Esma proposal may limit short-selling

Reporting requirement would bar securities without LEIs from being used in financing transactions

A proposal from the European Securities and Markets Authority (Esma) could limit the range of collateral that banks and investment firms can use in securities financing transactions (SFTs).  

From April 11, 2020, firms subject to European Union law will have to begin reporting the details of their financing trades under the Securities Financing Transactions Regulation (SFTR).

Implementing and technical standards set out the details that need to be mandatorily reported, which includes the legal entity identifier (LEI) for issuers of securities borrowed in securities lending trades, as well as for securities used as collateral for all types of SFTs. If a report does not contain the issuer LEI, then it must be rejected by the trade repository.

The draft text does not spell out the consequences of a report being rejected, but sources fear Esma will take the extreme approach of barring firms from using securities without LEIs.

“[A hardline approach] could seriously impact liquidity in certain securities as it would affect the ability of banks to finance or cover short positions in these securities, and therefore manage their funding and risk, and thus their ability to offer financial services to many customers,” says Alexander Westphal, a director at fixed-income advocacy group the International Capital Markets Association (Icma).

Many non-EU issuers still do not have LEIs. According to a study referenced in the International Securities Lending Association’s response to Esma’s consultation, a large number of securities that are actively used as collateral in SFTs were missing LEIs (see figure 1).

For securities actively used in SFTs, the study found that only 45% of issuers in the US and 34% in Japan currently have LEIs. The numbers are even lower for some Asian countries, such as South Korea and Taiwan.

“The problem that might arise with this ‘no LEI, no trade’ requirement is that we run the risk of narrowing the available collateral that can be used, which could then artificially affect the value of securities that do have LEIs versus those that don’t,” says Dan Chambers, the SFTR implementation lead at Nomura.

…we run the risk of narrowing the available collateral that can be used, which could artificially affect the value of securities that do have LEIs versus those that don’t

Dan Chambers, Nomura

Two sources, including a participant present at the hearing, say representatives of Esma voiced support for a hardline stance at an open hearing held in Paris on July 15.

A third source at a medium-sized European bank says they have also heard of Esma talking up a harsh “no trade” stance in conversations with other market participants.

A fourth and fifth source argue the very fact that including issuer LEIs in reports is mandatory in the implementing and technical standards implies firms cannot use securities without them, as SFT reports must be sent to repositories before the end of the next working day after the trade. If firms cannot report trades before then, it puts them in breach of Article 4 of SFTR, under which local regulators can impose sanctions on firms for infringing the rules.

“It isn’t explicitly stated in the draft guidelines, but the LEI being mandatory means that your report will not be accepted and therefore implies you have to have it,” says one consultant.

In response to a consultation on draft guidelines for reporting under SFTR, which concluded on July 29, industry associations put forward a variety of alternative approaches for Esma to take, including making the field optional or allowing the use of a dummy code until the issuer has been granted an LEI.

It isn’t explicitly stated in the draft guidelines, but the LEI being mandatory means that your report will not be accepted and therefore implies you have to have it

A consultant

Icma’s Westphal says one option is for firms to not include details of the security if it does not have an LEI. This would mean regulators receive reports, but not information on the particular security.

This interpretation is in doubt, however, as the LEI field for the issuer is conditionally mandatory on the collateral or instrument borrowed being a security and not a commodity transaction.

“One alternative to the extreme approach would be to take out any line of collateral that doesn’t have an LEI to make sure the report doesn’t get rejected at the trade repository, but this would obviously not be ideal either as it would result in incomplete reporting,” says Westphal.

Esma declined to comment on whether firms would be unable to use securities that do not have issuer LEIs within SFTs. In its response to Risk.net, the watchdog says it is committed to the adoption of LEIs, and that at the public hearing it held on July 15, it followed the agreed line in its consultation paper.

However, the consultation paper merely states the LEI is conditionally mandatory and does not specify whether the requirement means firms cannot use securities that don’t have them. 

LEI shortfall

Companies can obtain LEIs by applying to local operating units (LOUs). The costs range from $60 to more than $200. The London Stock Exchange Group is an assigned LOU, and charges £115 ($140) for an LEI, plus VAT; Bloomberg charges $65 for a single LEI, or $60 each if an entity buys ten.

LEIs make it easier for regulators to monitor the build-up of an individual firm’s exposures to other counterparties. Inclusion of issuer LEIs within SFT reports would mean regulators can quickly identify the build-up of exposure one firm runs to an individual issuer’s debt.

“Identification of the issuer is essential for the correct monitoring of financial stability, leverage and risks in the financial system,” states Esma within its draft guidelines. “As many issuers outside of the European Union still don’t have LEIs, the hardline interpretation will mean many of those non-EU securities cannot be used in SFTs transacted in Europe.”

Esma is now working on the final text of the rulemaking, which it says will be published in the fourth quarter of this year.

Correction, August 20: This article previously stated Esma’s forthcoming SFTR reporting guidelines require approval from EU legislators to become effective. In fact, Esma is implementing the guidelines as a tool for supervisory convergence among national regulators, and confirms it does not require legislative approval to do so. Figures demonstrating the cost of buying an LEI have also been updated.

Correction, August 22: This article has been further updated to correct the suggestion that Esma’s draft SFTR guidelines mandated inclusion of issuer LEIs during reporting. In fact, level two European legislation – in the form of implementing and technical standards – are the legal mechanism that mandates this. Risk.net will publish an in-depth feature article next week detailing how these mechanisms work in practice.