Transparency of shadow Banking Activities

Shadow banking refers to the system of credit intermediation that comprises entities and activities carried out outside the regular banking system. At this point one needs to delve a bit more on the concept of shadow banking. These activities are usually carried out by institutions that fulfil traditional banking functions even though they are loosely linked to the traditional system of regulated depository institutions. In simpler words, shadow banking is said to be the provision of capital to companies through loans or investments by other companies that are not classified as banks.  Even though the shadow banking industry is quite vital when it comes to the economy of a country, its operation outside the traditional banking regulations used to raise concerns regarding the risks it posed to the financial system. The shadow banking sector required to be regulated because of its size, of its close links to the regulated financial sector and the risks it created. Hence the necessity of the European Regulation 2015/2365 on Transparency of Securities Financing Transactions and of Reuse (SFTR) which amends the EMIR Regulation 648/2012. According to Article 20A of the Malta Financial Services Authority Act, the Minister for Finance, Prof Edward Scicluna has conferred upon him the power to make regulations in order to transpose and give effect to the provisions and requirements found in any legislative measure of the European Union. In this particular case, the Minister has made a Regulation – Legal Notice 78 of 2017 – in order to transpose and implement the relevant provisions of the SFTR. In the scenario that the Legal Notice issued by the Minister is in contrast with the provisions of the SFTR, then the latter shall prevail.

Securities financing transactions (SFT’s) were identified by the Commission as requiring better monitoring when it comes to shadow banking. The SFTR shall require firms to report their SFT to an approved EU trade repository with details of SFT’s concluded by all market participants including both financial and non-financial counterparties. This is only one of the ways through which the Regulation aims to improve the transparency of the SFT’s. SFT’s are transactions where securities are used to borrow cash or vice-versa and these  are deemed to include a repurchase transaction comprising sell/buy-backs, securities or commodities lending and borrowing transactions and a margin lending transaction.  In this case, ownership of the securities would temporarily change in return for cash. However at the end of the SFT, ownership shall revert back which means that both the counterparties remain with what they originally owned.   It should be noted that the definition of securities financing transactions in the SFTR does not cover derivatives as defined in the EMIR Regulation. Nonetheless the SFTR covers liquidity and collateral swaps which then again, are not covered by the definition of derivatives in the EMIR. One should take note of another key difference between the SFTR and EMIR which regards the obligations imposed on counterparties. In the scenario that a financial counterparty enters into an SFT with a non-financial counterparty which does not exceed the limits of at least two of the three criteria found in Article 3(3)[1] of the EU Accounting Directive, the financial counterparty shall have the responsibility to report on behalf of both counterparties. Moreover, the counterparties need to keep records of any SFT for a minimum of five years following its termination.  Apart from the requirement to report SFT’s, the SFTR aims to increase transparency in two other ways; by demanding managers of UCITS[2] and alternative investment funds (AIF’S) to disclose information regarding  the use they make of the SFT’s and total return swaps to their investors, both in their periodical reports and through pre-contract disclosures and also by imposing conditions on the reuse of financial instruments which have been provided as collateral, so that clients and counterparties can have a better understanding of the risks involved in order to give their consent to the reuse.

The SFTR came into force on 12^th January of 2016 and only a limited number of obligations have applied from such date. Other obligations shall be implemented by time in the upcoming two years; by April 2018 the trade repository reporting requirements for investments firms and credit institutions shall start to apply and by January 2019 shall start the reporting requirement for non-financial counterparties. Member States do not need to adopt national rules to give effect to the SFTR but rather they need to adopt rules to ensure that national competent authorities can supervise the implementation of the said Regulation  and also to give their national authorities powers to impose sanctions and other measures in order to enforce the provisions of the SFTR.

Hence, the rules entrenched in the SFTR improve on the transparency, the reporting system and the disclosure conditions for the institutions that engage in SFT’s. This way it is easier to monitor and assess the risks involved in these transactions mainly because SFT’s are an essential funding tool in the European Union.