The Securities Financing Transactions Regulation (the SFTR)1 requires that parties to “reuse arrangements” provide disclosure to their counterparties of the risks and consequences involved in such arrangements (the Reuse Disclosure Requirement). To facilitate compliance with the Reuse Disclosure Requirement, a group of industry associations2 has recently published an “SFTR information statement” (the Information Statement).3 This Update considers the Reuse Disclosure Requirement and how it is addressed by the Information Statement. In a previous Update, we considered other aspects of the SFTR, namely the investor disclosure and transparency reporting requirements applicable to alternative investment funds managed by alternative investment fund managers authorized or registered in accordance with the Alternative Investment Fund Managers Directive and UCITS or, where relevant, their management companies.4 As discussed further below, the Reuse Disclosure Requirement:
- applies not only to a wide range of repurchase and securities lending transactions, but also to a wide range of collateral arrangements, where reuse or rehypothecation of collateral comprising financial instruments (e.g., bonds and equities) is permitted;
- imposes direct obligations not only on EU entities, but also on non-EU counterparties in certain cases; and
- will require mandated disclosures starting July 13, 2016 in respect of both existing and future reuse arrangements.
What is the SFTR?
The SFTR came into force on January 12, 2016. It forms part of the package of European Union (EU) legislation targeted at reforming so called “shadow banking” and improving the transparency of securities financing transactions (SFTs), such as repurchase transactions, securities and commodities lending transactions, buy-sell back transactions and margin lending transactions.
The SFTR introduces a number of obligations relating to SFTs and certain “reuse arrangements,” which are described below:
- a requirement to keep a record of SFTs for five years following termination;5
- a requirement to report details of SFTs to an authorized trade repository;6 and
- the Reuse Disclosure Requirement, which requires the disclosure of certain risks to counterparties providing financial instruments under a collateral reuse arrangement, along with a requirement to obtain consent of such counterparties to collateral reuse arrangements and to comply with certain obligations when exercising a right of reuse.7
When does the SFTR enter into force?
Like all EU regulations (as opposed to EU directives), the SFTR is directly applicable and is not required to be transposed into the local law of each EU member state. The record-keeping obligation entered into force on January 12, 2016. The reporting requirement is subject to a phase-in period, the precise timing of which depends on certain regulatory technical standards and implementing technical standards (together, the so called “level 2 measures,” which are yet to be published by the European Securities and Markets Association) and is not expected to apply to any category of market participant before the beginning of 2018. The requirements relating to reuse arrangements, including the Reuse Disclosure Requirement, will enter into force on July 13, 2016.
What is the Reuse Disclosure Requirement?
The Reuse Disclosure Requirement, which is set out in Article 15(1)(a) of the SFTR, provides that, where a party has the right to reuse financial instruments (broadly, collateral, such as bonds or equities)8 it has received as collateral, such right is subject to the condition that the counterparty providing the collateral is “duly informed in writing” by the party receiving the collateral of the risks and consequences involved in the reuse arrangement.
Under the SFTR, the term “reuse” is defined by reference to a party that receives collateral in the form of financial instruments under a collateral arrangement (the receiving counterparty) and the counterparty that provides the collateral (the providing counterparty). The term is defined as: “the use by a receiving counterparty, in its own name and on its own account or on the account of another counterparty, including any natural person, of financial instruments received under a collateral arrangement, such use comprising transfer of title or exercise of a right of use [entitling the receiving counterparty to reuse the financial instruments] in accordance with Article 5 of Directive 2002/47/EC [the Financial Collateral Directive] but not including the liquidation of a financial instrument in the event of default of the providing counterparty.”
Many arrangements that are common in the financial markets are expected to be “reuse” arrangements for purposes of the SFTR. For example, the SFTR will apply to the title transfer arrangements under the English law-governed ISDA Credit Support Annex and the Global Master Repurchase Agreement, and to the right of reuse under the New York law-governed ISDA Credit Support Annex. Parties subject to such arrangements will therefore need to consider the Reuse Disclosure Requirements and be prepared to make the necessary disclosures no later than July 13, 2016.
The Reuse Disclosure Requirement will have a retroactive effect, as it will apply to all existing reuse arrangements, not just arrangements entered into from July 13, 2016.
Who is subject to the Reuse Disclosure Requirement?
Although the majority of the SFTR’s requirements related to SFTs apply to European entities and European branches of non-EU entities,9 the Reuse Disclosure Requirement has a broader reach.10 The following receiving counterparties are subject to the requirement:
- any receiving counterparty engaging in reuse that is established in the EU (including its branches, whether the branches are located inside or outside of the EU); and
- any non-EU receiving counterparty engaging in reuse where either:
- the receiving counterparty is acting through an EU branch; or
- the reuse arrangement relates to financial instruments from a providing counterparty that is established in the EU, or acting through a branch in the EU.
Therefore, by way of example, a Cayman hedge fund that has a U.S. based manager and is entitled to receive securities collateral from a European dealer under a New York law-governed ISDA Credit Support Annex containing a right of rehypothecation will be subject to the Reuse Disclosure Requirement.
How does the Information Statement work?
The Information Statement aims to assist receiving counterparties that are subject to the Reuse Disclosure Requirement in providing the necessary disclosures to their counterparties.
The Information Statement is drafted in such a manner that it can be sent directly to providing counterparties without edit. It operates only as disclosure and does not amend or supersede the terms of any transactions or collateral arrangements that exist between the parties. Appendix 2 of the Information Statement sets out examples of the types of agreements to which the Information Statement might apply, including the ISDA Credit Support Annexes and Credit Support Deed, the Global Master Repurchase Agreement, the ISDA/FIA Client Cleared OTC Derivatives Addendum, the Overseas Securities Lender’s Agreement and prime brokerage agreements which provide for the creation of security over financial instruments.
The Information Statement is not a protocol and, accordingly, parties will need to send individual Information Statements to all relevant counterparties to a reuse arrangement involving financial instruments.
The Information Statement informs providing counterparties of risks and consequences involved in reuse arrangements, including:
- the loss of proprietary rights in the collateral, which are replaced by an unsecured contractual claim for the delivery of equivalent financial instruments;
- the loss of any voting, consent or similar rights attached to the collateral and the rights to dividends, coupons or other payments related to the collateral;
- the fact that, in the event of default or insolvency of the receiving counterparty, the providing counterparty will have only an unsecured claim for the delivery of equivalent assets and so may never recover the full value of the collateral provided; and
- the fact that the tax consequences of the reuse arrangement may be different than the tax consequences that would apply in the absence of a reuse arrangement (i.e., where the providing counterparty does not transfer title).11
- You should carefully consider whether or not you engage in collateral reuse arrangements as a receiving counterparty, and, if so, you should prepare to make the necessary disclosures to your providing counterparties. The Information Statement should prove helpful in that regard.
- You should give thought as to how you can make evident that your providing counterparty has been “duly informed in writing” of the risks and consequences described in the Information Statement as required by the SFTR.
- You should consider whether, given your particular facts and circumstances (e.g., your regulatory status), it is necessary for you to supplement the risk disclosures in the Information Statement.
- Going forward, you should ensure that the content of the Information Statement is included in all new documentation that is subject to the Reuse Disclosure Requirement.
1 The Securities Financing Transactions Regulation (EU) 2015/2365 available at: http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32015R2365&from=EN.
2 The International Swaps and Derivatives Association, Inc. (ISDA), the Association for Financial Markets in Europe (AFME), the International Capital Markets Association (ICMA), the International Securities Lending Association (ISLA) and the Futures Industry Association (FIA).
3 The Information Statement is available on the websites of the industry bodies referred to above, e.g.
4 Please see our recent Update: http://www.sidley.com/en/news/ifad-update-2016-04-06.
5 Article 4(4) SFTR
6 Article 4(1) SFTR
7 Notably, the financial instruments are required to be transferred from the account of the collateral provider. We do not discuss this aspect of the SFTR in this Update.
8 Importantly, this term does not cover cash.
9 Please see our previous Update with regard to the scope of the SFTR’s investor disclosure requirements, available at: http://www.sidley.com/en/news/ifad-update-2016-04-06.
10 The scope of the Reuse Disclosure Requirement is set out in Article 2(1)(d) of the SFTR.
11 The full list of risks and consequences involved in reuse arrangements is set out at pages 2 to 5 of the Information Statement.
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