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Emerging From the Gloom: Shadow Banking In Sharp Relief


“Shadow banking” refers to that part of the financial system which extends credit but is fully or partially outside the regular banking sector, i.e. non-bank credit intermediation.  Despite the real benefits associated with shadow banking, the financial crisis of 2007-2008 highlighted a number of risks, particularly a heavy reliance on short-term wholesale funding, lack of transparency that hid growing amounts of leverage and maturity mismatches, and growing interconnectedness with the rest of the financial sector.  Together with the Money Market Funds Regulation (which is currently being reviewed by the EU Parliament and should soon enter the trialogue process), the proposed SFT Regulation[1] (“SFTR”) was the EU Commission’s first attempt to address these risks.

What does the SFT Regulation say?

The SFTR lays down rules regarding transparency of SFTs and the reuse of financial instruments received as collateral.  Broadly, it requires:

  • SFT data to be reported to trade repositories;
  • Detailed disclosure on SFT usage by:
    • UCITS management and investment companies (UCITS); and
    • Alternative investment fund managers (AIFMs); and
  • Prior disclosure and written consent before counterparties are permitted to rehypothecate assets.


The general obligation to report

The reporting framework created under the SFTR is largely identical to that under EMIR.  “Counterparties” must report the details of each “SFT” concluded on or after the date on which the obligation to report becomes effective, a date which seems unlikely to occur before 2018 in the case of UCITS and AIFs (the “Effective Date”), as well as any modification or termination thereof, to a trade repository no later than the following working day.  Broadly, all SFTs which were concluded before the Effective Date and which remain outstanding on that date and:

  • have a remaining maturity in excess of 180 days; or
  • have an open maturity and remain outstanding for a further 180 days

(“Open Transactions”) must be reported within 190 days of the Effective Date.  Delegation of reporting is permissible.

In-scope entities

Reporting must be undertaken by “counterparties” to SFTs – a very wide definition which includes both “financial counterparties” and “non-financial counterparties”.  “Financial counterparty” encompasses:

  • Investment firms;
  • Credit institutions;
  • Insurance and reinsurance undertakings;
  • UCITS and their management companies;
  • AIFs;
  • Pension funds;
  • CCPs and Central Securities Depositories; and
  • Any third country entity which would require authorisation or registration as one of the above if it were established in the EU.

A “non-financial counterparty” is any undertaking established in the EU or a third country which is not a “Financial counterparty”.

In-scope transactions

An “SFT” means:

  • A repurchase transaction;
  • Securities or commodities lending and securities or commodities borrowing;
  • A buy-sell back transaction or sell-buy back transaction; or
  • A margin lending transaction.

“Derivative contracts” as defined in EMIR are not considered to be SFTs.  However, the definition does include transactions that are commonly referred to as liquidity swaps and collateral swaps, which do not fall under the definition of “derivative contracts” in EMIR.

Who reports (one-sided or two-sided)?

Like EMIR, reporting is two-sided.  However, where a financial counterparty concludes a SFT with a non-financial counterparty which is a “medium sized undertaking” for the purposes of the Accounting Directive[2], the financial counterparty is responsible for reporting on behalf of both counterparties.  A non-financial counterparty will qualify as a “medium sized undertaking” where it complies with at least two of the following criteria:

  • balance sheet does not exceed EUR 20 million;
  • net turnover does not exceed EUR 40 million; or
  • average number of employees during the financial year does not exceed 250.


Counterparties must keep a record of any SFT concluded, modified or terminated for at least five years following the termination of the transaction.


Transparency in periodical reports

UCITS[3] and AIFMs[4] must inform investors about the use they make of SFTs and total return swaps (“TRS”).  The information to be provided is very detailed, but broadly focuses on five key areas:

  • The amount of fund assets being employed in SFTs and TRS;
  • Concentration data;
  • Aggregate transaction data (currency, maturity, domicile of counterparty etc.);
  • Collateral arrangements; and
  • Returns and costs associated with SFT and total return swap activity.

Transparency in pre-contractual documents

Every prospectus of a UCITS and the disclosure AIFMs are required to make to investors under the AIFMD[5] must include detailed information regarding:

  • The general permitted use of SFTs and TRS (together with a “clear statement that these techniques are used”);
  • Parameters around the use of SFTs and TRS (such as types of assets that can be used and maximum allowable usage as a proportion of assets under management);
  • Criteria for selecting counterparties;
  • Acceptable collateral;
  • Collateral valuation practices;
  • Risks associated with SFTs and TRS;
  • Safe-keeping arrangements;
  • Restrictions on re-use of collateral; and
  • Revenue sharing arrangements.

Transparency of Reuse

Any right of counterparties to reuse financial instruments received as collateral are subject to at least all the following conditions:

  • The provider must have been “duly informed in writing” by the receiver of the risks and consequences that may:
    • be involved in granting consent to a right of use of collateral; or
    • be involved in concluding a title transfer collateral arrangement; and
    • arise in the event of the default of the receiver;
  • The provider must have:
    • granted its “prior express consent, as evidenced by its signature in writing or in a legally equivalent manner” to a security collateral arrangement; or
    • expressly agreed to provide collateral by way of a title transfer collateral arrangement.

In addition, the reuse of collateral must be in accordance with the terms of the relevant collateral arrangement and involve the transfer of the financial instruments received under the relevant collateral arrangement from the account of the provider (unless the provider is established in a third country and its account is maintained in and subject to the law of a third country whereby the reuse can also be evidenced “by other appropriate means”).


As an EU regulation, the SFTR will be directly enforceable in all Member States.  Sanctions exist for breach of the obligation to report or provide transparency in relation to reuse of collateral.  However, any failure to report will not affect the validity or enforceability of an SFT or give rise to any claim of compensation from a party to a SFT.  Sanctions range from ‘cease and desist’ orders to censure to fines of up to 10% of turnover and extend to the members of the management body of a legal person.  Firms must have in place appropriate internal procedures for their employees to report any breaches.

Current Status

The European Parliament’s Committee on Economic and Monetary Affairs (ECON) issued a press release on 17 June 2015 announcing that an “informal deal” had been reached with the EU Council on the proposed SFTR.  The EU Council subsequently approved the final compromise text of the SFTR and the EU Parliament is scheduled to consider the matter further at its plenary session on 28 October 2015.  If it is passed at first reading, the text will then be passed to the EU Council for adoption.  The SFTR enters into force on the 20th day following its publication in the Official Journal of the EU (“OJ”).  It seems likely that this will occur in Q4 2015/Q1 2016.  Once enacted, the SFTR requires the EU Commission and ESMA to produce a number of technical standards and guidelines, including those regarding:

  • The information to be reported for different types of SFTs as well as the format and frequency of reports;
  • The types of transactions that have an equivalent economic effect and pose similar risk to SFTs;
  • The data to be published by trade repositories; and
  • The procedures to verify the details of SFTs reported to trade repositories.

In most cases, these are to be submitted by ESMA to the EU Commission within 12 months of the entry into force of the SFTR.  The implementation of reporting and transparency obligations are phased over the 21 months following publication in the OJ, meaning that we are unlikely to see meaningful implementation commence until late in 2017 at the earliest.

Final Thoughts

Unfortunately, the EU has not embraced the practical benefits of one-sided reporting.  As such, if EMIR is anything to go by, transaction data of sufficiently high quality to assist in the monitoring of systemic risk is likely to remain a distant prospect which imposes huge burdens on in-scope firms.

In terms of transparency, the SFTR represents a challenge in managing and monitoring the interaction between structured and unstructured data.  Fortunately, parallels exist with previous initiatives, such as collateral optimisation.  In effect, pre-contractual disclosure will commit UCITS and AIFMs to a definite path with respect to their usage of SFTs and TRs.  They will then be expected to deploy the tools necessary to monitor and report back on subsequent compliance with these commitments as part of their periodic disclosures.  This fact will require a number of firms to generate and analyse wholly new views of their data, views which extend beyond pure transactional information to include permitted counterparties, eligible collateral, concentration and overall usage limits, collateral re-use and custodial arrangements.

There are five basic data inputs which need to be effectively analysed if compliance is to be achieved – documentation, assets, collateral, investment guidelines and regulations.  An analysis of legal agreements is a logical starting point.  Once granular and validated legal data is obtained, it can be mapped to asset/collateral inventories.  In turn this data must be tracked against investment guidelines.  The circle is closed by amending legal agreements, where necessary, to ensure that they reflect investment guidelines and other pre-contractual disclosures as well as ongoing disclosure and consent requirements.

Given that each of the basic inputs can (and probably will) change, the circle then needs to be monitored.  This necessitates the creation of a flexible data architecture capable of manipulating, relating and visualising data with a view to anticipating, and not just reacting to, breaches of the SFTR.  Robust internal process will also be required in order to remedy breaches.

The lesson is to start early and have a clear plan.  All of the technology and processes necessary to achieve compliance already exist.  The SFTR is large and casts a long shadow, but it’s not one that you need fear.

[1] EU Regulation on “reporting and transparency of securities financing transactions

[2] Directive 2013/34/EU, Article 3(3)

[3] UCITS must include this information as part of the half-yearly and annual reports they are obliged to make under the UCITS IV Directive (Directive 2009/65/EC, Article 68)

[4] AIFMs must include this information in the annual report they are required to make under the AIFMD (Directive 2011/61/EU, Article 22)

[5] Directive 2011/61/EU, Article 23(1) and 23(3)

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