Towards Greater Transparency in Securities Lending - Colm Kincaid, Director of Securities and Markets Supervision

Opening Remarks to the International Securities Lending Association (ISLA) Morning Briefing

Good morning, it is a great pleasure to join you at this event and I would like to thank the International Securities Lending Association (ISLA) for the opportunity to speak to you this morning. ISLA’s continued engagement with the Central Bank of Ireland over the past number of years has served us well in the development of policy for the area of securities lending and we look forward to continuing this relationship.

Importance of securities lending

Securities lending is a global market that is experiencing a surge as investors try to maximise returns, last year covering $2.3 trillion assets and producing $9.2 billion revenue. As such, securities lending markets are an increasingly vital component of domestic and international financial markets, providing liquidity and greater flexibility to securities, derivatives and financing markets. Done properly, this also contributes to more efficient and less risky securities settlement arrangements. It facilitates investment strategies, enhances returns to otherwise dormant securities which may then be used to offset management and custody fees. Securities lending therefore forms part of the fabric of capital markets that complements lending by banks and helps allocate financial resources to where they can be most efficiently deployed.

To achieve these objectives, it is of course essential that any use, or re-use of securities assets, is conducted in a transparent manner and within a robust governance framework which operates to the benefit of investors and the integrity of the market as a whole.

Our 5 Principles for a Properly and Effectively Supervised Securities Market

To take this point a little further, when we look at supervising conduct on securities markets, we consider what we see through the lens of our five principles for a properly and effectively supervised securities market. Under these principles, we see a properly and effectively supervised securities market as one that:

1. Provides a high level of protection for investors and market participants
2. Is transparent as to the features of products and their market price.
3. Is well governed (and comprises firms that are well governed).
4. Is trusted, by both those using the market to raise funds and those seeking to invest.
5. I resilient enough to continue to operate its core functions in stressed conditions and to innovate appropriately as markets evolve.

These are the principles that have informed the strategic initiatives in securities and markets supervision that we have launched to support the Central Bank’s Strategic Plan 2019-2021, which we published in November 2018 . I do not propose to go into this Plan in great detail this morning, save to say that while there are many strands to our work at the Central Bank (given the breadth of our mandate), they are unified under the single banner of our mission to safeguard stability and to ensure that the financial system operates in the best interests of consumers, investors and the wider economy.

Nvertheless, I thought it would be useful to set out the specific initiatives underway in the field of securities and markets supervision particularly and to provide a little more detail on a number of them which I think are of particular relevance in the field of securities lending. While we deliver our mission through all our day-to-day supervisory activity (including our various authorisation functions), we have identified a number of specific initiatives to support the wider Central Bank strategy:

• Establishing a systematic, risk-based approach to how we supervise activity in wholesale securities markets across all of our various statutory mandates.
• Assertive risk-based supervision of the funds sector.
• Being an ever more effective gatekeeper.
• Continuing to improve how we harness data to do our work.
• Operationalising new legislation.
• The enforcement of securities market legislation.

In the context of securities lending, the obvious item that jumps out from the above is the operationalising of new legislation, which will of course include SFTR. I will speak to this in a moment.

However, first I would like to say a few words on the work we are doing to evolve our supervisory approaches to take account of the changing financial services landscape, under three headings in particular: our new framework for supervision of conduct on wholesale securities markets, our supervision of conduct in funds and how we are enhancing our use of data.

Supervision of Conduct on Wholesale Securities Markets

Wholesale financial market activity conducted in and from Ireland, and by branches of Irish firms in other jurisdictions, has increased in scale and sophistication. The development of a better articulated and systematic risk-based approach to the supervision of conduct on wholesale securities markets is therefore one of our key strategic initiatives in this cycle. Last year we focused on the design and implementation of a systematic risk-based approach to the supervision of conduct in wholesale securities markets. On 11 March we commenced our supervisory engagement with firms using this new framework by sending an Industry Expectations Letter to the CEOs of existing and incoming investment firms and credit institutions. In our letter we set out our high-level expectations in respect of how these financial service providers should identify, mitigate and manage market conduct risk. We will continue to engage with firms in relation to wholesale market conduct risk this year and intend to carry out a mix of thematic risk assessments and targeted risk assessments of individual firms.

It is also worth noting that, in devising this new framework and considering our priority supervisory themes, we have had regard to our work at an EU level with other National Competent Authorities (NCAs) and ESMA. Working together with our ESMA colleagues and fellow NCAs, there is now a concerted momentum to put in place more structured and targeted mechanisms to raise supervisory standards and drive EU convergence. As evidenced by our work at international bodies such as IOSCO, we also recognise the importance of global standards and cooperation in the field of securities and markets, not least because of the important contribution Ireland makes to international financial services generally.

In developing our new framework, we have also been very cognisant of the changes to the EU securities market taking place and planned on foot of Brexit, including the increase now underway in the scale and complexity of securities market activity carried on in and from Ireland. This includes assessing conduct risk within firms that have chosen to establish in Ireland in anticipation of Brexit, and we focused our deployment of our new wholesale market conduct toolkit on such firms in 2018. Managing the market disruption arising from Brexit continues to be a priority for the Central Bank and we expect firms to remain fully prepared for all plausible Brexit scenarios, with minimal disruption to clients.

Assertive Conduct Supervision of Funds

The funds industry in Ireland is an example of a sector of securities markets where Ireland is already a prominent EU and international jurisdiction, and the funds industry in Ireland continues to grow in nature, scale and complexity. This puts an onus on us to ensure that we continue to be effective supervisors of our global funds industry as it evolves and grows.

We have therefore made it a strategic initiative to build an ever more assertive risk-based approach to conduct supervision of funds, including using the methodology and tools we have developed for wholesale market conduct supervision. This allows us to identify the right themes to prioritise and to review those themes in a manner that achieves concrete sustainable improvements for investors. This year, in addition to regular triaging of supervisory issues, our areas of focus will include closing out our follow up engagement on the thematic review of UCITS performance fees through risk mitigation programmes imposed on relevant firms and redress to investors where required; and continuing our closet indexing review.

Finally, we are currently scoping a thematic review to assess how firms have implemented the package of measures introduced by CP86. The broad aim of this work will be to identify standards of industry compliance in order to inform our supervisory approach to this important area and ensure that the requisite systems of governance are in place to protect investors’ best interests. This includes the governance of securities lending activity of course.

Harnessing Data

Rapid technological development is a feature across the full spectrum of financial services. However, it presents particular challenges in the field of securities market supervision, where the scale and complexity of the data required to effectively supervise securities markets continues to rise and rise. We have therefore made it our strategic focus over the next three years to build our technological capability to harness the increasingly vast quantities of data reported to us, in order to enhance our supervisory approach and build up the systematic use of data analytics to support our supervisory engagement and outcomes.

Of course, we are not starting from scratch. Examples of our enhanced use of data and technology in our supervisory work this year include our use of data analytics to identify target funds in our wide ranging closet indexing review, as well as our intensified market monitoring in the run up to the 31 March and 12 April Brexit dates. We will continue to incorporate the use of data analytics in other key pieces of supervisory work this year, including to enhance efficiency and free up our supervisors to be more intrusive.
Of course, if we are to maximise the benefits of the vast quantities of data we receive under our supervisory mandates it is critical that that data is accurate and reliable. We are committed to the improvement of overall data quality and we have undertaken a considerable body of work on this area over the past year, primarily (but not exclusively) through our EMIR data quality work.

Securities Financial Transaction Regulation (SFTR)

I would like to conclude by saying a few words on the Securities Financing Transaction Regulation (SFTR).

In an address to ISLA a number of years ago , the Chair of ESMA spoke of ESMA’s conviction on the need to shed light on SFTs and allow regulators to build a more complete picture of potential financial stability activity and systemic risks coming from this activity. He also remarked at the time that it was common knowledge that in many cases SFTs are linked to the use of derivatives and without visibility around SFTs, regulators would not have the correct understanding of the exposure of their supervised entities. In introducing the Technical Standards under SFTR the following year, ESMA noted that bringing transparency and oversight into the multi-trillion euro market of securities financing was an important step in closing that regulatory gap, it being pivotal for financial stability that the risks associated with non-bank alternative credit provision are properly addressed. SFTR therefore represents an important policy response to the work of the FSB on shadow banking risks in securities lending and repos and forms part of a globally coordinated effort to increase transparency and reduce financial stability risks.

The Recitals to SFTR itself refer for example to the gaps and shortcomings revealed by the global financial crisis of 2007-2008 and the range of measures since adopted to enhance the resilience of the financial system. The Recitals also note that the financial crisis highlighted the need to improve transparency in the use of SFTs.

Reporting obligation

Given the importance of STFR’s objective, it should not be surprising that the Regulation introduces significant obligations on firms, not least in the field of transaction reporting, where SFTR represents in many respects, at least as significant a regime in scale and coverage as MiFIR and EMIR. 

With the SFTR Level II legislation having come into force in April, we now have certainty on the timelines for commencement of the transaction reporting obligations, with these being introduced on a phased basis from April 2020 to January 2021. Many of you will have started the work to adapt your systems for the implementation of the reporting requirements. I would urge those of you who have not to begin to consider your reporting obligations and the technology/systems underpinning that as soon as possible. While it is to be hoped that firms and regulators can leverage the experience of the transaction reporting regimes under MiFIR and EMIR , we should not underestimate the work that will be involved.

In supervising SFTR, we will look to learn from our experience of supervising EMIR. This includes reading across appropriately from the issues and concerns outlined in our recently published EMIR Letter to Industry . In that letter, we provided feedback on the main issues identified from reviews on EMIR data quality we undertook in 2018, so that appropriate action can be taken to ensure complete, accurate and timely reporting going forward. The letter was the culmination of a series of data quality checks on reported EMIR data focused on the extent to which reporting complies with the requirements under EMIR and related implementing and technical regulations and guidance. Key takeaways of general relevance include the need for boards to focus on oversight of reporting, especially where the reporting tasks have been delegated to third parties, including making reporting a standing agenda item at board meetings.

Transparency / Disclosure

While the SFTR transaction reporting regime has yet to go live, the SFTR pillars on collateral reuse, and on disclosure and transparency towards investors, already apply. I would like to briefly touch on the latter to impart our observations to date in relation to compliance with these disclosure requirements.

One of SFTR’s key objectives is to bring greater clarity to investors on the use of, risks associated with and revenues/costs generated from SFTs. This is achieved by disclosure in pre-offering documents and on an on-going basis through annual/semi-annual reports. What we have seen to date shows significant scope for improvement in order to make disclosures more comprehensive (particularly around costs impacting on the SFT revenue) and to adopt formatting and content that investors can more easily understand.

We have already had cause to engage with a number of firms on this front, requiring significant changes to their disclosures so that they are presented in a more informative and user-friendly format. Firms should also expect greater scrutiny and challenge on the treatment of fees and income received from stock lending activities and compliance with ESMA’s Guidelines which require that all the revenues arising from efficient portfolio management techniques, net of direct and indirect operational costs, should be returned to the UCITS. 

Compliance with the transparency obligations of SFTR is therefore an area that will remain under scrutiny by the Central Bank. I strongly urge firms to review the manner in which they are complying with this legislation and consider if they are truly and meaningfully adhering to the spirit of enhanced investor protection that informs its provisions. Quite simply, it is incumbent on regulated entities to put themselves in the shoes of the investor to whom the disclosure is directed and ask themselves whether it is truly framed to properly explain the issues and risks.

Conclusion

To conclude, securities lending is an important part of the evolution of securities markets. Done properly, it provides benefits and efficiencies that sit on all fours with the purpose for which capital markets have been established. But securities lending also brings complexity and an interconnectedness that must be carefully managed by regulated financial service providers engaged in this activity. Moreover, the activity must be transparently disclosed to the market and affected investors. Regulation is playing its part in supporting the framework needed to manage these risks, through initiatives such as SFTR and increased EU supervisory convergence. Industry is also active in advancing market standards, not least through the work of the International Securities Lending Association. The coming years will tell us a lot about how well the lessons of the last financial crisis have been learned and internalised into securities markets as they have evolved.

Thank you for your attention, I hope some of the insights and perspectives I have shared with you this morning will prove useful to you in your discussions this morning and in your work to ensure that securities lending makes its proper contribution to securities markets and how they serve investors and the wider economy.

I would like to thank Stephanie Kearns for her assistance with these remarks.

----------------------------------------------------------

¹ Cross, Gerry: Investment funds, securities lending, and European capital markets, Speech delivered to International Securities Lending Association Roundtable (14 November 2017).

² Financial Times: New rules will shine a light on securities lending (28 July 2018).

³ IOSCO: Securities Lending Transactions: Market Development and Implications (PDF 679.89KB), Technical Committee on Payment and Settlement Systems (July 1999).

⁴ Falco, Dominick: An Introduction to Securities Lending, AMEDA Dubai 2013 Conference (23 September 2013).

⁵ Sapir A, Veron, N, Wolff, G: Making a reality of Europe’s Capital Markets Union (PDF 423.67KB), Bruegel Policy Contribution Issue No 7 (April 2018).

⁶ Cross, Gerry: Investment funds, securities lending, and European capital markets, International Securities Lending Association Roundtable (14 November 2017).

⁷ Central Bank of Ireland: Strategic Plan 2019 - 2021 (PDF 1.3MB) (2019).

⁸ Central Bank of Ireland: Wholesale Market Conduct Risk (PDF 693.85KB) – Industry Communication (11 March 2019).

⁹ Regulation (EU) No 2015/2365 on transparency of securities financing transactions and of reuse and amending Regulation (EU) No 648/2012.

¹⁰ Maijoor, Steven: ISLA’s Annual Securities Finance and Collateral Management Conference (22 June 2016).

¹¹ ESMA: ESMA provides implementing details for SFTR, press release (31 March 2017).

¹² FSB: Strengthening Oversight and Regulation of Shadow Banking (18 November 2012).

¹³ For example, it has been noted that with SFTR’s 153 fields, four tables, six report types, 10 action types and permutations of the same, the EMIR and MiFIR reporting regimes pale in comparison Malik, S (2018) Post-haste, Securities Lending Times SFTR Annual 2018/19

¹⁴ Maijoor, Steven: ISLA’s Annual Securities Finance and Collateral Management Conference (22 June 2016).

¹⁵ Central Bank of Ireland: EMIR (PDF 2.87MB), industry communication (20 February 2019).

¹⁶ See for example Better Finance: Fund Managers frequently pocket large portions of the Revenues of Securities lending (11 May 2019).  See also Detlef Glow: Monday Morning Memo: Spotlight on the Concentration at the Promoter Level in the European ETF Industry (5 May 2019).

¹⁷ ESMA: Guidelines on ETFs and other UCITS issues ESMA/2014/937 (2014).