The practical impact of uncertainty: The SFTR view
In the second of a two-part special, the new ‘new normal’ advanced by attorneys Michael Huertas and Kai Andreas Schaffelhuber of Allen & Overy is discussed in the context of the Securities Financing Transaction Regulation

It is important to recall that the Securities Financing Transaction Regulation (SFTR) aims to make SFT markets in the EU safe and resilient. Improving transparency by introducing regulatory reporting to trade repositories has seemed to be the preferred way forward in achieving that goal. Much of this is based on the ‘legislative success’ that policymakers advanced in taking the 2009 G-20 ‘Pittsburgh Commitments’ on derivatives regulation through to implementation of the European Market Infrastructure Regulation (EMIR) in the EU.

Greater transparency, regulatory reporting and centralised clearing formed the ethos of that response, which also sought to reduce (perceived) threats from the nebulous terms ‘shadow banking’. SFTR stems from similar regulatory thinking.

As a result, market participants should remain quite cognisant that, regardless of practical difficulties around sufficient data capture and quality, EU policymakers and supervisors tasked with safety of EU markets can use SFTR surveillance to improve resilience of markets. It is important to note that EU policymakers, notably the European Commission, in cooperation with the European Securities and Markets Authority (ESMA), are in the driving seat to determine ‘equivalence’ of third countries.

In a post-Brexit world, there are currently no assurances that SFTs governed by English law, booked in the third-country UK, would remain compatible with the legislative aims of SFTR and the priority of improving resilience.

Those EU policymakers are also, in a multi-speed EU, tasked with mandates to complete integration of the single market and the eurozone, including through the capital markets union (CMU)-driven reforms. As a result, it is conceivable that some third countries might be viewed less favourably than others.

Even if the UK and its regime are deemed SFTR-equivalent, key problems remain. ESMA and national supervisory authorities would still, in accordance with SFTR’s provisions, need to conclude mutual agreements on information exchange, which are subject to the professional secrecy rules embedded in SFTR and generally go well beyond the scope of any high-level memorandum of understanding. These already take a long time for regulatory authorities to conclude. In addition to the supervisors, the same exercise is required of the respective central banks. Therefore, it is not just the private sector that will have to Brexit-proof itself for SFTR compliance (or other supervised areas), but also the public sector.

So what might this mean for SFT documentation?

Public sector-driven responses are also likely to coincide with and/or be shaped by private sector-driven changes, as was the case with EMIR, where industry associations played a leading role. It is conceivable that there is a probability that SFTs may be structured, documented, booked, (centrally) cleared and custodied in a very different manner as markets change. Again, this is further complicated as a result of Brexit or any renegotiated relationship of the UK as part of the EU.

While there is currently no immediate threat to the use of English law for financial market transactions, it might be wise to look at how these issues have been tackled in other jurisdictions that suffered legal uncertainty and use arbitration (possibly with the seat of arbitration located within the eurozone) as an appropriate forum for resolving disputes.

The issue of legal certainty can be summarised by the fact that the bulk of private international law rules (also known as conflict of law rules), as they apply in the UK to regulate commercial and financial market transactions (as well as collateral asset transactions and post-trade custody and servicing), rest on the UK’s membership of the EU. In effect, this development could lead to a decoupling of the choice of English law, preferred for its flexibility, certainty and pro-business point of view, from the choice of English courts. The latter are chosen by counterparties, often with no connection to England, due to the ‘neutral forum’.

The choice of English law will, following the UK’s exit from the EU, be continued to be respected and applied by courts of law in the member states of the EU, subject to the same limited exceptions that exist as the law currently stands. Much of the mechanics will be driven by which EU laws the UK (politically) decides to keep, but that choice should not prevent a move from disputes determined by English courts in favour of arbitration. Parties to SFTs, including when using the majority of master agreement documentation, need to agree to apply English law, but are free to choose arbitration (including with seat outside of England) instead of English courts.

Are there any alternatives?

More generally, this assessment on certainty might also merit looking at whether alternatives to English law-governed SFT master agreement documentation suites might be suitable for use. Alternatively, whether these may offer suitable transactional documentation upon which improvements can be more easily made. That assessment might also factor in whether the alternative to an English law-governed SFT master agreement is easier to Brexit-proof.
As a result, market participants may want to consider the cost/benefits of using non-English law-governed documentation (with a hypothetical lower Brexit risk) that may have more amendments required to make it compliant with SFTR or a host of other regulatory requirements.

It is unlikely that, for example, the 2001 or 2004 edition of the European master agreement (which allow the parties to freely choose their governing law and forum, subject to defined fallbacks) might eschew agreements that are based on English law. However, if fully SFTR-proofed, the European master agreement, like the agreements in national jurisdictions, could still provide credible alternatives due to its ‘jurisdiction agnostic’ design. This is especially the case if the EU, as part of the CMU and integrating the eurozone, continues to push the necessary agenda of increased ‘financialisation’ of domestic markets as vital precursors to greater standardisation, calibration and integration.

The contribution that widely accepted standardised documentation yields to greater financialisation of markets is important. Transaction documentation that is perhaps rooted to a legal system whose courts might find themselves outside the EU does raise risks for counterparties, but also for EU policymakers, and so arbitration arrangements might be more attractive.

As a result, Brexit- and SFTR-driven changes merit early engagement from market participants. They also will likely require continued and deeper engagement in 2017 from those industry associations that act as gatekeepers of the master agreement suites and related industry documentation and the transnational private regulatory regime, ie, rules and procedures that underpin how these operate.

There are certainly some lessons to be learned from the move to EMIR compliance that are sensible and very capable of being replicated and applied to the SFTR-proofing of documentation, but also the amount of data that will need to be captured and reported as SFTR requires. Again, tackling fragmentation from the outset is key. Part of this will require benchmarking industry-developed compliance solutions to ensure that conceptual inconsistencies do not exist and are not ‘hardwired’ into the solution. EMIR provides many examples of how industry associations developed documentation design aimed at assisting users who developed very different means of upgrading existing as well as new documentation to comply with EMIR.

The format, content and degree of conceptual equivalence of, for example, the EMIR-relevant International Swaps and Derivatives Association documentation, differs from its nearest equivalent, the ‘EMIR-Anhang’, or ‘EMIR Annex’, which was used to make German ‘DRV’ master agreements for financial derivatives transactions compliant with EMIR.

EMIR, like SFTR, is jurisdiction agnostic and so, where gaps exist between the EU law- and the national law-governed documentation or between two sets of documentation (whether governed by the same legal system or otherwise), conceptual gaps may exacerbate risk and conceptual translation risk.

The same is true of other industry associations, including those that have joined up and which have dealt with SFTR disclosure obligations on reuse. The work of those associations still differs slightly from, say, the German equivalent. Is there a need for difference in content and concepts? Probably not. The same is true in terms of messaging formats in the post-trade environment. While the bulk of this work is being driven by the private sector, taking a leaf out of other EU regulatory projects, such as the single euro payments area or Target2-Securities has, despite challenges, advanced unification of national systems into standardised pan-continental formats.
Is more needed for the post-trade environment? If the regulatory authorities continue, especially since the birth of EMIR, to drive greater granularity of regulatory disclosure and reporting as a desired supervisory outcome? What is different now, and this is crucial, is that in the nearly five years that have passed since EMIR was implemented, digitisation has continued to take root and transform business and regulatory change processes.

Revising for the new ‘new normal’ using regtech solutions

That positive disruption has even begun to spill over into so-called ‘regtech’ solutions, which can assist in the more efficient delivery of pragmatic documentation and process solutions to complex legal and regulatory workstreams.

The role of regulatory lawyers (both external and internally) is still likely to be valuable in assisting governance, risk and control functions within market participants to set overall regulatory strategy and process manage implementation.

For market participants generally, and those in SFT markets in particular, harnessing available support will remain necessary in order to drive efficiency as SFTR compliance challenges move from data capture, disclosure, reporting and verification to operative workstreams that have their own compliance issues. These are driven by the actual text of the rulemaking instrument and the circumstances of the counterparties, but also increasingly by the impact of the new ‘new normal’ on how trades are conducted.

Next steps

A next immediate step should be ensuring that UCITS funds (and their management companies), as well as EU-authorised managers of funds that are regulated as alternative investment funds, periodically disclose to their investors their uses of SFTs and total return swaps. This must be an SFTR-compliance obligation that is phased in. As with the existing SFTR disclosure obligations (such as the reuse disclosure obligation) that have already entered into force, it is important to note that certain national regulatory frameworks, including that of the UK, may have provisions covering the same concepts that go beyond what SFTR requires, and other jurisdictions may have different obligations.

Minding those gaps is important, especially as ESMA works to, on the one hand, revise EMIR, but also to prepare and submit its report and new proposals on SFTR ‘risk mitigation techniques’ by 13 October 2017. This SFTR report will cover progress on international efforts to mitigate the risks associated with SFTs, including international recommendations, especially those of the Financial Stability Board on haircuts for non-centrally cleared SFTs, and whether this would be replicable for markets in the EU.

It remains to be seen whether the output will follow or (as more likely) diverge from the EMIR risk mitigation techniques for OTC non-central counterparty cleared transactions. Given the likely tall order of impact, early buy-side engagement to complement sell side-led discussions might be advisable.

In any event, the political and macroeconomic rollercoaster of 2016 that has given birth to this new ‘new normal’ is likely to keep policymakers, market participants, advisers and stakeholders very busy for 2017 and beyond, where Brexit remains a contributing factor but increasingly a sideshow to much more important priorities.

All of this will not negate or stop the very concentrated efforts that a number of market participants will need to continue to advance in order to make sure their SFT documentation, processes and operations remain fit for purpose and resilient.
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