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The International Captial Market Association (ICMA) has published the third edition of its guide to the Securities Financing Transactions Regulation (SFTR) which shines new light on the contentious issue of reporting of settlement fails.
Phase one and two of SFTR will belatedly come into effect on 13 July for banks, central counterparties and central securities depositories, following a three-month delay for phase one caused by the COVID-19 disruption.
The latest ‘ICMA recommendations for reporting under SFTR’ guide includes new clarifications from the European Securities and Markets Authority (ESMA) that the association says instigated “extensive changes” to the previous version released on 30 June by its SFTR taskforce.
ICMA has made the new version of the recommendations available to members and non-members including an annotated version that highlights where changes have been made between version two and three.
Among the amendments to a variety of hot button issues, the primary question that has (mostly) been answered in the new version relates to the reporting of settlement fails, where industry stakeholders and regulators have so far appeared unable to reach a consensus.
Alexander Westphal, who manages ICMA’s SFTR taskforce, tells SLT that the association, along with most of the securities finance industry, had assumed that it was not necessary to report settlement fails for repo trades.
This is because, from a contractual point of view, a repo will cease to operate on the maturity date regardless of settlement and interest stops accruing.
“Unfortunately, ESMA did not agree with our interpretation,” Westphal explains, adding that the EU securities markets watchdog had pointed to one particular paragraph in the level three guidelines, which makes it necessary to report individual fails.
Firms that had been labouring under the understanding that is was not the case since January will, by the letter of the law, now have a matter of days to correct their reporting solutions before reporting starts.
Westphal, who is a director in ICMA’s market practice and regulatory policy team, explains that the requirement to report repos that failed to settle at maturity raises a host of new questions and challenges for firms which ICMA has also highlighted to ESMA.
Modifying the end-date of the repo following a fail, as required by ESMA, would indicate that the transaction is contractually still open although it is only the settlement that is still ‘pending’.
By pursuing this course “ESMA will not be able to distinguish between trades that are failing and those that are being contractually extended,” Westphal notes. “We understand why ESMA wants to do this, which is to monitor the exposure due to fails, but feel that the gain is insignificant compared to the problems created. Fail rates are generally small and will become smaller under the Central Securities Depositories Regulation, and are fully collateralised in repo.”
One of the pitfalls is that repos cleared by a central counterparty (CCP) that fail to settle at maturity will not be able to be reported in line with ESMA’s approach due to the netting functionality CCPs employ.
If a net settlement fails, it is not clear which of the underlying transactions should be extended unless the netting is unwound, which could seriously undermine financial stability, given that as much as 60 percent of euro repo activity is thought to be cleared.
Part of the reason those involved have found themselves on the eve of implementing a major reporting framework with several lingering areas of ambiguity is that regulators have not sufficiently taken into account the difference between securities lending and repo.
SLT understands that ESMA and national competent authorities, for their part, are happy to sidestep these sticky issues as they are more focused on gaining as full a picture of the market as possible, even if that includes some flaws in the dataset.
Unlike repos, a securities lending transaction’s settlement date is usually pushed back if it initially fails, which makes asking for these trades to be reported more logical to regulators wanting an insight into market risk.
“Regulators tried to come up with a one-size-fits-all approach for repo and securities lending but as a result, we have something that doesn’t fit either of them perfectly,” Westphal concludes.
Once SFTR is live and firms are reporting, it is expected that new wrinkles will emerge that will require more clarifications from ESMA and further editions of ICMA’s recommendations.
Despite the challenges, industry observers are hopeful that reconciliation rates of SFTR's two-sided reporting mechanism will be higher than those seen in the opening months of the European Market Infrastructure Regulation in 2012.
“It was clear from the start that this would be a gradual process,” Westphal says. “We received the final guidelines in January, which despite the three-months delay left little time for firms to implement and test, in part because of the ongoing constraints posed by the COVID-19 pandemic.”
