the end of 2012 global shadow banking assets accounted for EUR 53 trillion 2 , representing about half the size of the regulated banking system and mainly concentrated in Europe (around EUR 23 trillion) and in the United States (around EUR 19.3 trillion).
Actions regarding these matters have been international and coordinated through the G20 and the Financial Stability Board (FSB) which initiated a comprehensive work on the identification of key risks of the shadow banking system 3 . The overarching aim, as reaffirmed on several occasions by the G20, is to eliminate the dark corners in the financial sector that have a potential impact on systemic risk or merely result from regulatory arbitrage and extend regulation and oversight to all systemically important financial institutions, instruments and markets. In this context, in August 2013, the FSB adopted a policy framework consisting of eleven Recommendations addressing shadow banking risks in securities lending and repos. These Recommendations were subsequently endorsed in September 2013 by the G20 Leaders. The framework covers transparency of securities lending and repo transactions from financial institutions towards authorities as well as between fund managers and end investors, minimum standards for cash collateral reinvestment, rehypothecation of client assets, minimum regulatory standards for collateral valuation and management and evaluation of the introduction of CCPs in inter-dealer repo markets. This Regulation focuses on improving the transparency of securities lending and repo transactions. Transparency is important in order to ensure that authorities and all market actors concerned get an appropriate understanding of how the markets work and the magnitude and nature of any potential risks. In this context, transparency is a fundamental issue since it provides the information necessary to develop effective and efficient policy tools to prevent systemic risks.
In October 2012, the Liikanen report 4 concluded that the existing and ongoing regulatory reforms do not address all the underlying problems in the EU banking sector and issued a number of recommendations. The follow-up of these recommendations through the Regulation on structural banking reform, adopted at the same time as this proposal, will ban and put structural constraints on certain trading activities of banks. However, as stated in the Green Paper on shadow banking, adopted by the Commission on 19 March 2012, reinforcing banking regulation could drive a substantial part of banking activities beyond the boundaries of traditional banking and towards shadow banking. This would result in an increasingly opaque financial system and offer less scope for control by supervisors. This would come on top of already well-established links which currently exist between the regulated and the shadow banking sectors. Such regulatory arbitrage would greatly undermine the impact of the global and European financial reform efforts, creating substantial risks for financial instability. For this reason, the legal proposal on structural reform needs to be accompanied by binding transparency and reporting requirements for SFTs. Thus, these two sets of regulatory measures complement and mutually reinforce each other.
Confronted with these new legislative developments in the banking sector, including structural measures, it is possible that banks will shift parts of their activity into less regulated areas as shadow banking. In order to closely follow market trends regarding entities whose activities qualify as shadow banking, in particular in the area of securities financing transactions, it is necessary to implement transparency requirements that could aide supervisors and regulatory authorities in the identification of vulnerabilities as well as possible next steps to deal with any identified issues.
In order to ensure that the benefits achieved by strengthening the resilience of certain actors and markets are not diminished by financial risks moving to less regulated sectors, strengthening transparency and data availability in terms of shadow banking activities is essential. As highlighted in the Commission Communication on shadow banking and in the European Parliament Resolution on shadow banking of November 2012 5 , strengthening transparency and data availability, in particular for activities frequently undertaken by the shadow banking sector such as repurchase agreements and securities lending, also called securities financing transactions (SFTs) 6 , is essential. In this regard, the work undertaken by the FSB gives some precision about the transparency level that is required. Moreover, it is particularly important in order to observe the risks that may arise due to the interconnectedness of the regulated financial sector and the shadow banking sector, excessive leverage and pro-cyclical behaviour. Such an approach is fully in line with the 2013 FSB recommendations on shadow banking 7 , endorsed at the St-Petersburg G20 Summit, to dampen risks and pro-cyclical incentives associated with SFTs and rehypothecation that may exacerbate funding strains in times of market stress.
SFTs, other equivalent financing structures and rehypothecation play a vital role in the global financial system. SFTs consist of any transaction that uses assets belonging to the counterparty to generate financing means. In practice, this mostly includes lending or borrowing of securities and commodities, repurchase (repo) or reverse repurchase transactions, or buy-sell back or sell-buy back transactions. All these transactions have similar, even identical, economic effects. These techniques are used by almost all actors in the financial system, be they banks, securities dealers, insurance companies, pension funds or investment funds. They provide additional market liquidity, facilitate funding of market participants, support price discovery of tradable assets and enable monetary financing operations of central banks. However, they can also lead to credit creation via maturity and liquidity transformation and allow market participants to build large exposures to each other. The rehypothecation of the collateral to support multiple deals, in particular SFTs, allowed for increased liquidity as well as the build-up of hidden leverage and interconnectedness in the system.
When confidence in the value of assets, safety of counterparties and investor protection collapsed it created wholesale market runs leading to a sudden deleveraging and/or public safety nets (central bank facilities, etc.). In this context, trust and funding liquidity evaporated and it became impossible for even the biggest and strongest banks to access either short or long-term funding. They contribute to an increase in leverage and strengthen the pro-cyclical nature of the financial system, which then becomes vulnerable to bank runs and sudden deleveraging. While these techniques can have a significant impact on the performance of investment funds, they are currently not properly disclosed to investors. Contrary to other financial institutions, investment funds’ managers are using investor’s money when engaging in SFT activities. Without complete and accurate information regarding the use of SFTs and the potential conflicts of interest that may occur, investors are unable to take informed decisions. Thus, it is fundamental to reduce the lack of transparency of SFTs, other equivalent financing structures and rehypothecation.
Against this background, this Regulation aims at creating a safer and more transparent financial system and introduces measures to improve the transparency in three main areas: (1) the monitoring of the build-up of systemic risks related to SFT transactions in the financial system; (2) the disclosure of the information on such transactions to the investors whose assets are employed in these or equivalent transactions; and (3) the contractual transparency of rehypothecation activities. In practice, the proposed measures will cover the FSB recommendations 1 and 2 which require competent authorities to collect additional data on the use of SFTs, recommendation 5 which requires fund managers to be transparent towards their investors and recommendation 7 which in particular requires financial intermediaries to provide sufficient disclosure to their clients in relation to re-hypothecation of assets. Thus, these recommendations cover all the transparency aspects linked to the use of SFTs. To this end, this Regulation complements the proposed Regulation on structural reform of banks.
2. RESULTS OF CONSULTATIONS WITH THE INTERESTED PARTIES AND IMPACT ASSESSMENTS
The Commission launched a public consultation alongside its Green Paper on shadow banking on 19 March 2012. The input from stakeholders was wide and substantial. There was general support for a Commission initiative in this area and a growing consensus that supervision and a strengthened regulatory framework are needed to address the shadow banking system. The European Parliament's own-initiative report on shadow banking also highlighted the importance of appropriate measures in this area. Moreover, in November 2012 in preparing its international recommendations on shadow banking, the FSB conducted a public consultation on relevant problems in SFT markets, inter alia, the lack of transparency. As part of this consultation, there was broad support for more transparency in the securities lending and repo markets, while many respondents suggested taking into account existing reporting requirements and other available market data. Many stakeholders also agreed that trade repositories are likely to be the most effective way of collecting comprehensive repo and securities lending market data.
A more targeted public consultation on different UCITS (Undertakings for Collective Investment in Transferable Securities) issues was conducted in 2012 and stakeholders were notably asked about the need to increase the transparency requirements for investment funds. The Commission obtained a wealth of information about the current transparency standards in the asset management sector, as well as views on the possible ways to improve the transparency toward investors.
This initiative also reflects discussions with all major stakeholders, including securities and banking regulators, the ECB and all types of market participants. It takes into consideration the views expressed in a public consultation on shadow banking in 2012. The views of Member States were also sought.
An Inter-service Steering Group on bank structural reform was established in March 2013 with representatives from the Directorate Generals COMP, ECFIN, EMPL, ENTR, JUST, MARKT, SG, SJ, TAXUD and the JRC. The Impact Assessment Steering Group met in March 2013, April 2013 and September 2013 and supported the work on the Impact Assessment. The draft Impact Assessment was discussed with the Impact Assessment Board (the “IAB”) of the Commission on 16 October 2013. Following a negative opinion, a revised Impact Assessment was submitted in December 2013.
The impact assessment identifies three main problems in relation to securities financing transactions: the fact that regulators are unable to effectively monitor the use of SFTs, that there are risks that SFTs are used at the detriment of fund investors and that rehypothecation shifts the legal and economic risks in the market. Underlying all these problems are the core issues that were also identified by the FSB, namely the absence of comprehensive (frequent and granular) data on SFTs and that risk that SFTs create conflicts of interests between fund managers and fund investors.
In order to address the problems identified, the impact assessment concludes that a combination of different measures is necessary including reporting of SFTs to trade repositories, disclosure on the use of SFTs to fund investors and the need for prior consent to rehypothecation of the financial instruments and that these financial instruments are transferred to an account opened in the name of the receiving counterparty before rehypothecation can take place. This will ensure that the shadow banking activity of using SFTs is properly supervised and regulated. The use of SFTs as such will not be prohibited nor limited by specific restrictions but be more transparent. As such the retained options are not expected to create structural impacts on the SFT market. The retained options will increase the reporting costs for the counterparties but this increase will be outweighed by the benefits of having greater transparency for the competent authorities, clients, investors and society at large.
3. LEGAL ELEMENTS OF THE PROPOSAL
3.1.Legal basis
The legal basis for the proposal is Article 114(1) of the Treaty on the Functioning of the European Union (TFEU), which allows the adoption of measures for the approximation of national provisions aiming at the establishment and functioning of the internal market.
The FSB Recommendations and the developments envisaged following the structural reform of the Union banking sectior are likely to trigger the regulatory attention of Member States aiming to address the need for enhancing transparency of the activities that might migrate away from regulated banking groups towards shadow banks, where there may be less scope for control by supervisors. Uniform rules on transparency are thus needed to enhance financial stability, protect investors, enhance the cross-border provision of services and prevent regulatory arbitrage, and to prevent diverging national measures from creating obstacles to the smooth functioning of the internal market..
3.2.Subsidiarity
Under the principle of subsidiarity set out in Article 5 of the TFEU, in areas which do not fall within its exclusive responsibility, the EU should act only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the Member States, but can rather, by reason of the scale or effects of the proposed action, be better achieved at EU level.
This proposal aims at ensuring transparency of securities financing transactions, rehypothecation and other financing structures. The interlinkages of these shadow banking activities within the Internal Market and their systematic nature call for a coordinated Union action.
The majority of securities financing transactions as well as rehypothecation activities are performed on a cross-border basis between entities that often do not have their seats in the same jurisdiction and involve assets and currencies issued in different jurisdictions. Acting at the Union level is the minimum to cover a wide range of transactions and to allow regulatory authorities at national and Union level to have a comprehensive overview of the SFTs markets across the entire EU. The effectiveness of remedies implemented in an autonomous and uncoordinated way by individual Member States would likely be very low as such remedies would be able to capture just a portion of the market. Furthermore, given the systemic impact of the problems, uncoordinated action may even prove counterproductive because of the risk of data fragmentation and incoherence. Only aggregated data at the Union level can give the necessary macroeconomic picture that is required to monitor the use of SFTs.
As regards investment funds, the European fund industry has an important cross-border dimension. The share of cross-border assets for the European investment funds industry as a whole (UCITS and non-UCITS assets under management) has more than doubled during the last decade. As of 2012 around one of two investors buy a fund that is not domiciled in its country of residence. It is therefore important that the investor protection standards are applied evenly across the EU in order to ensure that all European investors benefit from the needed transparency over the use of SFTs.
3.3.Proportionality
Under the principle of proportionality set out in Article 5 of the TFEU, the content and form of EU action should not exceed what is necessary to achieve the objectives of the Treaties.
By refraining from regulating other than introducing transparency of securities transactions, rehypothecation and other financing structures, the proposal is limited to the measures necessary to allow for an effective removal of the risks posed by shadow banking entities.
The Regulation respects the fundamental rights and observes the principles recognised in the Charter of Fundamental Rights of the European Union.
3.4.Detailed explanation of the proposal
The proposed Regulation contains measures addressing reporting of SFTs to trade repositories (Chapter II and III), reporting requirement on funds (Chapter IV) and requirements on counterparties engaging in rehypothecation (Chapter V). The remaining chapters, on scope and definitions (Chapter I), supervision and competent authorities (Chapter VI), relationships with third countries (Chapter VII), administrative sanctions and measures (Chapter VIII) and review and final provisions (Chapters IX and X) apply to all these parts.
This section briefly outlines the main components of this regulation.
Contents
- 3.4.1.Scope of proposal (Chapter I)
- 3.4.2.Transparency of SFTs including registration and supervision of trade repositories (Chapters II and III)
- 3.4.3.Transparency towards investor (Chapter IV)
- 3.4.4.Transparency of rehypothecation (Chapter V)
- 3.4.5.Supervision and competent authorities (Chapter VI)
- 3.4.6.Relationships with third countries (Chapter VII)
- 3.4.7.Administrative sanctions and measures (Chapter VIII)
- 3.4.8.Review (Chapter IX)
This Regulation aims at enhancing financial stability in the EU by means of increasing transparency of certain market activities, such as SFTs, rehypothecation and other financing structures having equivalent economic effect as SFTs. It applies to all counterparties in SFT markets, investment funds as defined by Directives 2009/65/EC and 2011/61/EU and any counterparty engaging in rehypothecation. The proposed Regulation covers all financial instruments provided as collateral as listed in Annex I Section C of Directive 2004/39/EC (MiFID).
3.4.2.Transparency of SFTs including registration and supervision of trade repositories (Chapters II and III)
This Regulation creates a Union framework under which financial or non-financial counterparties of a SFT will efficiently report the details of the transaction to trade repositories. This information will be centrally stored and easily and directly accessible to the relevant authorities, such as ESMA, ESRB, the ESCB, for the purpose of identification and monitoring of financial stability risks entailed by shadow banking activities of regulated and non-regulated entities. These provisions are in line with the FSB recommendations which state that jurisdictions should decide on the most appropriate way to collect data and build on existing data collection processes and market infrastructures where appropriate. The FSB further states that trade repositories are likely to be an effective way of collecting such data.
This reporting should, to the extent possible, minimise respective operational costs for market participants and, thus, be built around pre-existing infrastructures and processes. ESMA should consider the existing standards established by Regulation 648/2012/EC and regulating trade repositories for derivative contracts and their future developments when drawing up or proposing to revise the regulatory technical standards foreseen in this Regulation.
The new provisions on transparency of the use of SFTs and other financing structures rules, set by this Regulation, are closely linked to Directives 2009/65/EC and 2011/61/EU since they form the legal framework governing the establishment, management and marketing of collective investment undertakings. In order to enable investors to become aware of the risks associated with the use of SFTs and other financing structures, fund managers should include detailed information on any recourse they have to these techniques in regular reporting intervals. The existing periodical reports that UCITS management or investment companies and AIF managers have to produce will be supplemented by this additional information on the use of SFTs and other financing structures. These new rules on transparency supplement the provisions of Directives 2009/65/EC and Directive 2011/61/EU on AIFMs. These new uniform rules on transparency of SFT and other financing structures should apply in addition to those laid down in Directives 2009/65/EC and 2011/61/EU. These provisions are in line with the FSB Recommendations which state that authorities should review reporting requirements for fund managers to end-investors against the FSB proposal and consider whether any gaps need to be addressed.
In order to increase contractual and operational transparency minimum information requirements should be imposed to counterparties engaging in rehypothecation. Any rehypothecation should therefore take place only with the express knowledge of inherent risks and prior consent of the providing counterparty in a contractual agreement and should be appropriately reflected in the securities accounts. The counterparty receiving financial instruments as collateral will be allowed to rehypothecate them only with the express consent of the providing counterparty and only after having them transferred to its own account. This requirement should be read in addition to Directive 2002/47/EC and Directive 2004/39/EC. The FSB Recommendations state that authorities should ensure that the regulation of client assets should provide sufficient disclosure to clients in relation to rehypothecation for clients to understand the risks. This Regulation is in line with this Recommendation.
The proposed Regulation defines the rules for designating competent authorities, for different purposes, including authorisation, registration, supervision and enforcement of the measures regarding reporting of SFTs to trade repositories and engaging in rehypothecation. After being notified by Member States, ESMA has to publish a list of the competent authorities and update it continuously on its website.
This Regulation entrusts the supervision of compliance with rules on investment fund’s transparency to the competent authorities already designated by Member States under Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to UCITS and Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers (AIFM). The reporting of as well as the compliance with rules on rehypothecation should be supervised by competent authorities designated by Member States according to Article 16 of this Regulation.
Given the global nature of securities financing transactions, relevant authorities of different jurisdictions have to be able to access data held at trade repositories located in different jurisdictions. In order to ensure mutual direct access to data by the relevant authorities, Article 19 of this Regulation empowers the Commission to conclude cooperation agreements with relevant third countries, provided professional secrecy, including the protection of business secrets shared by the authorities with third parties, is ensured.
Member States need to provide that appropriate administrative sanctions and measures can be applied to breaches of the proposed Regulation. To this end, a minimum set of administrative sanctions and measures should be available to the competent authorities, including withdrawal of authorisation, public warnings, dismissal of management, restitution of profits gained from the breaches of this Regulation where those can be determined, and administrative fines. When determining the type and level of sanctions, the competent authorities should take into account a number of criteria set in the Regulation, including the size and financial strength of the responsible person, the impact of the violation and the cooperative behaviour of the responsible person. The proposed Regulation does not prevent individual Member States from fixing higher standards.
The adoption of this Regulation would constitute the first set of transparency rules on SFTs, other financing structures and rehypothecation at EU level. It is therefore important to assess whether the measures described above have proved to be an effective and efficient way of achieving greater transparency of these activities. Therefore, three years after the entry into force of this Regulation, the Commission will report on the suitability of the transparency measures and, if appropriate, submit a revised proposal.
4. BUDGETARY IMPLICATION
The financial and budgetary impact of the proposal is indicated in the legislative financial statement attached.