The roadmap ahead
04 September 2018
Michael Huertas of Dentons explains the six key compliance and operational challenges that lay ahead for securities finance market participants
Image: Shutterstock
Tempers are certainly heated as European markets and politicians head back to work after a sizzling August. Put aside for a moment that Brexit has now truly turned messy and done so beyond just Westminster—having even resulted in ‘shellfish showdown’ among fishing vessels in the English Channel. While the prospect of a securities financing spat are still a way off, things could become quite difficult and possibly farcical on both sides of political divorce proceedings that are now at a very real prospect of a “no-deal” exit with much still needing to be done by many to Brexit-proof arrangements as well as compliance challenges ahead.
This urgency is especially warranted, following the EU’s frank rejection of Theresa May’s chequers proposal even, if the EU’s chief negotiator Michel Barnier, has hinted at the possibility of an olive branch being offered to, or at least discussed with the UK’s newest Brexit minister provided that the cherry-picking stops. That requirement may ring bells among certain quarters weary of a deal being dictated by Brussels even if both sides have come to some form of consensus in pushing back points of no-return on the political talks as well as the fact that achieving compliance on day-one post-Brexit, for example, on 1 April 2019 is likely to be folly. Irrespective of all of this, Brexit and prepping readiness in light of known changes is certainly no April fool’s.
The following six key compliance and operational challenges lay ahead for market participants regardless of where business lands in the EU27:
1. Lack of timely and complete applications from those relocating as part of their Brexit-proofing plans to the EU and changing tone:
Time is ticking and there is not much left until Brexit-day. This specifically means getting serious about plans, ensuring those plans reflect the EU’s Supervisory Principles on Relocations (SPoRs) both when getting the applications approved but following approval. That translates into entities having sufficient substance in terms of business and resources led out of the EU27 in place and in compliance with policies that reflect the EU27 regulatory regime to the satisfaction of EU supervisors.
The EU27 regulatory policymakers and supervisory authorities, notably the ECB, have clearly communicated further expectations on SPoRs as well as the messaging that it expects firms to be compliant rather than cute in workarounds across all areas and not just booking models. This sharpened tone from the EU27 has already meant that the ECB now speaks of firms’ ‘onshore’ capabilities versus ‘offshore’ exposure. This is more than just semantics but policymaking through a substantial change in positioning and a very real signal that the European Central Bank (ECB)-Single Supervisory Mechanism (SSM) will review the operations of new or expanded EU27 subsidiaries of those relocating as well as, where tolerated/approved, the operations of ‘third-country branches’ from the UK into the EU27.
2. A need for increased Brexit-proofing of contractual relationships and other client facing documentation:
Even if the urgency on pace is picking up piecemeal in terms of legal entity Brexit-proofing, consensus is beginning to emerge that more needs doing on ‘contractual continuity’. This term in itself encompasses many concepts as well as concerns under one hat. Chief among them is the risk that, post-Brexit, contracts, and obligations thereunder, will not be able to be performed or disputes enforced without amendment to terms. Some of that may be alleviated by moving contracts to the new and expanded EU27 legal entities from contractual counterparties historically in the UK or other third-countries, but other issues also present themselves in need of a solution. On the assumption that existing (pre-Referendum/Brexit-day) contracts will not benefit from sort of ‘grandfathering’, there is no panacea to contractual continuity and the resulting repapering that would be needed to move potentially multiple millions of terms and conditions.
On top of the much-publicised volume are the concerns of how to deal with optionality that exist in various master agreements across asset classes and transaction types. Add to that the bespoke nature of bilateral contracts, cross-default provisions and the paper headache becomes clearly in need of operational heavy-lifting. Getting to solutions may start with a document/risk exposure analysis, involve novation or other ‘permitted’ means of transfers but will require perhaps greater and more frequent inter-institutional cooperation amongst market participants and dialogue with supervisors.
Some of this coordination and cooperation on Brexit-proofing might want to happen prior to the EU and UK supervisory authorities set their own pace and dictate further formal and public expectations to the market. At present, Brexit letters sent to firms are showing differences in tone and that divergence could expand also on timing expectations. In terms of supervisory culture and proposed solutions both sides are approaching their shared problems from different angles and tones. The EU has set supervisory expectations on relocations and the UK has tried to preserve the status quo with its temporary permissions regime (TPR). Besides the TPR still needing to be formally approved, it is worth recalling that activity which the TPR might sanction could still fall foul of the EU’s own rules and expectations post-Brexit.
These issues also have some very real cascade effects that range from primary contractual relationships (for example, exposures to counterparties and various chains) through to infinite chains of secondary exposures (for example, EU27 entity facing UK firm but needing to service its own customers) and tertiary such exposures and relationships with financial market infrastructure providers. For securities financing transactions and documentation specifically, contractual continuity may not stop at changing just the contracting party to EU27 legal entities for EU facing business, but will likely require moving to new jurisdiction clauses favoring either alternative dispute resolution or the breadth of specialist courts that are beginning to crop up in challenger centers as well as documenting operational fallbacks along with whether jurisdiction should be exclusive or non-exclusive. The Loan Market Association’s (LMA) borrowing of concepts from the EU’s recovery and resolution regime and framing Brexit-related rebookings/transfers to a ‘designated entity’ in a standard form precedent available for the market to use has yet to be replicated by other industry associations.
As discussed below, the debate is only starting to rear its head as whether a change in jurisdiction clause, for example, from English Courts to say Frankfurt’s new International Chamber for Commercial Disputes would be best placed to also move to German law as the governing law of the relevant financial transaction. Unfortunately, the answer to that question is rather lawyerly “it depends… including which interests one is looking to serve”. This gets tricky and political even before one starts to weigh up the merits of moving exposures from English law governed documentation to documentation governed by the EU27 Member States.
Some industry associations have published standard clauses, drafting guidance including in how and when fallbacks should apply. Others have not. And this poses a potential in delayed timing as firms may push their own ‘house standard’ solutions with clients and counterparties, many of whom will want to ensure that any revisions to their Global Master Repurchase Agreement (GMRA), the Global Master Securities Lending Agreement (GMSLA), International Swaps and Derivatives Association (ISDA) and other securities financing and derivatives terms are not making changes that are adverse to their interests.
Acceptance for the ‘civil law copies’ of English law transaction documentation is, certainly in the derivatives space still novel, still subject to distrust on whether an Irish or French court appropriately adjudicate a dispute in the same favourable manner as the English courts, notably with the Financial List, can do. The EU has still taken no major effort to create the right tools for an equivalent to the UK’s Financial List to emerge. Aside from that lack of foresight comes the question for policymakers on both sides of the divorce proceedings as to what needs doing to ensure that English law master agreements, their New York law cousins and any ‘civil law copies’ can find the same amount of use, legal certainty and trust in documentation and market standards as the LMA documentation suites have been able to achieve, for example, a financing transaction using German law Investment Grade documentation on LMA standard receives no lesser treatment.
3. Potential for EU supervisors to increase scrutiny on Article 46(6) MiFIR in addition to existing SPoRs:
Upon the UK’s exit it will become a third-country and UK domiciled financial services firms will become third-country firms. Putting aside any prospect of an equivalence or other deal on regulatory recognition, access rights will be limited in line with rules set in EU legislation. Those rules differ across sectors and legislative instruments. Despite EU announcements to reform how it recognises and interacts third-country equivalence unless access rules are harmonised, firms will need to navigate a patchwork on the EU-side and one that gets worse as the UK’s rules begin to diverge conceptually. Great news for lawyers (in the know) but not so great for planning.
The European Supervisory Authorities, notably European Securities and Markets Authority (ESMA), European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA) and the ECB-SSM, acting in the lead in its Banking Union supervisory capacity, have each published SPoRs during 2017 and substantially updated during 2018. These SPoRs set some pretty strict goalposts on how existing EU law, including expectations of dealings with and operations of third-country firms are to be supervised and applications relating to new or expanded EU27 entities are to be completed, assessed and approved.
In addition to this sharpening of rules that apply regardless of whether the EU grants an ‘equivalence’ deal to the UK, market participants may want to take note of specific legislative provisions that apply in the event that the UK’s regulatory regime is determined, in accordance with the EU Commission’s discretion, to be equivalent. For securities financing transaction specifically, Title VIII of the directly applicable Markets in Financial Instruments Regulation (MiFIR) sets out criteria that third-country firms will need to abide by when accessing the EU’s single market for financial services. One core area that is reinforcing some of the debate touched upon above is that Art. 46(6) MiFIR is unequivocally clear in that: “Third-country firms providing services or performing activities in accordance with this Article shall, before providing any service or performing any activity in relation to a client established in the union, offer to submit any disputes relating to those services or activities to the jurisdiction of a court or arbitral tribunal in a member state.”
Consensus on what that means in practice is still emerging as supervisory approaches in this area have yet to find their own Brexit-view. What is conceivable, is that, as with the 2018 updates to the SPoRs, the more active firms in the market will need to demonstrate that they are proactively seeking consent from clients and highlighting risks of what it means if disputes are subjected to resolution in a third country. Whether that communication will go out with an assessment of the impact on say holdings of financial instruments that have an English law nexus whether as a matter of how they are documented or where they are executed, mobilised for collateral purposes, custodial or otherwise in circulation remains to be seen.
4. Extension of EU, and notably the ECB’s supervisory mandate to ‘bank-like’ activities from MiFID investment firms:
The EU Parliament, the Commission and the European Supervisory Authorities, notably ESMA and the EBA have long been worried about ‘bank-like’ activity being undertaken by non-bank financial institutions, for example, by MiFID Investment Firms as opposed to CRRCapital Requirements Regulation/Capital Requirements Directive IV credit institutions. In December 2017, the European Commission issued two legislative proposals for prudential requirements for investment firms. The aim of the proposals is to create a new simpler and more risk-sensitive prudential capital regime for MiFID investment firms built around quantitative metrics, called ‘K-Factors’, that define regulatory capital levels. However, the shift in prudential requirements may merit many firms needing to take early pre-emptive action to either source new regulatory capital or to put in place arrangements to limit risks that could flow into the K-Factors, which might lead to looking at rearranging regulated activities and who does what where.
The ECB, acting in its lead supervisory capacity in the Banking Union, which currently extends to the Eurozone has also expressed its own views on needing to extend the supervisory perimeter to include ‘bank-like’ activity. Most securities and derivatives transactions may be undertaken by non-credit institutions, for example, via so-called MiFID 730,000 firms. These are very much likely to be in-scope of the K-Factors and are also very much part of most structuring solutions for a number of Brexit-driven relocations. Consequently, this risk may require some forward planning at the legal entity but also potentially at the contractual level so as to manage regulatory capital allocation/planning. Change in this area is being advanced at a steady pace and with limited public consultation. Like with the EU’s actions on ‘shadow banking’ leading to the very concrete issues posed by Securities Financing Transactions Regulation (SFTR), the K-Factors and the ECB-SSM’s extension of its supervisory mandate to cover certain of those firms is a pretty real horizon risk.
5. Increased compliance challenges from SFTR and the Benchmarks Regulation (BMR):
The immediate next challenges on SFTR lie mostly with meeting transaction driven but also periodic reporting requirements. As with those regulatory projects that were finally brought over the line in 2018, meeting relevant SFTR obligations also require industry-wide coordination to ensure changes taken by individual firms are interoperable with those taken by others. SFTR’s most recent full deadline of Q1 2020 could sneak up faster than expected for a number of firms who may at that point also have to rethink how to implement the European Market Infrastructure Regulation (EMIR) 2.2’s changes, which go beyond just reporting.
While a lot of time has certainly been spent prior to and during 2018 on getting sell and buy-side SFTR-ready, with larger firms and their exposures leading the way, and those efforts increasingly cascading down to smaller firms improving their own compliance efforts, a real challenge for financial markets generally potentially rests with BMR not being as fully on the agenda of relevant firms or in quite the manner as EU27 supervisory authorities would like. EU Benchmarks Regulation (BMR) compliance and ensuring clients and counterparties comply extends to probably a larger part of financial markets and the real economy than say MiFID or certainly EMIR and SFTR.
BMR entered into force on 1 January 2018 and essentially requires any user of a benchmark upon which financial instruments or contracts derive price, asset allocation or their return including compensation/fees must observe compliance with governance and control obligations as well as ensuring that any ‘benchmarks’ themselves comply with the BMR. BMR is the EU response to rate-rigging and manipulation of reference rates such as LIBOR. The race to replacement rates, largely run by the ECB and the Bank of England in the EU is well afoot despite the differing stages of where the contenders are at. For market participants in securities financing transactions tension may arise where there are competing pressures within a firm or multiple firms’ communications on topics as mundane as which replacement rate should be used, which methodology and how quickly one transitions from existing overnight/funding or other interbank offer rates. The risk of overlooking BMR’s impact is real and understandable—whether supervisors will be as lenient given the pressures they have to police compliance and improve the rulebook in this area is wholly different matter.
6. Decoupling of equivalence of rules and lack of dialogue may mean double-compliance even if UK may introduce ‘domestic relief’ for some EU regulation, for example, SFTR-lite:
One of the mantras as well as myths pushed forward on the great British Brexit experiment is that leaving the EU will cause a bonfire of all that legislation that Her Majesty’s Government does not incorporate into the UK legal and regulatory regime. This is a double-edged sword for the UK as if it burns too much it risks any hope of an equivalence decision from the EU not being granted. Otherwise, failing an unlikely equivalence decision, in particular as the chequers deal confirmed that only (loose) ‘mutual recognition’ is on the table for the future framework for financial services means that any specific scorching of large parts of the EU’s single rulebook for financial services in the domestic regime would reduce that recognition further.
What is however conceivable and something that has been advocated for some time is that for UK domestic only transactions by UK firms, EU principles and rules could be disapplied or have some other form of “domestic relief”. It still remains to be seen whether the UK would push for some form of SFTR and/or EMIR-lite for domestic-only transactions as it is an attractive deliverable. However, doing so might very likely run contrary to the UK’s adherence to the 2009 G-20 Pittsburgh Commitments as well as on-going work plans of the Financial Stability Board.
And how are we doing for time?
It is not looking great in terms of picking up the pace but also for ‘day-one’ readiness and compliance. One issue is that, even with some form of political accord, assuming that occurs and yields to an extension of talks, preservation of the status quo on regulatory permissions or some other fix to preserve financial market stability 10 years after the worst of the last financial crisis, market participants need to pick up the pace. Against time-pressures for firms, the political calendar on both sides is quite full and UK parliamentary support for the incumbent prime minister may fall further. Further, the agreement between the UK and the EU on any transition/implementation period is contingent on a deal taking place in the first place. Absent that and the publication on 23 August by the UK on no-deal notices and time is tight and the breadth of critical challenges growing. The hope of the UK Second Referendum runs more risk of a false sense of hope during a period where time is of the essence.
Furthermore, with the EU’s State of the Union address on 12 September coinciding with the UK’s political party conference season along with the first ‘EU27 plus UK’ summit in Austria following the summer break, most will return to a full desk with politics and financial market policy-making let alone implementation running at very different paces. This matters as in the event that the Brexit timeline slips to next year without substantial negotiations the Austrian political presidency of the Consilium, one of the EU’s legislative bodies are handed over to Romania. Romania, unlike the very successful Bulgarian presidency, may have some very different views than those of Austria’s own plans on how to soften the blow from the UK’s current determined course towards, certainly for financial services, a hard-Brexit.
The above is a tall and very serious order. There are some quick fixes but most firm-specific decisions will merit perhaps taking advice that is more reflective of the EU’s view given that the negotiations and likely outcome are moving towards the UK realising in order to get some deal or the best out of a no-deal it will need to deal with the EU on the standards of engagement set by the EU. Some might argue this is not fair—those that prepare may benefit from first-mover or other competitive advantages over their peers.
This urgency is especially warranted, following the EU’s frank rejection of Theresa May’s chequers proposal even, if the EU’s chief negotiator Michel Barnier, has hinted at the possibility of an olive branch being offered to, or at least discussed with the UK’s newest Brexit minister provided that the cherry-picking stops. That requirement may ring bells among certain quarters weary of a deal being dictated by Brussels even if both sides have come to some form of consensus in pushing back points of no-return on the political talks as well as the fact that achieving compliance on day-one post-Brexit, for example, on 1 April 2019 is likely to be folly. Irrespective of all of this, Brexit and prepping readiness in light of known changes is certainly no April fool’s.
The following six key compliance and operational challenges lay ahead for market participants regardless of where business lands in the EU27:
1. Lack of timely and complete applications from those relocating as part of their Brexit-proofing plans to the EU and changing tone:
Time is ticking and there is not much left until Brexit-day. This specifically means getting serious about plans, ensuring those plans reflect the EU’s Supervisory Principles on Relocations (SPoRs) both when getting the applications approved but following approval. That translates into entities having sufficient substance in terms of business and resources led out of the EU27 in place and in compliance with policies that reflect the EU27 regulatory regime to the satisfaction of EU supervisors.
The EU27 regulatory policymakers and supervisory authorities, notably the ECB, have clearly communicated further expectations on SPoRs as well as the messaging that it expects firms to be compliant rather than cute in workarounds across all areas and not just booking models. This sharpened tone from the EU27 has already meant that the ECB now speaks of firms’ ‘onshore’ capabilities versus ‘offshore’ exposure. This is more than just semantics but policymaking through a substantial change in positioning and a very real signal that the European Central Bank (ECB)-Single Supervisory Mechanism (SSM) will review the operations of new or expanded EU27 subsidiaries of those relocating as well as, where tolerated/approved, the operations of ‘third-country branches’ from the UK into the EU27.
2. A need for increased Brexit-proofing of contractual relationships and other client facing documentation:
Even if the urgency on pace is picking up piecemeal in terms of legal entity Brexit-proofing, consensus is beginning to emerge that more needs doing on ‘contractual continuity’. This term in itself encompasses many concepts as well as concerns under one hat. Chief among them is the risk that, post-Brexit, contracts, and obligations thereunder, will not be able to be performed or disputes enforced without amendment to terms. Some of that may be alleviated by moving contracts to the new and expanded EU27 legal entities from contractual counterparties historically in the UK or other third-countries, but other issues also present themselves in need of a solution. On the assumption that existing (pre-Referendum/Brexit-day) contracts will not benefit from sort of ‘grandfathering’, there is no panacea to contractual continuity and the resulting repapering that would be needed to move potentially multiple millions of terms and conditions.
On top of the much-publicised volume are the concerns of how to deal with optionality that exist in various master agreements across asset classes and transaction types. Add to that the bespoke nature of bilateral contracts, cross-default provisions and the paper headache becomes clearly in need of operational heavy-lifting. Getting to solutions may start with a document/risk exposure analysis, involve novation or other ‘permitted’ means of transfers but will require perhaps greater and more frequent inter-institutional cooperation amongst market participants and dialogue with supervisors.
Some of this coordination and cooperation on Brexit-proofing might want to happen prior to the EU and UK supervisory authorities set their own pace and dictate further formal and public expectations to the market. At present, Brexit letters sent to firms are showing differences in tone and that divergence could expand also on timing expectations. In terms of supervisory culture and proposed solutions both sides are approaching their shared problems from different angles and tones. The EU has set supervisory expectations on relocations and the UK has tried to preserve the status quo with its temporary permissions regime (TPR). Besides the TPR still needing to be formally approved, it is worth recalling that activity which the TPR might sanction could still fall foul of the EU’s own rules and expectations post-Brexit.
These issues also have some very real cascade effects that range from primary contractual relationships (for example, exposures to counterparties and various chains) through to infinite chains of secondary exposures (for example, EU27 entity facing UK firm but needing to service its own customers) and tertiary such exposures and relationships with financial market infrastructure providers. For securities financing transactions and documentation specifically, contractual continuity may not stop at changing just the contracting party to EU27 legal entities for EU facing business, but will likely require moving to new jurisdiction clauses favoring either alternative dispute resolution or the breadth of specialist courts that are beginning to crop up in challenger centers as well as documenting operational fallbacks along with whether jurisdiction should be exclusive or non-exclusive. The Loan Market Association’s (LMA) borrowing of concepts from the EU’s recovery and resolution regime and framing Brexit-related rebookings/transfers to a ‘designated entity’ in a standard form precedent available for the market to use has yet to be replicated by other industry associations.
As discussed below, the debate is only starting to rear its head as whether a change in jurisdiction clause, for example, from English Courts to say Frankfurt’s new International Chamber for Commercial Disputes would be best placed to also move to German law as the governing law of the relevant financial transaction. Unfortunately, the answer to that question is rather lawyerly “it depends… including which interests one is looking to serve”. This gets tricky and political even before one starts to weigh up the merits of moving exposures from English law governed documentation to documentation governed by the EU27 Member States.
Some industry associations have published standard clauses, drafting guidance including in how and when fallbacks should apply. Others have not. And this poses a potential in delayed timing as firms may push their own ‘house standard’ solutions with clients and counterparties, many of whom will want to ensure that any revisions to their Global Master Repurchase Agreement (GMRA), the Global Master Securities Lending Agreement (GMSLA), International Swaps and Derivatives Association (ISDA) and other securities financing and derivatives terms are not making changes that are adverse to their interests.
Acceptance for the ‘civil law copies’ of English law transaction documentation is, certainly in the derivatives space still novel, still subject to distrust on whether an Irish or French court appropriately adjudicate a dispute in the same favourable manner as the English courts, notably with the Financial List, can do. The EU has still taken no major effort to create the right tools for an equivalent to the UK’s Financial List to emerge. Aside from that lack of foresight comes the question for policymakers on both sides of the divorce proceedings as to what needs doing to ensure that English law master agreements, their New York law cousins and any ‘civil law copies’ can find the same amount of use, legal certainty and trust in documentation and market standards as the LMA documentation suites have been able to achieve, for example, a financing transaction using German law Investment Grade documentation on LMA standard receives no lesser treatment.
3. Potential for EU supervisors to increase scrutiny on Article 46(6) MiFIR in addition to existing SPoRs:
Upon the UK’s exit it will become a third-country and UK domiciled financial services firms will become third-country firms. Putting aside any prospect of an equivalence or other deal on regulatory recognition, access rights will be limited in line with rules set in EU legislation. Those rules differ across sectors and legislative instruments. Despite EU announcements to reform how it recognises and interacts third-country equivalence unless access rules are harmonised, firms will need to navigate a patchwork on the EU-side and one that gets worse as the UK’s rules begin to diverge conceptually. Great news for lawyers (in the know) but not so great for planning.
The European Supervisory Authorities, notably European Securities and Markets Authority (ESMA), European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA) and the ECB-SSM, acting in the lead in its Banking Union supervisory capacity, have each published SPoRs during 2017 and substantially updated during 2018. These SPoRs set some pretty strict goalposts on how existing EU law, including expectations of dealings with and operations of third-country firms are to be supervised and applications relating to new or expanded EU27 entities are to be completed, assessed and approved.
In addition to this sharpening of rules that apply regardless of whether the EU grants an ‘equivalence’ deal to the UK, market participants may want to take note of specific legislative provisions that apply in the event that the UK’s regulatory regime is determined, in accordance with the EU Commission’s discretion, to be equivalent. For securities financing transaction specifically, Title VIII of the directly applicable Markets in Financial Instruments Regulation (MiFIR) sets out criteria that third-country firms will need to abide by when accessing the EU’s single market for financial services. One core area that is reinforcing some of the debate touched upon above is that Art. 46(6) MiFIR is unequivocally clear in that: “Third-country firms providing services or performing activities in accordance with this Article shall, before providing any service or performing any activity in relation to a client established in the union, offer to submit any disputes relating to those services or activities to the jurisdiction of a court or arbitral tribunal in a member state.”
Consensus on what that means in practice is still emerging as supervisory approaches in this area have yet to find their own Brexit-view. What is conceivable, is that, as with the 2018 updates to the SPoRs, the more active firms in the market will need to demonstrate that they are proactively seeking consent from clients and highlighting risks of what it means if disputes are subjected to resolution in a third country. Whether that communication will go out with an assessment of the impact on say holdings of financial instruments that have an English law nexus whether as a matter of how they are documented or where they are executed, mobilised for collateral purposes, custodial or otherwise in circulation remains to be seen.
4. Extension of EU, and notably the ECB’s supervisory mandate to ‘bank-like’ activities from MiFID investment firms:
The EU Parliament, the Commission and the European Supervisory Authorities, notably ESMA and the EBA have long been worried about ‘bank-like’ activity being undertaken by non-bank financial institutions, for example, by MiFID Investment Firms as opposed to CRRCapital Requirements Regulation/Capital Requirements Directive IV credit institutions. In December 2017, the European Commission issued two legislative proposals for prudential requirements for investment firms. The aim of the proposals is to create a new simpler and more risk-sensitive prudential capital regime for MiFID investment firms built around quantitative metrics, called ‘K-Factors’, that define regulatory capital levels. However, the shift in prudential requirements may merit many firms needing to take early pre-emptive action to either source new regulatory capital or to put in place arrangements to limit risks that could flow into the K-Factors, which might lead to looking at rearranging regulated activities and who does what where.
The ECB, acting in its lead supervisory capacity in the Banking Union, which currently extends to the Eurozone has also expressed its own views on needing to extend the supervisory perimeter to include ‘bank-like’ activity. Most securities and derivatives transactions may be undertaken by non-credit institutions, for example, via so-called MiFID 730,000 firms. These are very much likely to be in-scope of the K-Factors and are also very much part of most structuring solutions for a number of Brexit-driven relocations. Consequently, this risk may require some forward planning at the legal entity but also potentially at the contractual level so as to manage regulatory capital allocation/planning. Change in this area is being advanced at a steady pace and with limited public consultation. Like with the EU’s actions on ‘shadow banking’ leading to the very concrete issues posed by Securities Financing Transactions Regulation (SFTR), the K-Factors and the ECB-SSM’s extension of its supervisory mandate to cover certain of those firms is a pretty real horizon risk.
5. Increased compliance challenges from SFTR and the Benchmarks Regulation (BMR):
The immediate next challenges on SFTR lie mostly with meeting transaction driven but also periodic reporting requirements. As with those regulatory projects that were finally brought over the line in 2018, meeting relevant SFTR obligations also require industry-wide coordination to ensure changes taken by individual firms are interoperable with those taken by others. SFTR’s most recent full deadline of Q1 2020 could sneak up faster than expected for a number of firms who may at that point also have to rethink how to implement the European Market Infrastructure Regulation (EMIR) 2.2’s changes, which go beyond just reporting.
While a lot of time has certainly been spent prior to and during 2018 on getting sell and buy-side SFTR-ready, with larger firms and their exposures leading the way, and those efforts increasingly cascading down to smaller firms improving their own compliance efforts, a real challenge for financial markets generally potentially rests with BMR not being as fully on the agenda of relevant firms or in quite the manner as EU27 supervisory authorities would like. EU Benchmarks Regulation (BMR) compliance and ensuring clients and counterparties comply extends to probably a larger part of financial markets and the real economy than say MiFID or certainly EMIR and SFTR.
BMR entered into force on 1 January 2018 and essentially requires any user of a benchmark upon which financial instruments or contracts derive price, asset allocation or their return including compensation/fees must observe compliance with governance and control obligations as well as ensuring that any ‘benchmarks’ themselves comply with the BMR. BMR is the EU response to rate-rigging and manipulation of reference rates such as LIBOR. The race to replacement rates, largely run by the ECB and the Bank of England in the EU is well afoot despite the differing stages of where the contenders are at. For market participants in securities financing transactions tension may arise where there are competing pressures within a firm or multiple firms’ communications on topics as mundane as which replacement rate should be used, which methodology and how quickly one transitions from existing overnight/funding or other interbank offer rates. The risk of overlooking BMR’s impact is real and understandable—whether supervisors will be as lenient given the pressures they have to police compliance and improve the rulebook in this area is wholly different matter.
6. Decoupling of equivalence of rules and lack of dialogue may mean double-compliance even if UK may introduce ‘domestic relief’ for some EU regulation, for example, SFTR-lite:
One of the mantras as well as myths pushed forward on the great British Brexit experiment is that leaving the EU will cause a bonfire of all that legislation that Her Majesty’s Government does not incorporate into the UK legal and regulatory regime. This is a double-edged sword for the UK as if it burns too much it risks any hope of an equivalence decision from the EU not being granted. Otherwise, failing an unlikely equivalence decision, in particular as the chequers deal confirmed that only (loose) ‘mutual recognition’ is on the table for the future framework for financial services means that any specific scorching of large parts of the EU’s single rulebook for financial services in the domestic regime would reduce that recognition further.
What is however conceivable and something that has been advocated for some time is that for UK domestic only transactions by UK firms, EU principles and rules could be disapplied or have some other form of “domestic relief”. It still remains to be seen whether the UK would push for some form of SFTR and/or EMIR-lite for domestic-only transactions as it is an attractive deliverable. However, doing so might very likely run contrary to the UK’s adherence to the 2009 G-20 Pittsburgh Commitments as well as on-going work plans of the Financial Stability Board.
And how are we doing for time?
It is not looking great in terms of picking up the pace but also for ‘day-one’ readiness and compliance. One issue is that, even with some form of political accord, assuming that occurs and yields to an extension of talks, preservation of the status quo on regulatory permissions or some other fix to preserve financial market stability 10 years after the worst of the last financial crisis, market participants need to pick up the pace. Against time-pressures for firms, the political calendar on both sides is quite full and UK parliamentary support for the incumbent prime minister may fall further. Further, the agreement between the UK and the EU on any transition/implementation period is contingent on a deal taking place in the first place. Absent that and the publication on 23 August by the UK on no-deal notices and time is tight and the breadth of critical challenges growing. The hope of the UK Second Referendum runs more risk of a false sense of hope during a period where time is of the essence.
Furthermore, with the EU’s State of the Union address on 12 September coinciding with the UK’s political party conference season along with the first ‘EU27 plus UK’ summit in Austria following the summer break, most will return to a full desk with politics and financial market policy-making let alone implementation running at very different paces. This matters as in the event that the Brexit timeline slips to next year without substantial negotiations the Austrian political presidency of the Consilium, one of the EU’s legislative bodies are handed over to Romania. Romania, unlike the very successful Bulgarian presidency, may have some very different views than those of Austria’s own plans on how to soften the blow from the UK’s current determined course towards, certainly for financial services, a hard-Brexit.
The above is a tall and very serious order. There are some quick fixes but most firm-specific decisions will merit perhaps taking advice that is more reflective of the EU’s view given that the negotiations and likely outcome are moving towards the UK realising in order to get some deal or the best out of a no-deal it will need to deal with the EU on the standards of engagement set by the EU. Some might argue this is not fair—those that prepare may benefit from first-mover or other competitive advantages over their peers.
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