The UK’s Brexit transition period ended on 1 January. What has this final cut-off been like from a financial regulatory compliance perspective?
The pandemic was sufficiently distracting for people to not be focused on the end of the transition period. But, it’s also fair to say that the regulators didn’t provide a great deal of comments or detail around the expectations until quite late in the day.
For securities financing participants specifically, the main change came after the December deadline, on 11 January, when the EU enacted phase four of the Íø±¬³Ô¹Ï Financing Transactions Regulation (SFTR), for non-financial counterparties (NFCs), which the UK version did not onshore. This divergence was telegraphed much earlier in 2020 by the UK’s Chancellor of the Exchequer and so was a smooth process.
The other more nuanced difference is that while the regulation was written into UK law, the Q&As, guidelines and other ancillary documents produced by the European Íø±¬³Ô¹Ï and Markets Authority were not. But, most parties that are following UK SFTR are still adhering to these guidelines, even though they have no legal standing in the UK. This will become a more important topic once the UK regulator begins to publish its own Q&As that may diverge from guidance under EU SFTR. The Financial Conduct Authority (FCA) has already issued guidance on one area of SFTR that ESMA is yet to address and these instances will add up over time and create two distinct reporting regimes.
Looking ahead, the main question is if the UK will be offered an equivalency deal for financial services, along with passporting rights into the single market. SFTR is a hugely detailed and comparatively complex regulatory regime and if the UK doesn’t get what it wants then the FCA may be tempted to look at it and say it far exceeds the global requirements and standards as set out by the Financial Stability Board in 2015 and start stripping away some of the fields. The FCA may argue that a model looking at transactions on a settled position level and with less frequent reporting, more akin to the Japanese model, would still meet the international remit and allow the UK to monitor for any systemic risk, while also being a lot less onerous for firms to implement and operate.
If negotiations on passporting into the single market do fail, how likely is it that would result in a review of UK SFTR?
I think there’s a high probability that they go for some level of regulatory arbitrage. Yes there is the issue of sunk costs and any divergence means new builds and it means new controls, but much of the pain around SFTR comes post trade, post report and in operations. The volume of transactions that must be reported in a dual reporting model means that a significant number may not pair, and even if they do the chances of them matching across this colossal swathe of fields is still almost zero. This issue is partially mitigated through delegated reporting but that undermines the whole exercise of a double-reporting regime. I imagine operations teams are currently deploying huge amounts of resources just to support this flow and the largest UK players will be very keen to encourage a review of the rules, in particular, the scope and level of detail required for reporting loan and collateral security reference data.
At inception, SFTR was meant to be a macro market overview and yet the EU’s take on this idea was to make it micro-surveillance, anti-market manipulation regulation. If you ask for too much you get relatively low-quality data that doesn’t pair or match, and therefore cannot be reconciled. Right now the regulator is probably struggling to see the wood from the trees with the data it has. If SFTR was streamlined and focused on settled positions it would be much more straightforward to identify where exactly the concentration risks are, which firms are overly using leverage, which firms may be under collateralised, and which pieces of collateral are potentially being overused.
Looking at the work Kaizen has done to help clients with each phase of SFTR’s go-live, what has your experience been and what issues have you encountered?
As we approached the third and fourth phases of SFTR the entities in question became increasingly less inclined to report themselves. Not all, but most, buy-side firms and NFCs chose to delegate reporting to their broker-dealers as they are allowed to, but this negates any value to be had from double-sided reporting. Each buy-side firm may have up to 10 broker-dealers, each of whom are reporting their portion of the buy-side firm’s trades, potentially to a different trade repository (TR). Remember, however, that although these entities can delegate their reporting obligations, under SFTR they retain the responsibility for the completeness, accuracy and timeliness of those reports. This can still be incredibly burdensome given the fragmented picture I laid out above.
Where you have the same security being used as collateral for loaned security with two or more of your counterparties, are they reporting the same classification data for that security? Are they reporting to the same TR? To put a controls layer in to oversee all your broker-dealers becomes more and more difficult. These are just a few of many examples of issues with providing accurate data. The complexity here creates a situation where many firms that are particularly worried about complying with the rules in the strictest sense will either need to take on the reporting themselves or divert all their trade reporting data via another vendor that can coordinate everything.
For Kaizen Reporting specifically, what’s in your development pipeline and what are your key growth criteria for 2021 and beyond?
Our initial focus has been on our Accuracy Testing assurance product which is fast evolving. This isn’t sample-based testing, we test the entire reporting universe for the reporting period, so every single activity that gets reported goes through our testing process, giving a full picture of the quality of reported data. We also deploy hundreds of validation rules because we want to be rigorous in ensuring the TRs are applying all of the validation rules themselves. We’ve seen transactions that we do not believe should have passed validation and yet they’ve been accepted by the TR.
More recently, we are looking at the reports more holistically, so beyond just reviewing the individual fields and how they fit together, we are modelling the loan and collateral equilibrium throughout the life of the trades and the reporting period.
In addition, we are having a big push to build out our Advanced Reconciliations service for SFTR. Kaizen’s approach to reconciliation is a little bit different to some others in that we extract data from all of the respective golden sources as well as the firm’s books and records. We then create their SFTR reports with our interpretation of the regulation and reconcile those reports against the ones submitted to the TR. In addition to all of the accuracy elements that would be further enhanced through this process, we’re also looking for completeness, meaning any areas of under-reporting or over-reporting. In particular, in the collateral space, we have quite a strong inkling that the significant under-reporting of collateral occurs.
Thirdly, with the end of the Brexit transition period, there are a growing number of firms that are facing EU reporting obligations for the first time, particularly if they’re operating in the Euro money markets by offering secured or unsecured lending in euros. In such cases, those firms will have obligations under the money market statistical reporting for the European Central Bank and the European system of central banks. Also, a lot of EU firms have been establishing entities in the UK and some of those are coming under the sterling money market data collection reporting rules that the Bank of England requires. As such, we are in the process of building out Accuracy Testing for reports under both those regimes.
A final thing to mention are our core training courses for compliance and operations staff on the fundamentals of SFTR reporting. The key to accurate reporting is a strong understanding of the obligations. We also provide courses for the European Market Infrastructure Regulation and the Markets in Financial Instruments Regulation transaction and post-trade reporting.
When SFTR finally came fully into effect many operations teams stood down, but for Kaizen it really was just the beginning. As concerns grow around regulatory compliance, coupled with the prospect of being publicly known as lacking a robust regulatory controls environment and not protecting the interest of your clients and investors, there are many entities out there that need our services.
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