Friday, January 31, 2014

European Commission Release: Establishing a Central Database for Secured Financing Transactions

On January 29, 2014, the European Commission issued its long awaited proposal for the establishment of a central database for Secured Financing Transactions. This release is a part of a larger regulatory effort aimed at increasing the transparency of certain transactions in the shadow banking sector and to prevent regulatory arbitrage. The proposal aims to increase transparency in secured financing transactions, a term which is defined broadly to include repo, reverse repo, tri-party repo, securities lending transactions as well as total return swaps, collateral swaps and buy-sell transactions.

According to the release, the proposal aims to improve the transparency of securities financing transactions (SFTs) – mainly in the following three ways:

  1. First, the proposed regulation would require that all transactions are reported to a central database. This would allow supervisors to better identify the links between banks and shadow banking entities and would shed more light on some of their funding operations. As a consequence, supervisors would be able to monitor the exposures to and risks associated with SFTs and, if necessary, take better-targeted and timelier actions.

  2. Second, it would improve transparency towards investors on the practices of investment funds engaged in SFTs and other equivalent financing structures by requiring detailed reporting on these operations, both in the regular reports of funds and in pre-investment documents. This would lead to better-informed investment decisions by investors. 

  3. Finally, this proposal would improve the transparency of the rehypothecation (any pre- default use of collateral by the collateral taker for their own purposes) of financial instruments by setting minimum conditions to be met by the parties involved, including written agreement and prior consent. This would ensure that clients or counterparties have to give their consent before rehypothecation can take place and that they make that decision based on clear information on the risks that it might entail.

Interestingly, rather than proposing the creation of a central repository by government or central bank, the Commission advises that the creation of a central repository may be best carried out by institutions or service providers that are already in this space. Also, the Commission does not suggest the creation of a single securities repository, and actually enumerates what it would require of a financial institution wanting to set one up. Certainly, a multi-repository structure has implications for regulators, and while a multi repository structure may create competition it could create differences in how individual firm may choose to report its trades.

There is some question about how well grounded in reality the Commission's fears about regulatory arbitrage really are.  Also, the Commissions concerns about rehypothication may be misplaced as well. While it is indeed important to control excess leverage and pro-cyclicality of secured financing transactions, the rehypothication of securities that is part and parcel of the vast majority of such transactions is entirely necessary to make them useful.  Because the borrowing of specific securities is nearly always done to meet a requirement to deliver the security, on lending is by definition a requirement of the transaction.  This aspect of secured financing transactions is well understood, and efforts to curb on lending could effectively destroy the very transactions the proposed restrictions are trying to regulate.