Navigating collateral reporting under SFTR
03 July 2020
In this article, Jonathan Lee and Tony Weedon of Kaizen Reporting provide their recommendations for addressing the challenges of collateral reporting
Image: alphaspirit/Shutterstock.com
Macro and micro regulation wrapped up in a single reporting regime
The 麻豆传媒 Financing Transactions Regulation (SFTR) challenge is made more complicated by the dual purpose of the regulation. The European 麻豆传媒 and Markets Authority (ESMA) states that the regulation is intended to 鈥渁ssess the risks related to the integrity of price formation and the orderly functioning of the SFT markets鈥� and 鈥渁 trade state report will also allow the authorities to access the most granular trade-level data, i.e. the latest state on all the outstanding trades that are required for financial stability, market monitoring and surveillance of bank-like risks and level of interconnectedness of the financial system.鈥�
This desire to capture both macro systemic and micro trade level risks in the SFT markets presents a significant and challenging compromise in the nature of reporting. Indeed, the periodic, settled position level reporting required by other jurisdictions is far less complex to provide and far more straightforward to interpret from a regional and global macro-prudential perspective. From a collateral reporting perspective, this added desire to perform trade level surveillance and market monitoring underlines the importance of maintaining the direct link between loans and collateral. If it weren鈥檛 for the micro surveillance requirements, it would make far more sense to report all collateral on a net exposure basis. However, this added complexity should provide clarity around collateral scarcity, tight collateral conditions, the dynamics of collateral reuse, and the loan rates.
There is a conflict in these dual purposes. Trade level reporting is inherently messy. Timely trade level timely data is subject to nuances in the settlement cycle and a lack of stored reference data to classify it. Trade data in itself with every lifecycle event doesn鈥檛 lend itself to accurate position level data. This is because you do not have a base starting position (exacerbated by the lack of a backloading requirement). So it will take longer to establish positions as historic trades work their way out of the system.
Also, by insisting on such a large number of matchable and reconcilable fields from both parties, you risk never (or only very latterly) achieving a clean dataset of consistent values because many transactions are left in an unreconciled state with fundamental differences indefinitely.
To illustrate this, if a larger dealer is executing 10,000 new trades every day across several hundred counterparties, in its current state, it seems unrealistic to ever expect all of these transactions to match in their entirety. Either regulators will need to come to terms with only partially matched data (in which neither party is necessarily correct) or simply take the approach of using single-sided reports in order to complete their analysis of regional market activity. Clearly this pessimistic view is in direct conflict with the intention of the regulators.
Difficulty resolving the data set
Firms鈥� relationship with collateral is often fleeting. It is a means to obtain lower cost financing, manage dealer inventory and maintain capital adequacy requirements and liquidity buffers. On many transactions, collateral is only disclosed on settlement date and, given its varied and often illiquid nature, it is unlikely to pre-exist in every case in a firm鈥檚 books and records. Therefore, the regulators鈥� insistence on passing all of the classification requirements onto counterparties rather than using golden sourced reference data, presents a unique and unprecedented challenge.
While MiFID II transaction reporting only requires the ISIN and CFI codes, SFTR requires everything including the kitchen sink! For loaned securities and collateral, firms are required to populate the ISIN code, issuer LEI, credit quality, CFI code, maturity date, jurisdiction of the issuer, collateral type (an FSB bespoke field) or a series of commodity details if the collateral is a commodity. In effect, regulators are testing the firm鈥檚 reference data abilities just as much as they are testing their ability to provide timely economic transaction reports. As far as regulators are concerned, their ability to dish out fines does not involve a ranking of the importance of fields. Getting the classification of a piece of collateral right is often said to be just as important as getting the price or the quantity right. Regulators deem that if they can鈥檛 trust one value, they cannot trust any aspect of the report. This whole task needs to be taken very seriously.
Full disclosure is required
Don鈥檛 try to be too clever. There are no fields that are intended by regulators to be entirely optional: they simply couldn鈥檛 write enough validation rules to make every field conditional.
Don鈥檛 try second-guessing what is or isn鈥檛 acceptable. Be as open and transparent as possible. If you are fully aware of details of the collateral at the point of execution (irrespective of whether the collateral is allocated on a later date), then you must disclose all of the known details in the new transaction report (NEWT), within the confines of the validation rules. Ensure that your collateral reporting (along with the loan and other aspects of the transaction) is as complete and accurate as possible. Reference data and market data sourcing should be kept under constant review, keeping your vendors on their toes and ensuring that every data item has an owner - a data guardian. As soon as you are aware of any changes in collateral, its pricing or classification, this should be reported by close of business the following business day.
Settled vs contractual? The moment an SFT deal is struck, it becomes reportable
As soon as an SFT transaction is agreed, it becomes reportable on the next business day. Regardless of whether the 鈥榦n鈥� leg of the transaction settles and is followed through or not, it is a reportable event. If the on leg doesn鈥檛 settle and both parties agree to cancel the transaction then from a reporting perspective this should be reported as a termination (ETRM) because it existed as a legal contract, even if only temporarily. If alternatively, both parties agreed to move the value date (start date) forward then this should be reported the following business day as a modification (MODI). If bilaterally agreed, it is a modification and not a correction (CORR). We appreciate that this exacting interpretation of the regulation is somewhat in conflict with normal securities lending practice of only recognising transactions subject to settlement finality.
In our view this latter approach is not in keeping with the spirit of the regulation as a whole.
Closing transactions 鈥� where settlement finality matters
When it comes to correctly reporting the 鈥榦ff鈥� leg of a transaction, again it is important to keep regulators on top of developments in the contract. If you have agreed to close a contract on a future date (the anticipated settlement date), then this should be reported as a closing leg with a maturity date (end date) added to the transaction using a modification (MODI).
Alternatively, if the intended closure is the same day, then this can be reported using a termination (ETRM). Having reported this, if the return doesn鈥檛 take place, then the maturity date (end date) and other economic details should be modified (MODI) on the next business day. If a termination (ETRM) was booked, then this report should be suppressed if it doesn鈥檛 take place. Again, the alternative approach suggested by elements of the securities lending community is to wait for settlement finality before reporting the intention to close a transaction. We do not believe to be consistent with the regulatory intent.
Unfortunately, regulators take a dim view of system limitations in providing this reporting. Links between risk management, booking systems and back-office systems may well need upgrading but this is not a concern of regulators. Regulators also believe that by implicitly requiring firms to upgrade their systems, they are playing a valuable part in reducing systemic risk across the industry.
Settlement status 鈥� how SFTR differs
Other regulatory reporting regimes, such as for MiFID II, transaction reporting are satisfied by assuming perfect settlement. Given that this regulation is placing a part of the very fabric of the capital market under scrutiny and provides a picture of leverage, collateral and liquidity risk, there is a need to understand outstanding risks rather than just contractual risks. This is why settlement status becomes key. This requirement differs from other transaction reporting regimes that focus on traded market risk rather than exposure risk and will allow you to assume perfect settlement.
Why collateral reporting is so fundamental to understanding the functioning of the repo market?
Trade level collateral reporting gives a clear view of the relative pricing of the market, the market鈥檚 view on particular credit and demand for individual securities, asset classes, credit quality etc. It provided perspective on shorts in the market and where particular pieces of collateral (seen through the pricing of loans) become very expensive because they are behind other investment strategies. Collateral reporting provides a gauge of liquidity and credit conditions and a barometer of the health of the outright cash securities markets.
Repo bilateral margin collateral reporting
One of the greatest collateral reporting challenges under SFTR has been how to report bilateral margins for repo transactions (discretely) from their trade level collateral in accordance with the Global Master Repurchase Agreement (GMRA). Even to this day, the ESMA guidelines have still not presented any clear examples that enable firms to report in line with the contract.
The European Repo & Collateral Council (ERCC) division of the International Capital Market Association (ICMA) has worked closely with the industry and trade repositories (TRs) to provide a model for reporting repo collateral that is consistent with the transactions, the GMRA and the TR validation rules.
The approach proposed is to maintain distinct trade level collateral and bilateral margin collateral. This involves reporting new bilateral repo transactions on trade date +1 with their trade level collateral details, unique transaction identifiers (UTIs) and the collateralisation of the net exposure field when it鈥檚 marked true. On settlement date +1, the current state of the bilateral margins should be reported with a collateral update using the other counterparty LEI and Master agreement details but no UTIs.
The value of each piece of open trade level collateral should also be updated using collateral updates including the UTIs. On this basis, the collateral can be aggregated and trade level collateral updates will not interfere with bilateral margin collateral updates.
[See diagram: Repo Bilateral Margin Reporting Process]
Kaizen鈥檚 Recommendations:
鈥� Install data guardians. Ensure every data item is appropriately sourced and has an accountable owner.
鈥� Devote significant effort to sourcing SFTR data internally or around installing effective governance around externally sourced vendor data. Make your vendors earn their keep!
鈥� Prioritise data sources i.e. ESMA demand official sources for data points such as CFI codes, so use official sources such as the numbering agencies and FIRDS rather than data vendors wherever possible.
鈥� Be upfront, transparent and timely in all of your SFTR reporting including the collateral. Do not withhold know transaction details and ensure daily collateral updates of changes and pricing. Ensure executions are always reported on a trade date +1 basis.
鈥� If the pricing of collateral or the quantity of collateral has changed in relation to open and outstanding term transactions then provide settlement date +1 collateral updates accordingly.
鈥� Stay honest to the transactions: if the master agreement indicates that the transaction is collateralised at the trade level, then report accordingly. Do not allow net collateralisation reporting to absorb what should be trade level collateral reporting if this is not consistent with the contract.
鈥� Follow ICMA ERCC best practice on bilateral margin reporting for repo until such time that ESMA have provided a Q&A or clear guidelines regarding any alternative approach. This process will involve maintaining two distinct sets of collateral and collateral updates (trade level and portfolio level) in relation to the repo book.
The 麻豆传媒 Financing Transactions Regulation (SFTR) challenge is made more complicated by the dual purpose of the regulation. The European 麻豆传媒 and Markets Authority (ESMA) states that the regulation is intended to 鈥渁ssess the risks related to the integrity of price formation and the orderly functioning of the SFT markets鈥� and 鈥渁 trade state report will also allow the authorities to access the most granular trade-level data, i.e. the latest state on all the outstanding trades that are required for financial stability, market monitoring and surveillance of bank-like risks and level of interconnectedness of the financial system.鈥�
This desire to capture both macro systemic and micro trade level risks in the SFT markets presents a significant and challenging compromise in the nature of reporting. Indeed, the periodic, settled position level reporting required by other jurisdictions is far less complex to provide and far more straightforward to interpret from a regional and global macro-prudential perspective. From a collateral reporting perspective, this added desire to perform trade level surveillance and market monitoring underlines the importance of maintaining the direct link between loans and collateral. If it weren鈥檛 for the micro surveillance requirements, it would make far more sense to report all collateral on a net exposure basis. However, this added complexity should provide clarity around collateral scarcity, tight collateral conditions, the dynamics of collateral reuse, and the loan rates.
There is a conflict in these dual purposes. Trade level reporting is inherently messy. Timely trade level timely data is subject to nuances in the settlement cycle and a lack of stored reference data to classify it. Trade data in itself with every lifecycle event doesn鈥檛 lend itself to accurate position level data. This is because you do not have a base starting position (exacerbated by the lack of a backloading requirement). So it will take longer to establish positions as historic trades work their way out of the system.
Also, by insisting on such a large number of matchable and reconcilable fields from both parties, you risk never (or only very latterly) achieving a clean dataset of consistent values because many transactions are left in an unreconciled state with fundamental differences indefinitely.
To illustrate this, if a larger dealer is executing 10,000 new trades every day across several hundred counterparties, in its current state, it seems unrealistic to ever expect all of these transactions to match in their entirety. Either regulators will need to come to terms with only partially matched data (in which neither party is necessarily correct) or simply take the approach of using single-sided reports in order to complete their analysis of regional market activity. Clearly this pessimistic view is in direct conflict with the intention of the regulators.
Difficulty resolving the data set
Firms鈥� relationship with collateral is often fleeting. It is a means to obtain lower cost financing, manage dealer inventory and maintain capital adequacy requirements and liquidity buffers. On many transactions, collateral is only disclosed on settlement date and, given its varied and often illiquid nature, it is unlikely to pre-exist in every case in a firm鈥檚 books and records. Therefore, the regulators鈥� insistence on passing all of the classification requirements onto counterparties rather than using golden sourced reference data, presents a unique and unprecedented challenge.
While MiFID II transaction reporting only requires the ISIN and CFI codes, SFTR requires everything including the kitchen sink! For loaned securities and collateral, firms are required to populate the ISIN code, issuer LEI, credit quality, CFI code, maturity date, jurisdiction of the issuer, collateral type (an FSB bespoke field) or a series of commodity details if the collateral is a commodity. In effect, regulators are testing the firm鈥檚 reference data abilities just as much as they are testing their ability to provide timely economic transaction reports. As far as regulators are concerned, their ability to dish out fines does not involve a ranking of the importance of fields. Getting the classification of a piece of collateral right is often said to be just as important as getting the price or the quantity right. Regulators deem that if they can鈥檛 trust one value, they cannot trust any aspect of the report. This whole task needs to be taken very seriously.
Full disclosure is required
Don鈥檛 try to be too clever. There are no fields that are intended by regulators to be entirely optional: they simply couldn鈥檛 write enough validation rules to make every field conditional.
Don鈥檛 try second-guessing what is or isn鈥檛 acceptable. Be as open and transparent as possible. If you are fully aware of details of the collateral at the point of execution (irrespective of whether the collateral is allocated on a later date), then you must disclose all of the known details in the new transaction report (NEWT), within the confines of the validation rules. Ensure that your collateral reporting (along with the loan and other aspects of the transaction) is as complete and accurate as possible. Reference data and market data sourcing should be kept under constant review, keeping your vendors on their toes and ensuring that every data item has an owner - a data guardian. As soon as you are aware of any changes in collateral, its pricing or classification, this should be reported by close of business the following business day.
Settled vs contractual? The moment an SFT deal is struck, it becomes reportable
As soon as an SFT transaction is agreed, it becomes reportable on the next business day. Regardless of whether the 鈥榦n鈥� leg of the transaction settles and is followed through or not, it is a reportable event. If the on leg doesn鈥檛 settle and both parties agree to cancel the transaction then from a reporting perspective this should be reported as a termination (ETRM) because it existed as a legal contract, even if only temporarily. If alternatively, both parties agreed to move the value date (start date) forward then this should be reported the following business day as a modification (MODI). If bilaterally agreed, it is a modification and not a correction (CORR). We appreciate that this exacting interpretation of the regulation is somewhat in conflict with normal securities lending practice of only recognising transactions subject to settlement finality.
In our view this latter approach is not in keeping with the spirit of the regulation as a whole.
Closing transactions 鈥� where settlement finality matters
When it comes to correctly reporting the 鈥榦ff鈥� leg of a transaction, again it is important to keep regulators on top of developments in the contract. If you have agreed to close a contract on a future date (the anticipated settlement date), then this should be reported as a closing leg with a maturity date (end date) added to the transaction using a modification (MODI).
Alternatively, if the intended closure is the same day, then this can be reported using a termination (ETRM). Having reported this, if the return doesn鈥檛 take place, then the maturity date (end date) and other economic details should be modified (MODI) on the next business day. If a termination (ETRM) was booked, then this report should be suppressed if it doesn鈥檛 take place. Again, the alternative approach suggested by elements of the securities lending community is to wait for settlement finality before reporting the intention to close a transaction. We do not believe to be consistent with the regulatory intent.
Unfortunately, regulators take a dim view of system limitations in providing this reporting. Links between risk management, booking systems and back-office systems may well need upgrading but this is not a concern of regulators. Regulators also believe that by implicitly requiring firms to upgrade their systems, they are playing a valuable part in reducing systemic risk across the industry.
Settlement status 鈥� how SFTR differs
Other regulatory reporting regimes, such as for MiFID II, transaction reporting are satisfied by assuming perfect settlement. Given that this regulation is placing a part of the very fabric of the capital market under scrutiny and provides a picture of leverage, collateral and liquidity risk, there is a need to understand outstanding risks rather than just contractual risks. This is why settlement status becomes key. This requirement differs from other transaction reporting regimes that focus on traded market risk rather than exposure risk and will allow you to assume perfect settlement.
Why collateral reporting is so fundamental to understanding the functioning of the repo market?
Trade level collateral reporting gives a clear view of the relative pricing of the market, the market鈥檚 view on particular credit and demand for individual securities, asset classes, credit quality etc. It provided perspective on shorts in the market and where particular pieces of collateral (seen through the pricing of loans) become very expensive because they are behind other investment strategies. Collateral reporting provides a gauge of liquidity and credit conditions and a barometer of the health of the outright cash securities markets.
Repo bilateral margin collateral reporting
One of the greatest collateral reporting challenges under SFTR has been how to report bilateral margins for repo transactions (discretely) from their trade level collateral in accordance with the Global Master Repurchase Agreement (GMRA). Even to this day, the ESMA guidelines have still not presented any clear examples that enable firms to report in line with the contract.
The European Repo & Collateral Council (ERCC) division of the International Capital Market Association (ICMA) has worked closely with the industry and trade repositories (TRs) to provide a model for reporting repo collateral that is consistent with the transactions, the GMRA and the TR validation rules.
The approach proposed is to maintain distinct trade level collateral and bilateral margin collateral. This involves reporting new bilateral repo transactions on trade date +1 with their trade level collateral details, unique transaction identifiers (UTIs) and the collateralisation of the net exposure field when it鈥檚 marked true. On settlement date +1, the current state of the bilateral margins should be reported with a collateral update using the other counterparty LEI and Master agreement details but no UTIs.
The value of each piece of open trade level collateral should also be updated using collateral updates including the UTIs. On this basis, the collateral can be aggregated and trade level collateral updates will not interfere with bilateral margin collateral updates.
[See diagram: Repo Bilateral Margin Reporting Process]
Kaizen鈥檚 Recommendations:
鈥� Install data guardians. Ensure every data item is appropriately sourced and has an accountable owner.
鈥� Devote significant effort to sourcing SFTR data internally or around installing effective governance around externally sourced vendor data. Make your vendors earn their keep!
鈥� Prioritise data sources i.e. ESMA demand official sources for data points such as CFI codes, so use official sources such as the numbering agencies and FIRDS rather than data vendors wherever possible.
鈥� Be upfront, transparent and timely in all of your SFTR reporting including the collateral. Do not withhold know transaction details and ensure daily collateral updates of changes and pricing. Ensure executions are always reported on a trade date +1 basis.
鈥� If the pricing of collateral or the quantity of collateral has changed in relation to open and outstanding term transactions then provide settlement date +1 collateral updates accordingly.
鈥� Stay honest to the transactions: if the master agreement indicates that the transaction is collateralised at the trade level, then report accordingly. Do not allow net collateralisation reporting to absorb what should be trade level collateral reporting if this is not consistent with the contract.
鈥� Follow ICMA ERCC best practice on bilateral margin reporting for repo until such time that ESMA have provided a Q&A or clear guidelines regarding any alternative approach. This process will involve maintaining two distinct sets of collateral and collateral updates (trade level and portfolio level) in relation to the repo book.
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