Taking stock of ESMA’s first review of EU securities financing transactions markets

RegCORE Client Alert | Capital Markets Union

QuickTake

On 9 April 2024 the European Securities and Markets Authority published its long-awaited report (the Report)Press release available here and report here.Show Footnote providing its first comprehensive market-level overview on EU securities financing transactions (SFTs).SFT means (i) a repurchase transaction (commonly referred to as repos); (ii) securities or commodities lending and securities or commodities borrowing (commonly referred to as securities lending); (iii) a buy-sell back transaction or sell-buy back transaction; or (iv) a margin lending transaction. The definitions of these four types are further defined in SFTR.Show Footnote SFTs are a lifeblood to liquidity generation/management and mobilisation of collateral assets that are crucial to the functioning of the EU as well as global securities markets and trading. The Report assesses data available from only certain MIFID II client categorisation types i.e., in the institutional or wholesale markets (i.e. MiFID II eligible counterparties and professional clients) as well as those wholesale market participants who for MIFID II purposes are categorised as retail clients (this would include say a pension fund but not private individuals).See Client Alert on a supervisory warning on securities lending to retail investors (here individuals are in focus) available here.Show Footnote

The Report contributes to ESMA’s supervisory tasks as well as those of national competent authorities (NCAs) but makes for important reading for financial services firms (as financial counterparties – FCs) and non-financial counterparties (NFCs) that are market participants engaging in the SFT market. It also makes for valuable reading for all other market participants engaged in arrangements that are economically/conceptually similar but not (currently) captured by the application of the EU’s SFT Regulation (SFTR)Available here. SFTR creates a pan-EU framework on the conduct, transparency and reporting of SFTs to trade repositories.Show Footnote as it applies to SFTs and total return swaps (TRS) (not covered in the Report).SFTR defines a TRS as a derivative contract as defined in EMIR in which one counterparty transfers the total economic performance, including income form interest and fees, gains and losses from price movements, and credit losses, of a reference obligation to another counterparty.Show Footnote This particularly would include loans secured by financial instruments that do not meet the SFTR definition of margin lending which is “a transaction in which a counterparty extends credit in connection with the purchase, sale, carrying or trading of securities, but not other loans that are secured by collateral in the form of securities.” This has been area of debate as to whether general purpose loans with use of proceeds unconnected to trading activity but still collateralised by a portfolio of securities, or securities held in a margin or custody/trust account would be included in SFTR or (as drafted in the SFTR are) not. Crucially, for crypto-assets, subject to either (i) MiCAR or (ii) traditional financial services legislation (as the case may be) and as defined by the evolving rules on designation of crypto-asset classifications (see here and subsequent updates) much will depend on whether a crypto-asset is a security, and then subject to traditional financial services rules, and whether any staking or lending of such securities token will fall within the definition of a SFT or a TRS or something else not (currently) covered by legislative and/or regulatory rules at all.

This Client Alert assesses the findings in the Report and the key takeaways for SFT market participants in light of ESMA and NCAs further supervisory actions.

Key findings in the Report

The data in the Report is comprised of reporting submitted by SFT market participants to trade repositories as required by SFTR and as shared with NCAs and ESMA. ESMA has previously communicated its supervisory expectations on strengthening SFTR required data to be submitted to SFTR Trade Repositories. This will be an area that remains in further focus, regardless of the legislative review of SFTR. That legislative review and subsequent “refit” planning is not expected until 2025 (thus dovetailing efforts in the derivatives space with EMIR 3.0), but the Report points to some interesting aspects, that FCs and NFCs will want to table in advance and be ready for action. 

The Report provides the first comprehensive market overview of the EU’s repo market and serves to supplement the twice-yearly ESMA Report on Trends, Risks and Vulnerabilities. ESMA acknowledges that this inaugural edition of the Report focuses solely on repo transactions, which make up the largest share of SFTs but that future editions will include other SFTs and more risk indicators as well as possible revisions of data and methods. Readers are encouraged to provide ESMA with feedback or suggestions on the Report.

ESMA’s main finding in the Report include:

• Scope and size of EU SFT markets: the total outstanding exposure of SFTs was EUR 9.8 trillion in September 2023. Of that, repos accounting for 6.7 trillion (or 68% of total), securities lending for EUR 2.3 trillion (23%), buy-sell backs for EUR 743 billion (8%) and margin lending for EUR 124 billion (1%). Repo markets are mostly interbank transactions with professional intermediaries approximately 4,000 entities covering 95% of the repo market. In contrast, securities lending transactions usually connect NFCs with FCs (especially in the cover of short sales) and ESMA established there were approximately 61,000 client accounts for 11,000 legal entities. A similar share of client account was evidenced by ESMA i.e. 10,000 legal entities and 101,000 client accounts reflecting the large number of financial intermediaries such as prime brokers and the large number of financial intermediaries. For buy-sell back, ESMA evidenced 2,000 legal entities participating in transactions in September 2023 with less than 3,000 client accounts. 
• Make-up of market participants: Unsurprisingly banks make up over 52% of the repo market with concentration predominantly localised in fee EEA jurisdictions, with France as the primary domicile holding 55% of EEA repo borrowing and 53% of EEA repo lending in September 2023. Germany weighted in with 17% borrowing and 19% lending, followed by Italy with 7% borrowing and 5% lending and Ireland with 5% borrowing and 6% lending. 
• Repo maturity: Repo tenors are to a large extent of very short maturity. 21% and 19% of repo principal amounts respectively mature on the reporting date or the day after (T or T+1). Securities lending and margin lending have comparably much longer maturities. In terms of outstanding transactions at end of September 2023, there were 1.4 million (i.e. 72% of total) outstanding securities lending transactions, 305,000 (16%) outstanding repo transactions, 193,000 (10%) outstanding margin lending transactions, 32,000 (2%) outstanding buy-sell back transactions.
• Cross-border linkages: Equally unsurprisingly, (i) 41% of repo amounts are between EEA counterparties (with 79% of EEA borrowing and 77% of EEA lending concentrated amongst counterparties in France, Germany and Italy) and (ii) despite Brexit, links with the UK remain strong with 12% of repo amounts being borrowed from the UK and EEA lending to the UK at 9%. While not discussed in the Report it is important to note that the UK has historically been the centre of the SFT market and English law has shaped much of the legal principles and leading documentation suites as well as domestic law versions in the EU such as the German DRV or France’s FBF agreements. However, for cross-border (including in the EU) the Global Master Repurchase Agreement (GMRA) and the Global Master Securities Lending Agreement (GMSLA) remain the leading documentation even if both only exist as English law versions. They also have remained the preferred choice of documentation despite innovation by the International Swaps and Derivatives Association (ISDA) to introduce the SFT Definitions and related SFT Schedule Provisions to facilitate easier trading of SFTs under the global preferred documentation for OTC derivatives (whether under English, New York, Irish or French law governed ISDA documentation).
• Trading mainly OTC: Repo trading (43%), buy-sell back principal amounts (28%) and securities lending transactions (8%) are concluded on exchange, which ESMA is quick to point out allows for pre- and post- trad transparency, standardisation, liquidity and best-execution requirements to apply, which is useful for regular, short-term repos with liquid securities. By contrast OTC transactions continue to play a significant role, offering flexibility and customisation of terms, collateral and counterparties. 
• Clearing and settlement: 61% of repo transactions remain uncleared (i.e. not through central counterparty (CCP) clearing arrangements) with 55% processed bilaterally and 6% managed with a third party. Securities lending transactions are almost never cleared.
• Repo collateral use: Government bonds remain the main form of collateral employed. The cleared segment predominantly employed EEA sovereign bonds (88% of collateral) while the non-cleared segment features greater choice, with only 79% of sovereign bonds as collateral. More particularly, 84% of repos outstanding were “specific” i.e., specific financial instruments to be delivered as collateral were agreed in advance as opposed to “generic” has a choice on what collateral asset to provide. 
• Repo haircuts:The repo haircut is a relevant risk control measure for uncleared transactions, expressed as a percentage, that represents the difference between the market value of the collateral and the cash loan amount obtained by pledging said collateral. Repo rates display notable variation based on the country of issuance of the collateral; with the median rate for EEA instruments below the ECB Deposit Facility Rate.Show Footnote As CCPs collect margin at the portfolio level using proprietary risk models, cleared repos often report zero haircuts to SFTR trade repositories at the transaction level. In contrast, higher haircuts apply in non-cleared transactions, especially when involving a more diverse pool of asset classes. ESMA also found that non-cleared repos backed by government bonds often display no haircut.

One of the key issues for the SFT market remains the need to ramp-up the harmonisation and standardisation of data and practices across jurisdictions and market segments. The Report, in building off earlier work of ESMA, identifies several issues and inconsistencies in the reporting and validation of SFT data, such as the use of different identifiers, formats, and definitions, which affect the quality and comparability of the data and limit its usefulness for risk analysis and monitoring. 

The Report, again building off earlier work of ESMA, also notes the lack of a common framework and methodology for measuring and assessing the leverage, interconnectedness, and procyclicality risks associated with SFTs, which hampers the effective identification and mitigation of systemic risks. 

Finally, as in previous publications the Report calls for further cooperation and coordination among ESMA, NCAs, and other relevant authorities and stakeholders, both at the EU and global level, to address these challenges and enhance the consistency and efficiency of the SFT regulatory framework. 

Given the above, there are some key takeaways that FCs and NFCs may want to focus on now (as no regret actions) ahead of being directed to do so by respective supervisors or the legislative changes contemplated as part of the SFTR Review and “refit” drafting of various reforms becoming a regulatory reality.

Key takeaways for FCs and NFCs

ESMA noted in its Report that (our emphasis in bold):

“Within EEA entities, banks mainly function as net borrowers, with EEA banks concentrating 56% of borrowing and 54% of lending activities on average in 2023. The second largest entity is CCPs, with 29% and 33% in borrowing and lending. As expected, and in line with the relevant regulations, while UCITS serve as net lenders, AIFs emerge as net borrowers, both primarily engaged in bilateral repo transactions. 

The concentration of European repo markets is important when observing the exposures of the top entities, as the first five entities alone accounted for a substantial 49% of the total repo exposures in September 2023, and the first ten entities for 64%. This concentration has slightly increased since September 2022, where the first five entities amounted to 46% and the first ten to 59% of repo exposures respectively. The concentration level is higher for the uncleared segment.

Concentration can also be visualised through network charts, which depict two different pictures of the principal segments of the European repo markets. By design, the centrally cleared network displays a star-shaped pattern – or rather, multiple star-shaped patterns around multiple CCPs, with significant exposures flowing through one CCP in particular, and a few large clearing members. Additionally, several counterparties act as clearing members to multiple CCPs and represent indirect connection links between them.

Conversely, the non-centrally cleared market is significantly more interconnected and involves counterparties from heterogeneous sectors. The core-periphery structure illustrates the intermediation role of large banks, which are connected between themselves at the core, and through which a variety of counterparties belonging to different sectors access the repo market.”

With ESMA and NCAs focus on appropriate concentration risk management being an area for improvement for a number of FCs and indirectly NFCs, it is conceivable that the findings in the Report may influence regulatory action further (besides honing in on haircuts) for future supervisory lifecycles.See also discussion by M. Huertas in “Custody, Collateral and Client Money Regulation in the post-crisis world: a comparative study” and the notion of Collateral Ecosystem Participant Concentration Risk.Show Footnote Recent ructions across financial markets in 2023, while not impacting SFTs per se, have caused regulatory and supervisory policymakers to put concentration risk (more broadly) very much back on the forefront of policy and scrutiny. So too has the debate on CCPs and their ability to defuse risk and how they can act even further as circuit breakers as opposed to catalyst of risk propagation channels. 

One area that may come into focus of ESMA and other members of the European System of Financial Supervision also is to assess the adequacy, currency and resilience of contractual arrangements. Much focus since the 2008 Global Financial Crisis has been in the OTC derivatives space with innovation being advanced by say ISDA in how to translate regulatory requirements elegantly into market standard contractual clauses. Similar efforts across GMRA, GMSLA and to a lesser extent only “national” documentation suites have been slower to take route. The solution however is not merely to take what ISDA has done and replicate to non-ISDA SFT documentation but rather it requires deeper rooted review and possibly change to contracts.

FCs and NFCs may have want to look at legal risk and concentration risk exposures generally as well as the adequacy of (legacy) transaction documentation in place between market participants where ESMA and/or NCAs may (rightly or wrongly) consider there to be a potential or actual risk of (excessive) over-concentration. Such review may also be warranted given that UK and EU laws and regulations and supervisory expectations (in particular on collateral) are continuing to (slowly) diverge, including on the application and interpretation of EU legislation. 

Any futureproofing of contractual arrangements may also be well placed to go hand in hand with reviewing (i) whether and (ii) if yes: how to on-shore EU booking models as well as the use of EU-onshore dispute resolution venues so that enforceability of collateral and/or disputes can be effected, efficiently and expeditiously in the EU-27. In some instances, this may go well beyond repapering existing GMRAs, GMSLAs and other documentation to have trades merely entered into between two EU counterparties. 

Outlook

The SFT market is expected to face significant challenges and opportunities in the coming years, as it adapts to the changing regulatory, economic, and technological environment. It remains a cornerstone for liquidity and funding purposes, but also has a number of potential risks and vulnerabilities impacting financial stability and market integrity. The implementation of SFTR reporting requirements, which aim to enhance the transparency and oversight of SFTs, has been a major achievement for the EU, but also a complex and costly process for market participants. The Report provides valuable insights into the current state and functioning of the SFT market, as well as the areas where further supervisory actions and improvements are needed. 

Another key challenge for the SFT market is the innovation and digitalisation of the financial sector, which offers new opportunities and benefits, but also new risks and challenges. Earlier work of ESMA has acknowledged the potential of new technologies, such as distributed ledger technology (DLT), artificial intelligence (AI), and cloud computing, to improve the operational efficiency, security, and resilience of the SFT market, as well as to facilitate the access and participation of new entrants and smaller players. However, ESMA has also warned that these technologies may pose new operational, legal, and cyber risks, as well as create new sources of complexity and interdependence, which require adequate oversight and governance. Earlier work of ESMA also recognised the emergence and growth of new forms and venues of SFTs, such as peer-to-peer (P2P) platforms, CCPs and tri-party agents, which may have implications for the market structure, competition, and risk distribution. The Report encourages ESMA and NCAs to monitor and assess the impact and evolution of these innovations and developments and to ensure that the SFT regulatory framework remains fit for purpose and adaptable to the changing market conditions and needs. Some FCs and NFCs may consider taking (no regret) action to be well positioned ahead of further efforts by ESMA to address the issues found in the Report. 

In conclusion, the SFT market is a dynamic and diverse market that plays a vital role in the functioning and efficiency of the EU financial system, but also still poses significant challenges and risks for the regulators and supervisors. The Report provides a comprehensive and detailed overview of the SFT market, based on the first set of granular data collected under the SFTR reporting regime, which represents a major step forward in the transparency and understanding of the market. The Report also identifies the main areas where further supervisory actions and improvements are needed, as well as the key trends and developments that will shape the future of the SFT market. The Report serves as a valuable input and guidance for ESMA and NCAs, as well as for market participants and other stakeholders, to enhance the efficiency, resilience, and integrity of the SFT market, and to ensure that it contributes to the achievement of the EU’s policy objectives and priorities.

About us

PwC Legal is assisting a number of financial services firms and market participants in forward planning for changes stemming from relevant related developments. We have assembled a multi-disciplinary and multijurisdictional team of sector experts to support clients navigate challenges and seize opportunities as well as to proactively engage with their market stakeholders and regulators. We assist both FCs and NFCs with large-scale complex derivatives and SFT repapering projects through an integrated EU on-shore team of English, Irish, New York, French, Dutch and German qualified lawyers. The team uses cutting-edge Legal Tech to track, triage and tackle transaction documentation, regulatory and risk driven changes to clauses as well as wider collateral arrangements and the establishment of both a digitised documentation inventory and hierarchy that meets the needs of clients’ and their counterparties’ various stakeholders without hindering the ability for them to focus on the ability to trade.

Moreover, we have developed a number of RegTech and SupTech tools for supervised firms, including PwC Legal’s Rule Scanner tool, backed by a trusted set of managed solutions from PwC Legal Business Solutions, allowing for horizon scanning and risk mapping of all legislative and regulatory developments as well as sanctions and fines from more than 1,500 legislative and regulatory policymakers and other industry voices in over 170 jurisdictions impacting financial services firms and their business.

Equally, in leveraging our Rule Scanner technology, we offer a further solution for clients to digitise financial services firms’ relevant internal policies and procedures, create a comprehensive documentation inventory with an established documentation hierarchy and embedded glossary that has version control over a defined backward plus forward looking timeline to be able to ensure changes in one policy are carried through over to other policy and procedure documents, critical path dependencies are mapped and legislative and regulatory developments are flagged where these may require actions to be taken in such policies and procedures.

If you would like to discuss any of the developments mentioned above, or how they may affect your business more generally, please contact any of our key contacts or PwC Legal’s RegCORE Team via de_regcore@pwc.com or our website.