SFTR to SFDR: The new, new regulatory frontier
02 March 2021
Experts in securities lending, repo, regulation and law were brought together to navigate the unique challenges of moving from a regulatory world based on rules to one based on principles
Image: stock.adobe.com/ jenteva
Moderator:
Ali Kazimi
Managing director
Hansuke Consulting
Panellists:
Danny Corrigan
CEO
London Reporting House
Farrah Mahmood
Senior regulatory analyst
ISLA
Roy Zimmerhansl
Practice lead
Pierpoint Financial Consulting
The Securities Financing Transactions Regulation (SFTR) and the Sustainable Finance Disclosure Regulation (SFDR) are vastly different in scope, aim, and design, but they do share one key trait. They represent a radically new rules framework, unlike anything the securities finance market has seen before.
For the securities finance market participants, after the harsh, direct gaze of regulators in SFTR, the incoming ESG rules are a return to form, bringing familiar challenges of being caught up in a broad-brush regulation not written for them or particularly well suited to their industry structure.
SFTR was an ambitious project by EU regulators to respond to the perceived market vulnerabilities laid bare by the global financial crisis, primarily targeted at the misleading moniker of shadow banking. Securities lending and the short selling it facilitates were already highly regulated markets before SFTR, with frameworks like Regulation SHO in the US all but eliminating naked shorting. But the actual dimensions of industry were a mystery to regulators. Hence the demand for granular transaction reporting to allow the scale of repo and securities lending markets to be comprehensively mapped out.
SFDR is different. ESG is an entirely new feature to capital markets and has taken even longer to trickle down throughout the securities finance world. The first phase of implementation on 10 March will be the EU regulator’s first real attempt at standardising and crystallising the ethereal concept of sustainable financing in law.
The SFTR to SFDR webinar, hosted by Ali Kazimi, who operates as a tax integrity specialist for Hansuke Consulting, assessed the recent past of SFTR, which only fully came into force in January, while also pivoting to address the fast-approaching challenges of complying with the very different style of market governance SFDR presents.
The one-off webinar was hosted in partnership with the Chartered Institute of Securities and Investments and Securities Finance Times and is available to view on-demand in our multimedia hub.
SFTR’s recipe for success
Look at your SFTR data and think of the Ottolenghi Cookbook, declared Danny Corrigan, simultaneously revealing his culinary and regulatory credentials. SFTR, he says, is much better than previous reporting frameworks such as the European Markets Infrastructure Regulation, and the data that’s been available for almost a year now is “really good”.
The vast variety of transaction data that’s now available can be viewed as a recipe for knowing your own business better, Corrigan explained, adding: “It was designed for regulators but you can use it yourself.”
Kazimi acknowledged that SFTR was widely considered a success but questioned the cost of compliance. The cost was “enormous”, Corrigan conceded, but argued a firm can make the endeavour worthwhile if it utilises the new data to optimise their businesses.
Corrigan plans to practice what he preaches and his new venture, London Reporting House, will launch in April and offer to repurpose clients’ SFTR data to help them develop their securities finance business, with a specific focus on environmental, social and governance (ESG) practices, such as green bonds.
Roy Zimmerhansl agreed that SFTR was largely a success and offered kudos to the trade associations, including the International Securities Lending Association (ISLA) and the International Capital Market Association (ICMA), for the central role they played in rallying various market participants into working groups that produced a lot of guidance for those in scope.
According to Zimmerhansl, there are two real winners of SFTR: those firms that use the new data for their own ends, and the people that sold the supercomputers to regulators trying to crunch the mountain of transaction reports they now receive every day.
Zimmerhansl added that it is less than clear what various regulators will do with all this data as there has never been a clear aim underpinning the broad reporting requirements beyond casting the widest possible net to capture the market’s activity. Watch this space.
SFTR to SFDR: From rules to principles
At the centre of any conversation around the adoption of ESG across the global securities finance market is a single inescapable problem: the lack of standardisation. Today, financial institutions can make grand claims about their commitment to sustainability with very little scrutiny from either the market or regulators. For example, retail investors shopping around for ETFs to invest in may be presented with a fund’s high ESG rating from MSCI, or indeed another agency, but there is precious little oversight of how these scores are calculated. The variety of opinions on how well securities lending and ESG coexist ranges from not at all — a view mostly held by ETF managers and pension funds — to completely (as argued by ISLA and most other market participants), and there is a lot of open water between those two poles.
According to Zimmerhansl, the main battlefield is collateral. Today, a beneficial owner may present a collateral exclusion list to its agent lender that will bar it from accepting any assets that do not comply with its ESG policy. Common offenders are businesses involved in fossil fuels, weapons manufacturers or other so-called ‘vice stocks’ such as tobacco.
Zimmerhansl called for a more nuanced approach to account for the shifting ESG landscape. For example, what should be done with energy companies seeking to transition to more sustainable models? That type of behaviour should be promoted not shunned, he argued, meaning a binary collateral lens of ‘oil is bad, solar is good’ is sub-optimal.
Service providers are craving conformity in the ESG space to escape managing the bespoke requirements of their clients, but in the global marketplace, this is unlikely to come soon. Zimmerhansl noted that SFDR is an attempt by the EU to bring general standardisation and oversight to the sustainability space but that doesn’t take into account the rest of the world.
“Inevitably we’re going to have to adjust and adapt our models so that it’s much more about mass customisation, rather than mass standardisation. That’s the challenge for the industry,” he stated.
Among the issues of marrying ESG and securities lending, collateral is second only to the question of recalls of on-loan stocks to exercise voting rights. The issue of ensuring assets are recalled in time has been an ongoing sticking point for lenders and Zimmerhansl predicts that beneficial owners will be increasingly proactive in recalling stock despite the inevitable hit to revenues. Lenders will want to avoid being called out for taking small profit bumps instead of exercising their powers as investors.
“Any time an investor isn’t voting their shares and someone else is, it’s because that long investor has chosen not to vote those shares because shares are always recallable. So it’s an active choice they’re making to make their shares available for short sellers,” Zimmerhansl explains.
Prepare to disclose … something
Beyond the primary challenge of writing the rules of engagement for a market that no two participants can agree on, the hurdle for compliance is raised further still by the lack of granular detail on what the EU’s market overseers want.
ISLA’s Farrah Mahmood outlined the unusual situation of the market preparing for the go-live of the level-one SFDR text, which only outlines the requirements in the broadest terms, before the level-two regulatory technical standards (RTS), which provides more granular detail, are ratified by the European Parliament.
Last year, the European Commission published a consultation paper setting out proposals for the level-two RTS, which closed in September. The original timeline was for the final report to come out in December to allow time before the 10 March deadline, but COVID-19 put paid to that.
In November, the commission confirmed the RTS would be delayed but reiterated in-scope firms must be ready to comply with the level-one come March.
Then, in January, the level-two text appeared after all with a caveat that it would apply from January 2022.
So, is securities lending in scope? We don’t know. ISLA members are waiting on the response to a letter sent by several EU authorities to the commission seeking clarification to key terminology that defines what activities are in-scope of SFDR.
The letter was sent in early January and a response is expected before 10 March, although it will not leave the securities lending industry much time to get their houses in order if, as is expected, the commission applies the broadest possible meaning of whether a product ‘promotes’ ESG and therefore falls under the SFDR disclosure rules.
Away from Brussels, ISLA’s own working groups are also finding a lack of consensus of whether securities lending is in-scope due to the different areas that the business sits under with each member’s structure. SFDR is relevant for ‘portfolio management’ activities as defined under the second Markets in Financial Instruments Directive (MiFID II). ISLA has since found its members received different external counsel on this and therefore they are split on where securities lending should sit, Mahmood explained. Some ISLA members were advised that only the cash reinvestment element of a securities lending business is considered a portfolio management activist while others disclose their entire programme under MiFID II, and will therefore have to do the same under SFDR.
ISLA’s ESG steering group is attempting to square the circle and is standing by to act once the letter’s response is available.
Kazimi asked for more details on whether ISLA was working with other trade bodies in the same successful way it had while tackling SFTR, to which Mahmood highlighted the work of ICMA and others that all contribute to the greater capital market understanding of what’s required and how to get there.
Kazimi probed further, pitching an audience question that asked whether securities lending was meant to be swept up in SFDR in the first place. Mahmood suggested that it probably wasn’t top-of-mind for those drafting the text. As is so often the case, securities lending is caught up in wider trends and must adapt accordingly regardless.
On this point, Zimmerhansl emphasised that ESG required a much broader-church approach than SFTR and called for all capital market participants to be included in discussions. Zimmerhansl also serves on the college of advisors for the Global Principles for Sustainable Securities Lending which focuses on gaining contributions from buy-side members (including pension funds and hedge funds), along with academics and other stakeholders as part of its mission to create a securities lending market that is indisputably ESG-compatible.
It’ll all come out in the greenwash
The most controversial area in the ESG sphere is around ‘greenwashing’ — the act of disingenuously promoting your sustainable ideals in a superficial way to dupe clients. SFDR is a direct response to this issue but the vagaries of the initial requirements for website disclosures of ESG products fall far short of solving the problem.
Mahmood suggested progress will be made once the taxonomy is released, which will act as a list of activities and specific performance criteria for contributing to ESG objectives.
“That’s going to create a common language for financial institutions, investors and policymakers,” she explains. “Once you’ve got that standardisation and common ground everybody is going to be reporting to the same criteria.”
Corrigan agrees and said an ESG-focused taxonomy for different securities will go a long way to cutting through the noise and allow investors to easily compare one asset’s characteristics with another.
He added that central banks also have a part to play by dictating their collateral requirements for their primary repo market. If they were to only accept broadly ESG-friendly collateral then that would quickly influence the secondary market, he argued.
However, Zimmerhansl was unconvinced. He suggested the market needs to be better at self-policing by investigating a firm’s green credentials, as well as regulatory oversight. It’s here that the surge in retail investors, a major force behind the drive for ESG adoption by buy and sell-side institutions, may be at risk of undermining its aims, he suggested.
“Is the market better off with Citron Research not doing any more short reports because of the abuse that they’ve taken over GameStop,” he questioned. “We will need more people checking greenwashing credentials rather than fewer. Partly that’s because people will make mistakes and genuinely think that they’re complying, as well as those people with more malevolent goals.”
Turning to the recent past for examples, Zimmerhansl noted that both Wirecard and NMC health were members of mainstream indexes the FTSE 100 and the DAX 30, respectively. “I don’t recall a lot of long investors or passive index holders calling out fraud and I don’t recall regulators or auditors doing it, I saw journalists and short sellers doing it.”
“I think there is a role for short sellers that’s really valuable and I have a list of over 30 companies that have been spotted by short sellers and not regulators or long investors.”
Commenting on the evolution of ESG as an industry hot topic, Kazimi observed that the first wave of ESG was vague enough to allow firms to talk loudly about their sustainability agenda without having to back that up with action. More recently, second-wave ESG brings more structure and definition to the conversation and will require firms to internalise that thought process and make changes.
Zimmerhansl said 2021 should be viewed as a year for “debate, challenge and engagement” to drive progress on practical issues such as ESG collateral. He also doubled down on calls for the conversation to not be limited to association working groups to agree on an industry-wide consensus on sustainable principles within securities finance for the future.
Ali Kazimi
Managing director
Hansuke Consulting
Panellists:
Danny Corrigan
CEO
London Reporting House
Farrah Mahmood
Senior regulatory analyst
ISLA
Roy Zimmerhansl
Practice lead
Pierpoint Financial Consulting
The Securities Financing Transactions Regulation (SFTR) and the Sustainable Finance Disclosure Regulation (SFDR) are vastly different in scope, aim, and design, but they do share one key trait. They represent a radically new rules framework, unlike anything the securities finance market has seen before.
For the securities finance market participants, after the harsh, direct gaze of regulators in SFTR, the incoming ESG rules are a return to form, bringing familiar challenges of being caught up in a broad-brush regulation not written for them or particularly well suited to their industry structure.
SFTR was an ambitious project by EU regulators to respond to the perceived market vulnerabilities laid bare by the global financial crisis, primarily targeted at the misleading moniker of shadow banking. Securities lending and the short selling it facilitates were already highly regulated markets before SFTR, with frameworks like Regulation SHO in the US all but eliminating naked shorting. But the actual dimensions of industry were a mystery to regulators. Hence the demand for granular transaction reporting to allow the scale of repo and securities lending markets to be comprehensively mapped out.
SFDR is different. ESG is an entirely new feature to capital markets and has taken even longer to trickle down throughout the securities finance world. The first phase of implementation on 10 March will be the EU regulator’s first real attempt at standardising and crystallising the ethereal concept of sustainable financing in law.
The SFTR to SFDR webinar, hosted by Ali Kazimi, who operates as a tax integrity specialist for Hansuke Consulting, assessed the recent past of SFTR, which only fully came into force in January, while also pivoting to address the fast-approaching challenges of complying with the very different style of market governance SFDR presents.
The one-off webinar was hosted in partnership with the Chartered Institute of Securities and Investments and Securities Finance Times and is available to view on-demand in our multimedia hub.
SFTR’s recipe for success
Look at your SFTR data and think of the Ottolenghi Cookbook, declared Danny Corrigan, simultaneously revealing his culinary and regulatory credentials. SFTR, he says, is much better than previous reporting frameworks such as the European Markets Infrastructure Regulation, and the data that’s been available for almost a year now is “really good”.
The vast variety of transaction data that’s now available can be viewed as a recipe for knowing your own business better, Corrigan explained, adding: “It was designed for regulators but you can use it yourself.”
Kazimi acknowledged that SFTR was widely considered a success but questioned the cost of compliance. The cost was “enormous”, Corrigan conceded, but argued a firm can make the endeavour worthwhile if it utilises the new data to optimise their businesses.
Corrigan plans to practice what he preaches and his new venture, London Reporting House, will launch in April and offer to repurpose clients’ SFTR data to help them develop their securities finance business, with a specific focus on environmental, social and governance (ESG) practices, such as green bonds.
Roy Zimmerhansl agreed that SFTR was largely a success and offered kudos to the trade associations, including the International Securities Lending Association (ISLA) and the International Capital Market Association (ICMA), for the central role they played in rallying various market participants into working groups that produced a lot of guidance for those in scope.
According to Zimmerhansl, there are two real winners of SFTR: those firms that use the new data for their own ends, and the people that sold the supercomputers to regulators trying to crunch the mountain of transaction reports they now receive every day.
Zimmerhansl added that it is less than clear what various regulators will do with all this data as there has never been a clear aim underpinning the broad reporting requirements beyond casting the widest possible net to capture the market’s activity. Watch this space.
SFTR to SFDR: From rules to principles
At the centre of any conversation around the adoption of ESG across the global securities finance market is a single inescapable problem: the lack of standardisation. Today, financial institutions can make grand claims about their commitment to sustainability with very little scrutiny from either the market or regulators. For example, retail investors shopping around for ETFs to invest in may be presented with a fund’s high ESG rating from MSCI, or indeed another agency, but there is precious little oversight of how these scores are calculated. The variety of opinions on how well securities lending and ESG coexist ranges from not at all — a view mostly held by ETF managers and pension funds — to completely (as argued by ISLA and most other market participants), and there is a lot of open water between those two poles.
According to Zimmerhansl, the main battlefield is collateral. Today, a beneficial owner may present a collateral exclusion list to its agent lender that will bar it from accepting any assets that do not comply with its ESG policy. Common offenders are businesses involved in fossil fuels, weapons manufacturers or other so-called ‘vice stocks’ such as tobacco.
Zimmerhansl called for a more nuanced approach to account for the shifting ESG landscape. For example, what should be done with energy companies seeking to transition to more sustainable models? That type of behaviour should be promoted not shunned, he argued, meaning a binary collateral lens of ‘oil is bad, solar is good’ is sub-optimal.
Service providers are craving conformity in the ESG space to escape managing the bespoke requirements of their clients, but in the global marketplace, this is unlikely to come soon. Zimmerhansl noted that SFDR is an attempt by the EU to bring general standardisation and oversight to the sustainability space but that doesn’t take into account the rest of the world.
“Inevitably we’re going to have to adjust and adapt our models so that it’s much more about mass customisation, rather than mass standardisation. That’s the challenge for the industry,” he stated.
Among the issues of marrying ESG and securities lending, collateral is second only to the question of recalls of on-loan stocks to exercise voting rights. The issue of ensuring assets are recalled in time has been an ongoing sticking point for lenders and Zimmerhansl predicts that beneficial owners will be increasingly proactive in recalling stock despite the inevitable hit to revenues. Lenders will want to avoid being called out for taking small profit bumps instead of exercising their powers as investors.
“Any time an investor isn’t voting their shares and someone else is, it’s because that long investor has chosen not to vote those shares because shares are always recallable. So it’s an active choice they’re making to make their shares available for short sellers,” Zimmerhansl explains.
Prepare to disclose … something
Beyond the primary challenge of writing the rules of engagement for a market that no two participants can agree on, the hurdle for compliance is raised further still by the lack of granular detail on what the EU’s market overseers want.
ISLA’s Farrah Mahmood outlined the unusual situation of the market preparing for the go-live of the level-one SFDR text, which only outlines the requirements in the broadest terms, before the level-two regulatory technical standards (RTS), which provides more granular detail, are ratified by the European Parliament.
Last year, the European Commission published a consultation paper setting out proposals for the level-two RTS, which closed in September. The original timeline was for the final report to come out in December to allow time before the 10 March deadline, but COVID-19 put paid to that.
In November, the commission confirmed the RTS would be delayed but reiterated in-scope firms must be ready to comply with the level-one come March.
Then, in January, the level-two text appeared after all with a caveat that it would apply from January 2022.
So, is securities lending in scope? We don’t know. ISLA members are waiting on the response to a letter sent by several EU authorities to the commission seeking clarification to key terminology that defines what activities are in-scope of SFDR.
The letter was sent in early January and a response is expected before 10 March, although it will not leave the securities lending industry much time to get their houses in order if, as is expected, the commission applies the broadest possible meaning of whether a product ‘promotes’ ESG and therefore falls under the SFDR disclosure rules.
Away from Brussels, ISLA’s own working groups are also finding a lack of consensus of whether securities lending is in-scope due to the different areas that the business sits under with each member’s structure. SFDR is relevant for ‘portfolio management’ activities as defined under the second Markets in Financial Instruments Directive (MiFID II). ISLA has since found its members received different external counsel on this and therefore they are split on where securities lending should sit, Mahmood explained. Some ISLA members were advised that only the cash reinvestment element of a securities lending business is considered a portfolio management activist while others disclose their entire programme under MiFID II, and will therefore have to do the same under SFDR.
ISLA’s ESG steering group is attempting to square the circle and is standing by to act once the letter’s response is available.
Kazimi asked for more details on whether ISLA was working with other trade bodies in the same successful way it had while tackling SFTR, to which Mahmood highlighted the work of ICMA and others that all contribute to the greater capital market understanding of what’s required and how to get there.
Kazimi probed further, pitching an audience question that asked whether securities lending was meant to be swept up in SFDR in the first place. Mahmood suggested that it probably wasn’t top-of-mind for those drafting the text. As is so often the case, securities lending is caught up in wider trends and must adapt accordingly regardless.
On this point, Zimmerhansl emphasised that ESG required a much broader-church approach than SFTR and called for all capital market participants to be included in discussions. Zimmerhansl also serves on the college of advisors for the Global Principles for Sustainable Securities Lending which focuses on gaining contributions from buy-side members (including pension funds and hedge funds), along with academics and other stakeholders as part of its mission to create a securities lending market that is indisputably ESG-compatible.
It’ll all come out in the greenwash
The most controversial area in the ESG sphere is around ‘greenwashing’ — the act of disingenuously promoting your sustainable ideals in a superficial way to dupe clients. SFDR is a direct response to this issue but the vagaries of the initial requirements for website disclosures of ESG products fall far short of solving the problem.
Mahmood suggested progress will be made once the taxonomy is released, which will act as a list of activities and specific performance criteria for contributing to ESG objectives.
“That’s going to create a common language for financial institutions, investors and policymakers,” she explains. “Once you’ve got that standardisation and common ground everybody is going to be reporting to the same criteria.”
Corrigan agrees and said an ESG-focused taxonomy for different securities will go a long way to cutting through the noise and allow investors to easily compare one asset’s characteristics with another.
He added that central banks also have a part to play by dictating their collateral requirements for their primary repo market. If they were to only accept broadly ESG-friendly collateral then that would quickly influence the secondary market, he argued.
However, Zimmerhansl was unconvinced. He suggested the market needs to be better at self-policing by investigating a firm’s green credentials, as well as regulatory oversight. It’s here that the surge in retail investors, a major force behind the drive for ESG adoption by buy and sell-side institutions, may be at risk of undermining its aims, he suggested.
“Is the market better off with Citron Research not doing any more short reports because of the abuse that they’ve taken over GameStop,” he questioned. “We will need more people checking greenwashing credentials rather than fewer. Partly that’s because people will make mistakes and genuinely think that they’re complying, as well as those people with more malevolent goals.”
Turning to the recent past for examples, Zimmerhansl noted that both Wirecard and NMC health were members of mainstream indexes the FTSE 100 and the DAX 30, respectively. “I don’t recall a lot of long investors or passive index holders calling out fraud and I don’t recall regulators or auditors doing it, I saw journalists and short sellers doing it.”
“I think there is a role for short sellers that’s really valuable and I have a list of over 30 companies that have been spotted by short sellers and not regulators or long investors.”
Commenting on the evolution of ESG as an industry hot topic, Kazimi observed that the first wave of ESG was vague enough to allow firms to talk loudly about their sustainability agenda without having to back that up with action. More recently, second-wave ESG brings more structure and definition to the conversation and will require firms to internalise that thought process and make changes.
Zimmerhansl said 2021 should be viewed as a year for “debate, challenge and engagement” to drive progress on practical issues such as ESG collateral. He also doubled down on calls for the conversation to not be limited to association working groups to agree on an industry-wide consensus on sustainable principles within securities finance for the future.
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