Don’t Fear the Repo

The role of repurchase transactions (repo) in the financial markets

AI Generated Image

Health Warning: The contents of this article are based on publicly available resources, which may be subject to change or further refinement. No legal or tax advice is provided in this article or on The Flaw Blog. All hyperlinks provided have been checked as of the date of publication.

Introduction

Back in the blissful pre-pandemic period of 2019, I wrote an article (‘How Stock Lending Works‘) that contained a brief mention of what repurchase (“repo”) transactions are in the overall world of stock lending – check it out here. I wanted to explore that repo theme in this article. So, in this repo-focused article, we will take a more detailed look at the following topics:

• The Significance of the Repo Market
• What are Repo Transactions?
• Why are Repos Used?
• What is Repo Collateral?
• Role of Repo Agents and Investment Guidelines
• Repo Master Agreements – GMRA and MRA
• Triparty Collateral Managers
• Cleared Repo
• Credit Risk and Events of Default
• Fedwire in the US Repo Market
• Day in the Life of a US Repo Trading Desk
• Regulation of Repo Transactions
• Repo Jargon

The Significance of the Repo Market

Before we dive into all that, it’s worth noting the global scale and significance of the repo market. According to the Financial Times, the U.S. repo market averaged about $12.6 trillion in daily exposures in Q3 2025, roughly $0.7 trillion more than earlier estimates (‘Repo is even bigger than we thought‘ (paywalled). An International Capital Market Association (“ICMA“) industry survey found that the European repo market was even bigger – the total value of repos outstanding on the books of financial institutions in Europe as of December 2025, hit a record high of €13.65 trillion. Interestingly, non-US dealers (largely euro entities) account for 40% of dollar repo volumes (‘The Negative-haircut repo phenomenon‘) (paywalled). There is no doubt that the repo market has quietly grown in significance over the years and is getting more attention now.

What are Repo Transactions?

Repos are typically used to invest short-term capital (cash). An investor (“repo buyer“) who has short-term cash to invest may consider buying certain securities (typically, fixed income securities such as bonds or government debt) with an agreement to sell them back at a future date to the same counterparty (“repo seller“). The security in question functions as collateral in the repo transaction. Presence of collateral makes the arrangement a secured financing. The counterparty to the investor is typically a broker-dealer in the market (e.g., Goldman Sachs).

Somewhat amusingly, the repo market looks at everything from the point of view of the broker-dealer and calls such an investment of cash into securities as a “reverse repo” with the term “repo” usually understood to be a repo seller transferring out securities in return for cash. Two sides of the same coin.

Why are Repos Used?

As we’ve discussed, repo transactions allow one party (e.g., a broker-dealer) to obtain short-term cash while providing securities as collateral to the cash provider (i.e., the investor). For broker-dealers, repos support balance sheet funding, market-making, inventory financing, and liquidity management. For cash investors, they provide a low-risk short-term investment with collateral protection. Sophisticated investors may also sometimes act as repo sellers providing securities from their portfolio as collateral in repo transactions in order to raise short-term cash from market counterparties (e.g., investment banks). Repos are also used for monetary policy transmission by central banks such as the Bank of England (“BoE“) and the European Central Bank (“ECB“).

What is Repo Collateral?

Collateral in a repo transaction consists of securities delivered by the repo seller (e.g., broker-dealer) to secure repayment of cash advanced by the repo buyer (investor). Depending on the parties’ risk framework, eligible collateral generally includes: (1) Government Bonds (e.g., U.S. Treasury Bonds); (2) U.S. Agency Securities (e.g., mortgage-backed securities issued by Fannie Mae or Freddie Mac); (3) Supranational Debt (e.g., bonds issued by the World Bank, International Monetary Fund (“IMF“), or European Investment Bank (“EIB“)); (4) Corporate Bonds; and (5) Equities (although less common). The collateral protects the cash lender (repo buyer) against counterparty default, with valuation adjusted through haircuts or margin ratios to reflect market and liquidity risk. Since title transfers outright, the repo buyer may be able to ‘reuse’ (see ‘Repo Jargon’ below) the collateral (e.g., for raising liquidity) unless contractual restrictions apply. Daily mark-to-market and margin maintenance ensure that the value of collateral remains sufficient throughout the life of the transaction. For example, if the collateral value falls below certain margin limits, the party providing the collateral (e.g., the repo seller) will need to put in more collateral.

In a repo transaction, the repo seller retains all economic rights in the securities provided as collateral to the repo buyer. However, due to the securities being transferred on a title transfer basis, any interest or other distributions in relation to the collateral securities accrue to the repo buyer as the holder of record. These distributions are therefore provided by the repo buyer back to the repo seller as a substitute payment to replicate the relevant distribution. This is called a “manufactured payment”.

Role of Repo Agents and Investment Guidelines

Some sophisticated buy-side investors (e.g., sovereign wealth funds, asset managers, pension funds, or insurance companies) may appoint a repo agent to transact on their behalf. Where an investor enters into repo on an agency basis, the investor’s investment guidelines become critical because the agent must act strictly within the principal’s mandate. These guidelines typically specify eligible counterparties (e.g., named broker-dealers), permitted collateral types, issuer concentration limits, maturity limits, minimum credit ratings, haircut parameters, and jurisdictional restrictions. Agents must also observe restrictions on credit risk, collateral liquidity, and settlement infrastructure. If discretionary authority is limited, the agent cannot deviate even where market opportunities exist. The guidelines therefore operate both as a risk-control framework and as a legal authority boundary for the agent’s execution activity. The guidelines would form an important part of the repo agent’s client services agreement signed with the investor.

Repo Master Agreements – GMRA and MRA

The ICMA Global Master Repurchase Agreement 2011 (“GMRA 2011“) is the current international standard master agreement for legally documenting repo transactions outside the U.S. The GMRA 2011 covers multiple asset classes and jurisdictions and is supported by netting opinions obtained by ICMA from a panel of legal counsel that are updated annually. Although the previous version, the GMRA 2000 still exists, the GMRA 2011 aimed to improve flexibility and address lessons learned from the 2008 Great Financial Crisis – especially regarding valuation in stressed market conditions. The GMRA 2011 is also more aligned with the procedures of the 2002 International Swaps and Derivatives Association (“ISDA“) Master Agreement in relation to events of default.

The Securities Industry and Financial Markets Association (SIFMA) Master Repurchase Agreement (“MRA“) is the principal U.S. domestic repo agreement and serves a similar function to the GMRA. The MRA is widely used for U.S. Treasury Bonds, U.S. Agency Securities, and mortgage-backed repo transaction activity.

Both master agreements operate on a title transfer framework in relation to the cash and collateral in a repo transaction (i.e., one party takes title to the securities collateral and the other takes title to the invested cash). Other key provisions include: close-out netting mechanics, margin maintenance provisions, events of default, and representations between parties. Annexes commonly supplement the master agreement to set out terms pertaining to the activities of a repo agent, investment in equities, or jurisdiction-specific tax matters. The terminology and default framework of the GMRA 2011 and MRA align closely with local insolvency laws and securities market practice.

Triparty Collateral Managers

Parties to a repo transaction could deliver cash and collateral to each other on a bilateral basis. However, they often appoint a specialist ‘triparty agent’ to manage the cash and collateral movements.  Bank of New York Mellon (BNY Mellon), JP Morgan, Euroclear and Clearstream are some of the key triparty agents in the global market. Rather than bilateral delivery of specific securities, the triparty collateral manager selects and maintains collateral within agreed eligibility criteria on its platform. The triparty structure reduces operational burden and supports large collateral pools, especially for investors and is particularly efficient where collateral substitutions occur frequently or where investors require strict automated eligibility controls. The triparty agent will administer collateral allocation, valuation, substitution, and margining between repo counterparties. These triparty provisions are documented in a separate triparty agreement that the investor (collateral receiver) and the counterparty (collateral provider) sign with the triparty agent. Triparty agreements are called Collateral Use Agreements (“CUAs“) in the U.S repo market.

Cleared Repo

Cleared repo interposes a central counterparty (“CCP“) such as FICC (see below) between original counterparties, so each faces the CCP rather than each other. This reduces bilateral counterparty credit exposure through novation, multilateral netting, and default fund protection. Clearing also improves balance sheet efficiency by reducing gross exposures and supporting regulatory capital optimisation. On 13 December 2023, the U.S. Securities and Exchange Commission (“SEC”) adopted a final rule (the “Treasury Clearing Rule”) providing for the mandatory central clearing of certain secondary market transactions involving U.S. Treasury Bonds (press release here). The Fixed Income Clearing Corporation (“FICC“), a subsidiary of the Depository Trust & Clearing Corporation (“DTCC“), is a CCP and clearing agency that provides, clears, nets, and settles U.S. government securities (including U.S. Treasury Bonds and U.S. Agency Securities) and mortgage-backed securities (“MBS“).

Credit Risk and Events of Default

In a repo transaction, the primary risk is counterparty credit risk i.e., that one of the counterparties fails to perform its obligations to the other e.g., the broker-dealer to whom the investor provided cash defaults or becomes insolvent and cannot return the cash. If an event of default occurs (as defined under the relevant master agreement), the non-defaulting party can terminate the repo transactions, seize the collateral, and calculate a close-out amount (applying close-out netting – see ‘Repo Jargon’ below). The risk is that, on enforcement, the collateral’s value or liquidity is insufficient to fully cover the exposure, leading to a loss. Overall however, because legal title to the collateral securities transfers to the investor (when cash goes the other way), repos offer stronger insolvency protection than unsecured lending. Economically, the transaction functions as a secured loan, but legally it is structured as a sale and forward repurchase of collateral securities.

Fedwire in the US Repo Market

Fedwire is the system U.S. banks use to move cash (“Fed Funds“) and government securities (“Fedwire Securities“) (e.g., U.S. Treasury Bonds and U.S. Agency Securities) to settle repo transactions. Fedwire Securities transfers run during the day (from 8:30 am) and effectively set the repo market deadline with key cutoffs around mid-afternoon (3:15 to 3:30pm). The Fed Funds system runs longer (9:00 pm prior day to 7:00 pm in the day), allowing banks to balance payments later in the day. In simple terms, Fedwire is the plumbing that makes such U.S. market repo trades actually settle.

Day in the Life of a US Repo Trading Desk

Given the importance of U.S. Treasury Bonds in the global repo market, I’ve chosen to highlight briefly how a U.S. repo trading desk operates. Typically, the desk operates primarily between 7:00 a.m. and 4:00 p.m. ET, though the internal workday often starts earlier for market preparation. This is divided into two parts:

• The Morning Rush (7:00 a.m. – 9:00 a.m.): This is the most critical window. Approximately 64% of daily volume is executed by 8:30 a.m. as traders secure funding for the day and the market establishes the Secured Overnight Financing Rate (“SOFR“) rate (also see ‘Repo Jargon’ below); and
• The Afternoon Close (1:00 p.m. – 4:00 p.m.): Trading continues at a slower pace throughout the day. The desk then shifts focus to settlement; repo transactions submitted after 4:00 p.m. are usually no longer processed on the same trading day and instead move to the next trading day.

Regulation of Repo Transactions

In the UK and European market, repo transactions sit within the Markets in Financial Instruments Directive (“MiFID II“) regulatory framework for conduct, transparency and broader firm obligations, shaping how firms execute and oversee securities trades. Investors would typically be categorised as ‘Professional Clients’ or ‘Eligible Counterparties’ under MiFID II. In the UK, repo activity would also be a regulated activity under the Financial Services and Markets Act (“UK FSMA“). Repos are securities financing transactions (“SFTs“) and they are also subject to the Securities Financing Transactions Regulation (“SFTR“), which imposes detailed transaction reporting, transparency and disclosure requirements for reuse (rehypothecation) (see ‘Repo Jargon’ below). Where client assets are involved, the Financial Conduct Authority (FCA)‘s CASS Rules in the UK (or equivalent local European rules) govern custody, segregation and collateral arrangements to protect client money and assets (securities). In the US, comparable oversight is fragmented across regulators (e.g., SEC, CFTC and Federal Reserve), combining reporting, prudential and market practice rules for repo activity.

Repo Jargon

“Close-out netting“: The contractual process – typically after a default – of terminating all outstanding repo transactions, valuing the collateral, and netting the amounts to produce a single amount payable by one party to the other.

“CUSIP“ (Committee on Uniform Securities Identification Procedures): A 9-character identifier used mainly in the U.S. and Canada to identify securities (e.g., a specific U.S. Treasury Bond or corporate bond).

“DvP“ (Delivery versus Payment): A settlement method where securities (e.g., repo collateral) and cash move simultaneously (e.g., via Fedwire), eliminating principal settlement risk.

“Evergreen Repo“: An evergreen repo automatically rolls over for successive periods unless terminated by notice, combining operational continuity with short-term repricing flexibility. Evergreen Repos typically roll over every week or month rather than daily.

“Fail” / “Failing”: When one party does not deliver cash or securities on the agreed settlement date.

“Forward Repo“: A forward repo is agreed today but begins on a future date, allowing parties to lock in funding or collateral terms in advance.

“GC“ (General Collateral): A repo where the specific collateral security doesn’t matter, only that it meets a broad eligibility class, so it trades at a general market funding rate rather than a “special” rate.

“Haircut” (or Margin): The overcollateralisation applied to a repo (e.g., lending $100 against $105 of collateral securities) to protect against risk.

“ISIN” (International Securities Identification Number): A 12-character alphanumeric code that uniquely identifies a specific security e.g., equity securities or bonds on a global basis.

“Manufactured Payment“: A substitute payment made to the repo seller by the repo buyer to replicate income (e.g., interest coupon or dividend) on the collateral provided during the repo term.

“Open Repo“: An open repo has no fixed maturity date and continues until either party gives notice to terminate, with the rate typically reset daily or periodically. Open Repos typically roll over every night.

“Overnight Repo“: An overnight repo starts on trade date and matures the following business day, making it the shortest standard repo tenor and a core instrument for daily liquidity management.

“Rehypothecation” (or “Reuse“): The right of the cash lender to use, sell, or re-pledge the received collateral securities for its own purposes during the term of the repo, subject to an obligation to return equivalent securities at maturity. Such reuse is typically to raise liquidity.

“Repo Rate“: the interest rate on the secured financing effected via a sale and repurchase of securities (i.e., the repo transaction), representing the return to the cash provider (investor/repo buyer) over the life of the transaction.

“Reverse Repo”: A reverse repo is an investment of cash by an investor into collateral securities but seen from the point of view of the broker-dealer providing collateral securities and taking in cash.

“Roll” (or “Rolling the repo”): Closing out a maturing repo and simultaneously entering into a new repo (often same collateral) to extend funding or borrowing beyond the original term.

“SOFR“: The Secured Overnight Financing Rate (SOFR) is a broad, transaction-based measure of the cost of borrowing cash overnight, secured by U.S. Treasury securities collateral. It is published daily by the New York Federal Reserve. Similar rates in the UK and European markets are, respectively, Sterling Overnight Index Average (SONIA) and Euro Short-Term Rate (ESTR).

“Sell/Buy-Back” or “Buy/sell-back“: A sell/buy-back or buy/sell-back achieves the same economic result as repo through two outright securities trades, usually without manufactured payment provisions unless specifically documented.

“Specials” (vs General Collateral): A specific security in high demand that trades at a below-market repo rate (sometimes negative), indicating scarcity of that ISIN.

“Spot/Next Repo“: A spot/next repo begins on the standard settlement date (usually T+2 in many bond markets) and unwinds one business day later.

“Term Repo“: A term repo has a fixed maturity beyond one day – ranging from a few days to several months with the repo rate agreed for the full term at inception.

“Tom/Next Repo“: A tom/next (tomorrow-next) repo starts one business day after trade date and matures the following business day, commonly used to bridge short settlement or funding needs.

END

Post-Brexit: CRD VI and Cross-Border Banking in the EU/EEA

AI Generated Image

Health Warning: The contents of this article are based on publicly available resources including EU legislation, which may be subject to change or further refinement. No legal or tax advice is provided in this article or on The Flaw Blog. All hyperlinks provided have been checked as of the date of publication.

Contents

• Introduction
• Current Cross-Border Business Models in the EU/EEA
• New Requirement to Establish Third Country Branches
• What are Core Banking Services?
• Exemptions to the Third Country Branch Regime
• Reverse Solicitation
• Grandfathering and Transitional Measures
• Capital Requirements Regulation (CRR III)
• Regulatory Impact Analysis
• Open Issues for Global Banking Groups
• Conclusion
• Timeline and Next Steps
• Resource Hyperlinks

Introduction

The EU has recently passed legislation known as the Capital Requirements Regulation (EU) 2024/1623 (“CRR III“) and the Capital Requirements Directive (EU) 2024/1619 (“CRD VI“) that will update the current EU/EEA banking regime as set out in the key EU legislation known to the market as “CRD IV“.

One key change that is set to be introduced when CRD VI becomes effective is that ‘core’ banking services (i.e., deposit-taking, lending and guarantees) that may currently be provided to EU/EEA clients from outside the EU/EEA (i.e., on a “cross-border” basis) by global non-EU/EEA entities would effectively be prohibited, and a locally-regulated branch would need to be established in each relevant EU/EEA Member State where such core banking services are to be provided unless a specific exemption was applicable.

In keeping with EU legislative parlance, we will refer to global non-EU/EEA entities as “Third Country Firms“, the newly mandated locally-regulated branch in EU/EEA Member States as “Third Country Branch” and the totality of these branch regulatory requirements proposed by CRD VI as the “Third Country Branch Regime“.

The analysis of the Third Country Branch Regime goes beyond the UK and Brexit because it will be relevant to US and other global banking groups currently providing cross-border banking services to clients in the EU/EEA.

Current Cross-Border Business Models in the EU/EEA

At present, the regulation of cross-border banking services in the EU/EEA is non-homogeneous with Member States having different approaches. Therefore, global banking groups outside the EU/EEA can provide cross-border banking services to EU/EEA clients as permitted by local law. Many such services are provided from global banking operations in financial centres such as New York, London and Zurich. EU/EEA clients benefit from the global footprints of these banking groups and the breadth of services they can provide from one location globally. Global banking groups benefit from the scale of global business that they can service from the same location and may have done business from such locations (e.g., London) for operational, tax, balance sheet capital, regulatory or other historic reasons.

Establishing local banking operations in each relevant EU/EEA Member State in order to provide certain banking services to certain clients would take away many operational and other advantages for such global banking groups.

New Requirement to Establish Third Country Branches

Under new Article 21c being added into CRD IV, EU/EEA Member States will need to require Third Country Firms to establish a branch in their territory and apply for a branch authorisation (licence) in order to be able to commence or continue to provide core banking services to clients in the relevant Member State. There are some exemptions to this requirement, which we discuss below.

Where the Third Country Branch Regime applies and a Third Country Branch is set up, then under the new Title VI (Articles 47 to 48r) provisions to replace the current Title VI in CRD IV, harmonised requirements for authorisation, capital requirements, supervision, governance and reporting would apply to the Third Country Branch established in the relevant EU/EEA Member State.

What are Core Banking Services?

Under new Article 47 being added to CRD IV, “core” banking services are defined as the provision of: deposit-taking, lending or guarantees and commitments. Lending would include consumer credit, credit agreements relating to immovable property, factoring, with or without recourse, and financing of commercial transactions (including forfeiting). Other banking services (e.g., payment services) are not sought to be regulated under this new Third Country Branch Regime although draft early proposals referred to all banking services.

The application of the core banking services definition is bifurcated: (a) in relation to the provision of deposit-taking, the new requirements would apply to any Third Country Firm; but (b) in relation to the provision of lending or guarantees and commitments, the requirements only apply to Third Country Firms which would be considered credit institutions (banks) or large investment firms (broker-dealers) if they were established in the EU. In addition, commodity dealers, collective investment undertakings (funds) and insurance undertakings are expressly excluded from the requirements.

Exemptions to the Third Country Branch Regime

The Third Country Branch Regime does not apply in the following circumstances:

1. Inter-bank Activity: where the Third Country Firm provides a service to a client or counterparty in the EU/EEA that is a credit institution (bank).
2. Intra-group Activity: where the services are provided to an EU/EEA entity that is a member of the same group as the Third Country Firm.
3. MiFID Services: where the services in question are investment services regulated under the EU’s Markets in Financial Instruments Directive (“MiFID II“) including any ‘accommodating ancillary services’, such as deposit-taking or the granting of credit (e.g., margin loans) related to such investment services.
4. Reverse Solicitation: where there is the specific application of reverse solicitation in the context of banking services (discussed below).
5. Entity Types: where feasible, lending or guarantees business could be migrated to group entities that are not considered banks or large broker-dealers, to group EU entities or other entity types excluded from the requirements.
6. Financial Sector Entities: where the EU Commission has conducted a review (after 10 July 2025) and exemptions to these requirements have been made available to financial sector entities in addition to credit institutions (banks). These could include financial institutions, insurance and reinsurance entities.

Reverse Solicitation

The Third Country Branch Regime does not apply where a Third Country Firm provides a service to an EU/EEA client that is a retail or professional client, or an eligible counterparty client (each as defined in MiFID II) where such client approaches a Third Country Firm at its own exclusive initiative for the provision of any core banking services (“Reverse Solicitation“). However, certain conditions apply, which are similar to the regulatory guidance for Reverse Solicitation (also called reverse enquiry) under MiFID II. These conditions are as follows:

• Solicitation and Close Links. Where a Third Country Firm solicits a client including through another entity or one having close links with the Third Country Firm (e.g., a group entity), it shall not be deemed to be a service provided at the own exclusive initiative of the client (or potential client) and Reverse Solicitation will not apply.
• No New Service Categories. Reverse Solicitation does not entitle Third Country Firms to market categories of services other than those that the client had solicited. Such other service categories can only be provided through a Third Country Branch in the relevant EU/EEA Member State.
• Related Services. The establishment of a Third Country Branch is not required for any services necessary for, or closely related to the provision of the service originally solicited by the client, including where such closely-related services are provided subsequently to those originally solicited.
• Monitoring. Local regulatory authorities will be empowered to require credit institutions (banks) and Third Country Branches established in their territory to provide them with the information they require to monitor the services provided at the own exclusive initiative of the client where such services are provided by Third Country Firms that are part of the same group.

Reverse Solicitation based on the own exclusive initiative of the client has, thus far, been mainly relevant in relation to investment services under MiFID II, but is now recognised (even codified) in the proposed changes under CRD VI in the context of core banking services. However, Reverse Solicitation should not form the basis of a business model because it carries significant regulatory risk.

Reverse Solicitation is: (a) generally used only on a one-off or exceptional basis when the client has taken the first initiative, which should be evidenced and retained; (b) there should have been no marketing by a firm targeting the client or client’s domicile; and (c) any Reverse Solicitation conditions from EU or local regulators should have been met.

Grandfathering and Transitional Measures

The Third Country Branch Regime contains a grandfathering provision that provides that in order to preserve clients’ acquired rights under existing contracts, the regime would not apply to existing contracts that were entered into before 11 July 2026 (“Cut Off Date“). However, there is no further guidance about grandfathering and questions do remain such as the position of contracts entered into before the Cut Off Date but subsequently amended or in a Reverse Solicitation situation (discussed above) if a related service is provided to the same client after the Cut Off Date when the original service was provided to the client under a contract before the Cut Off Date.

Under Article 2 of CRD VI, a 12-month transition period applies to the Third Country Branch Regime, which would not apply until 11 January 2027 whereas other proposed changes in CRD VI would be effective from 11 January 2026. See Timeline and Next Steps below.

Capital Requirements Regulation (CRR III)

This article has focussed on the Third Country Branch Regime in CRD VI. However, it is worth noting that the new Capital Requirements Regulation (CRR III), which has direct effect in the EU as a regulation (no national implementation), will apply from 1 January 2025 and is part of the same overall EU banking package of legislation with CRD VI. CRR III largely deals with implementing Basel III prudential capital standards and provisions such as the management of Environmental, Social and Governance (ESG) risks for EU credit institutions (banks).

Regulatory Impact Analysis

1. What is the Third Country Firm’s footprint in the EU/EEA in terms of banking clients?
2. Are any banking activities provided cross-border core banking services as defined?
3. What group entity types currently provide banking services into the EU/EEA?
4. To what extent could any of the exemptions be relied upon?
5. Could certain core banking services business be migrated to other group entities?
6. If a Third Country Branch is required, which EU/EEA Member States are relevant?
7. Would it be better to establish an EU credit institution (banking subsidiary) with passporting rights in the EU/EEA instead of multiple Third Country Branches?
8. What’s the timing for the licence application process in relevant EU/EEA Member States?
9. What new regulatory requirements apply (e.g., balance sheet capital, supervision, etc.)?

Open Issues for Global Banking Groups

1. Unregulated Services. Certain core banking services may currently be unregulated in EU/EEA Member States (e.g., certain lending in Ireland). Would such Member States be obliged to change national law when implementing CRD VI?
2. Waivers. Certain EU/EEA Member States (e.g., Germany) provide licence waivers for cross-border banking business being conducted within their borders. Would such waivers be removed by the implementation of CRD VI?
3. Characteristic Performance. Other Member States (e.g., Luxembourg) may have a more constructive interpretation of activities actually performed on their territory and may not seek to regulate truly cross-border business where the characteristic performance takes place overseas. Would the harmonised implementation of CRD VI change such interpretations in relation to core banking services?
4. Inter-dealer Activity. There is an exemption for inter-bank activity (discussed above). Would a similar exemption be available when activities are carried out on an inter-dealer basis? This would generally envisage two investment firms (broker-dealers) carrying out own account transactions with each other.
5. Accommodating Ancillary Services: How closely do accommodating ancillary services (e.g., providing loans or deposit-taking) need to relate to investment services so that they fall within the MiFID II regime and not the Third Country Branch Regime?
6. Guidance. When will EU/EEA-wide guidance be available on these and other issues (e.g., the scope of grandfathering discussed above)? The European Banking Association (EBA) usually provides such EU/EEA-wide regulatory guidance on banking issues.

Conclusion

The Third Country Branch Regime is stated to be an initiative to harmonise the EU/EEA banking regime and provide for the local supervision of core banking service providers in the EU/EEA. However, the passage into law of this regime can also be viewed as the latest regulatory land-grab by the EU of financial services by erecting barriers for non-EU/EEA entities serving EU/EEA clients.

It remains to be seen what global banking groups do in response to the Third Country Branch Regime in order to continue to service their EU/EEA banking clients. Some may establish Third Country Branches in one or more EU/EEA Member States, some may choose to set up or capitalise an EU credit institution (banking subsidiary), while others may seek to rely on applicable exemptions. Third Country Firms may also consider moving certain banking business to group entities not caught by the new requirements. All of these options are likely to come with operational and other challenges such as capital requirements and enhanced supervisory and reporting regulations.

One unfortunate result of these new regulatory measures may be that some global banking groups may conclude that, given their limited footprint, doing cross-border banking business in the EU/EEA with these new restrictions is not viable and they may exit the market and thus reduce the choice of banking service providers available to EU/EEA clients.

Timeline and Next Steps

• EU Parliament approval of CRD VI took place on 24 April 2024
• The EU Council then adopted CRD VI on 30 May 2024
• CRD VI was published in the EU Official Journal on 19 June 2024
• CRD VI enters into force on 9 July 2024 (i.e., 20 days after Official Journal publication)
• EU Member States to implement CRD VI as national law in 18 months (10 January 2026)
• A 12-month transition period applies to the CRD VI Third Country Branch provisions
• The CRD VI Third Country Branch Regime starts to apply from 11 January 2027

Resource Hyperlinks

• Latest Updates on the Banking Package (EU) – 14 December 2023
• EU Parliament Approval of CRR III and CRD VI – 24 April 2024
• Council of the EU Press Release – 30 May 2024
• New CRD VI Directive (EU) 2024/1619 EU Official Journal Publication – 19 June 2024
• New CRR III Regulation (EU) 2024/1623 EU Official Journal Publication – 19 June 2024
• Current CRD IV Directive Legislative Text – Annex I List of Banking Activities
• Current CRR Regulation Legislative Text
• Current MiFID II Directive Legislative Text – Annex A List of Investment and Ancillary Services

Providing Cross-Border Financial Services to Clients in the Middle East

Gulf Cooperation Council Countries (Shaded Green) via meconstructionnews.com

Health Warning: The contents of this article are based on publicly available resources, which are subject to change. Some of these resources were only available as unofficial English translations of official materials published in Arabic. No legal or tax advice is provided in this article or on The Flaw Blog. All hyperlinks provided have been checked as of the date of publication.

Introduction

The Middle East is a huge market for financial services with many sovereign wealth funds, local banks and other large players on the buy-side looking to purchase financial services provided by global banks and investment firms – especially on a cross-border basis. The region is geographically and culturally diverse with various countries. Each country has a unique legal and regulatory regime governing financial services. However, there are some common regulatory themes that run throughout the region.

In this article, we will mainly consider a sub-set of the Middle East that comprises The Cooperation Council for the Arab States of the Gulf also known as the Gulf Cooperation Council (GCC). The GCC is a trade bloc, which has six members: The Kingdom of Bahrain, the State of Kuwait, the Sultanate of Oman, the State of Qatar, the Kingdom of Saudi Arabia (KSA), and the United Arab Emirates (UAE). It was set up in 1981 and is headquartered in Riyadh, KSA.

In this article we look at the typical issues to consider before marketing and providing cross-border financial services to clients located in this GCC region. When we say “cross-border” we mean that services are actually performed in and provided from a country location outside the client location. Typically, the relevant financial services are provided from global financial centres like London, New York or Paris and the clients would be entities domiciled in GCC countries (e.g., the UAE).

We will look at the following topics with respect to the GCC:

• Licensing of Financial Services;
• Cross-Border Measures;
• Reverse Solicitation;
• Exemptions to Licensing Requirements;
• Regulation in the DIFC, ADGM and QFC;
• Kingdom of Saudi Arabia (KSA);
• Travel for Business;
• Final Thoughts; and
• Regulatory Sources.

Licensing of Financial Services

In general, carrying out financial services activities (e.g., banking or trading securities) in or form a country in the GCC would require a regulatory licence from the local banking or securities (i.e., markets) regulator. In addition, local business licences may be needed for carrying on any business on the ground in the relevant GCC country. What if local law in a GCC country is silent in relation to cross-border financial services, as is often the case? In cross-border scenarios, all activities take place overseas and the only nexus with the relevant GCC country is that the client is domiciled there (e.g., trading in US Dollar-denominated securities listed in New York for a UAE-domiciled client as opposed to trading in locally-listed UAE securities denominated in UAE Dirhams).

It follows that if care is taken that all activities take place overseas (i.e., not in or from the relevant GCC country) and there is no other nexus apart from client domicile, then it may be possible to make the case that cross-border financial services could be provided to clients in the relevant GCC country without triggering local licensing requirements. Examples of such cross-border considerations are discussed in the ‘Cross-Border Measures’ section below. This discussion may not apply in relation to the Kingdom of Saudi Arabia (KSA), which operates a different regulatory regime (see ‘Kingdom of Saudi Arabia (KSA)’ below).

Note: It is always worth considering obtaining the relevant local licences if the volume and frequency of the activities in country are such that local regulators would expect an overseas financial services provider to operate with such licences. Although tax issues are not covered in this article, it is worth mentioning that there could be a tax permanent establishment risk if carrying out business activities in a country even without an otherwise taxable presence such as a branch or subsidiary.

Cross-Border Measures

Although a jurisdiction-by-jurisdiction assessment is required, here are 10 examples of measures that an overseas financial services provider could take so as to reduce the risk of activities taking place in or from the relevant GCC countries:

1. Local Presence: There shouldn’t be any physical or legal presence (e.g., an office) in the relevant country.
2. Websites: Websites and social media shouldn’t contain marketing aimed at clients in the relevant country including using local language.
3. Travel: Trips by representatives to meet with clients in country should be limited to social visits without discussing specific services.
4. Meetings: Meetings in a relevant country should be by client invitation only and be infrequent. 
5. Clients: Clients should have been introduced overseas or themselves requested a meeting (see ‘Reverse Solicitation’ below).
6. Client Types: Clients should preferably be sophisticated or high net worth investors. Providing such investors with services is more likely to be exempted.
7. Marketing: No promotional activities (e.g., cold calls, roadshows) should be carried out or service-related materials given out while in country.
8. Information: Specific information relating to services should be provided strictly on a cross-border basis. 
9. Contracts: Contracts related to services provided should be executed overseas and not be governed by the local law of the relevant country.
10. Payments: Payments or forms related to cross-border services provided shouldn’t be accepted inside the relevant country.

Note: the above examples are broad measures and specific advice would be needed in relation to proposed activities in any particular country. Some of the measures discussed may be permitted on the basis of a market practice tolerated by local regulators, which position could change without notice. These measures may not be as relevant in the Kingdom of Saudi Arabia (KSA), where a different regime applies (see ‘Kingdom of Saudi Arabia (KSA)’ below).

Reverse Solicitation

What if a prospective client approaches an overseas financial services provider? This is the basis of the reverse solicitation (reverse enquiry) concept. Services provided pursuant to reverse solicitation may be permitted in the GCC without triggering local licensing requirements because such services would likely be seen as requested of and provided by an overseas financial services provider outside the relevant GCC country where all activities take place overseas (e.g., in New York or London). For reverse solicitation to be available, there must be an own exclusive initiative by the client to approach the overseas financial services provider with no prior marketing by the overseas financial services provider in the relevant GCC country. Enquiries or meeting invites from the client should be documented to evidence the client’s initiative.

Exemptions to Licensing Requirements

Various GCC countries operate regimes where there are exemptions from licensing, registration or other local requirements for financial services activity if certain conditions are met. Exemptions may be available at law, pursuant to regulatory guidance or based on market practice and informal positions taken by regulators (so-called ‘tolerated practice’). Some examples of potential exemptions (non-exhaustive) are discussed below. If an exemption is available and any conditions met, it provides a specific basis to rely on, or, at least, additional comfort.

Note: all exemptions discussed are subject to change over time and legal advice would need to be taken regarding their availability at a particular point of time or given a particular set of circumstances.

• UAE Professional Investors Regime (including High Net Worth). Under the UAE Securities and Commodities Authority (SCA) Board of Directors’ Decision No. 13/RM) of 2021 (text not available) (also referred to as the SCA Rulebook), there are exemptions for the financial promotion of securities made without a UAE licence to “Professional Investors”, which include high net worth individuals (HNWIs) and various other categories of investors including government bodies, regulated firms, listed companies, and family offices. HNWIs include those with a net worth more than 4 million UAE Dirhams ($1.1 million).
• UAE Exempt Professional Investors (Funds). The SCA has provided official guidance on the marketing of foreign investment funds in the UAE (mainland). This includes various exemptions from registration and local requirements for certain types of clients (e.g., Exempt Professional Investors – government institutions, agencies, or companies wholly owned by the government). In addition, Reverse Solicitation is specifically listed as an available exemption in the above guidance.
• Qatar Collaboration Exemption. Although not a formal exemption, it is possible for overseas financial services providers to provide financial services to clients in Qatar using the licence permissions of locally-licenced institutions they collaborate with.
• Bahrain Reverse Solicitation. Based on an interpretation of applicable regulation, provided there was a reverse solicitation from a client, the Central Bank of Bahrain (CBB) may continue to tolerate overseas financial entities providing financial services on a cross-border basis into Bahrain without a licence or commercial registration requirement.
• KSA CMA Resolution (Saudi Five). Under a resolution by the Capital Market Authority (CMA) dated 19/05/1434H (corresponding to 31/03/2013G) (understandably, the text is not widely available but it is referred to in this material), overseas financial service providers are permitted to provide securities-related services without a local licence to the following KSA bodies: (a) the Ministry of Finance Public Investment Fund (PIF); (b) the Saudi Central Bank (SAMA); (c) the General Organization of Social Insurance (GOSI); (d) the Public Pension Agency (PPA); and (e) the Saudi Arabian Investment Company (Sanabil Investments). These bodies are sometimes also referred to as the “Saudi Five”.
• KSA Reverse Solicitation. Under CMA regulatory guidance (FAQs), overseas financial services providers regulated in their home jurisdictions are exempt from KSA licensing requirements in relation to securities transactions when dealing with clients who have initiated contact on a reverse solicitation basis (see ‘Reverse Solicitation’ above) and the client is either an investment company (net assets of at least 10 million Saudi Riyal (SAR)) or a high net worth person whose total investments or net assets exceed SAR 50 million. The relevant transaction must not be for securities issued or listed in the Kingdom of Saudi Arabia (KSA) apart from KSA government bonds.
• KSA Correspondent Banking. Correspondent banking services (i.e., where a bank acts as a middleman to accomplish transactions on behalf of a bank in another country) may be seen as services taking place overseas (e.g., in the USA) by overseas financial services providers for the benefit of KSA-regulated banks. Rules set out by the local regulator (SAMA) suggest that such overseas correspondent banking services for KSA-regulated banks may therefore be permissible without overseas financial services providers obtaining local licences in the KSA. Interestingly, the following resource from the KSA government provides lists of correspondent banking relationships held by various KSA-regulated banks.

Regulation in the DIFC, ADGM and QFC

It is worth noting that the UAE includes the Dubai International Financial Centre (DIFC) and the Abu Dhabi Global Market (ADGM). These are distinct areas within the cities of Dubai and Abu Dhabi respectively, each with its own separate regulatory regime. They started as inward initiatives aimed at global firms wanting to set up a business presence to trade and carry out activity in the region under a modern regime largely based on international legal and business principles. Similarly, there is the Qatar Financial Centre (QFC) in the city of Doha in Qatar, which operates a separate regulatory regime to mainland Qatar.

When we have discussed the UAE or Qatar in this article, we refer to the rest of the country (i.e., the mainland) apart from these special regulatory areas. Regulatory licences to operate in the DIFC, ADGM or QFC are available and should be considered by global firms providing financial services frequently and having a large client base in the region. Such licences would usually not cover cross-border activity carried out overseas or business activity in other regions (ie., on the mainland) in these countries. However, under a Fund Passporting Regime, qualifying domestic UAE mutual funds can be marketed throughout the DIFC, ADGM or mainland UAE without obtaining multiple licences.

Kingdom of Saudi Arabia (KSA)

A separate, stricter regulatory regime applies in the KSA and the ability to provide services to KSA clients by observing cross-border measures is extremely limited. Banking services provided into the KSA require local licences. There are no formal exemptions although unlicenced overseas financial services providers may have historically provided banking services in the KSA on the basis of a market practice tolerated by the local regulator. In addition, as discussed above, correspondent banking type services could be provided to KSA-regulated banks without obtaining local licences where the activities take place overseas. Securities-related services (even purely cross-border) for KSA clients would trigger a licensing requirement and can only be provided on the basis of applicable exemptions e.g., Saudi Five or to high net worth clients on the basis of reverse solicitation (both as discussed in ‘Exemptions to Licensing Requirements’ above). There may also be various exemptions applying to different types of securities services under the relevant KSA securities legislation.

Travel for Business

As we have discussed, financial services provided by overseas entities in or from countries in the GCC are likely to trigger licensing requirements (including for local business licences or approvals) but activities carried out totally on a cross-border basis may be permissible. It is in this context that business travel to the GCC region should be viewed. Travel to the region may change the position of otherwise permissible cross-border activities. Therefore, any travel should be subject to strict guidelines including a detailed consideration of the Cross-Border Measures discussed above.

Travel by employees or representatives to GCC countries increases the risk that activities by an overseas entity will be viewed as taking place in country and not on a cross-border basis. In addition, travel may eliminate the availability of reverse solicitation (discussed above) and could also create a taxable presence. Infrequent business trips for social visits with clients in country would carry less risk. However, such risks cannot be eliminated because of the risk that carrying out activities on the ground itself carries. It is aways worth noting that since the breach of licensing requirements is likely to be a criminal offence, business travel to the region carries at least a theoretical risk of fines, criminal convictions and imprisonment.

Final Thoughts

The GCC region of the Middle East is a large market with many well-resourced clients who require international financial services. It is therefore not surprising that global banks and investment firms are interested in providing these clients with financial services while observing applicable rules. Care should be taken by these overseas financial services providers to obtain jurisdiction-specific legal advice in respect of proposed activities with clients and any planned business travel to the region. If all activities are to be performed overseas, any relevant cross-border measures should be followed. If activities are likely to trigger licensing requirements, consideration should be given to obtaining licences beforehand or ensuring any relevant exemptions are followed. Where reverse solicitation is available or necessary in order to provide services to clients, there must have been an own exclusive initiative by the client and it must be evidenced. It should be borne in mind that each GCC country has a different regulatory regime and some countries like the Kingdom of Saudi Arabia (KSA) may have a stricter one in place.

Regulatory Sources

Country	Banking Regulator	Securities Markets Regulator
Bahrain	Central Bank of Bahrain (CBB)	Capital Markets Supervision Directorate (CMSD)
Oman	Central Bank of Oman (CBO)	Capital Market Authority of Oman (CMA)
Kuwait	Central Bank of Kuwait (CBK)	Capital Markets Authority (CMA)
Qatar	Qatar Central Bank (QCB)	Qatar Financial Markets Authority (QFMA)
KSA	Saudi Central Bank (SAMA)	Capital Market Authority (CMA)
UAE	Central Bank of the UAE (CBUAE)	Securities and Commodities Authority (SCA)

Table setting out regulators and hyperlinks to their websites

Post-Brexit: Is there still EU/EEA Market Access for UK-regulated Firms?

Introduction

The UK is no longer part of the EU as a result of Brexit. UK-regulated financial services firms that could previously access the EU/EEA market using passporting rights under EU legislation can no longer do so. The UK is now treated as a Third Country (i.e., non-EU/EEA) by EU/EEA Member States. However, what if there’s an existing EU/EEA client relationship, live opportunity or the client approaches a firm in the UK? For example, if a UK-regulated branch of a US banking group was approached by a French professional client that wanted to buy US Treasury Bills or foreign exchange (FX).

This article explores whether, and if so, on what basis UK-regulated financial services firms (e.g., banks and investment firms) may still be able to provide financial services to clients in the EU/EEA post-Brexit without triggering licensing requirements in the EU/EEA. Much of this analysis will also be relevant to Third Country firms from other non-EU/EEA jurisdictions such as the USA.

We will cover the following topics:

1. Brexit;
2. Passporting;
3. Equivalence;
4. Considerations in relation to EU/EEA Market Access that could enable UK-regulated firms (and other Third Country firms) to provide financial services to EU/EEA based clients post-Brexit; and
5. What’s Next? Things to watch in this space.

In this article, references to ‘EU/EEA‘ mean the 27 EU Member States and the European Free Trade Association (EFTA) countries: Iceland, Liechtenstein and Norway. These 3 EFTA countries are rule-takers who benefit from the application of most EU legislation. Switzerland is not part of the EEA although it is an EFTA country.

Health Warning: What follows is a general discussion of various EU/EEA concepts and potential considerations based on publicly available information including from regulatory authorities. Such material could change over time. All links to sources are in blue underlined text and checked as of the date of publication. The considerations discussed are likely to differ from country to country and may apply differently based on the business model or individual circumstances of the relevant firm. No legal advice is provided in this article or on The Flaw blog.

Brexit – UK Withdrawal from the EU

The UK left the EU on 31 January 2020 pursuant to the EU-UK Withdrawal Agreement.  A transition period applied until 31 December 2020 when EU rules continued to apply to the UK. The EU and UK entered into a trade deal in December 2020.  However, this deal did not include an agreement on the provision of financial services. While the UK was an EU Member State and during the transition period, UK-regulated firms could take advantage of passporting rights (discussed below).  

What are EU/EEA passporting rights?

Where passporting applies under relevant EU legislation, the decision to issue an authorisation to a firm by the regulators of one Member State (Home Member State) is then valid for the entire EU/EEA. A firm may then provide the services, or perform the activities, for which it has been authorised, throughout the EU/EEA, either through the establishment of a branch (‘freedom of establishment’) or the free provision of services (‘freedom of services’). Before passporting, firms usually need to notify their Home Member State regulator of their intention to provide services on a passported basis.  

Passporting rights are set out in several pieces of EU legislation – notably:

• Banking: Capital Requirements Regulation & Directive (together CRD IV);
• Investment Services: Markets in Financial Instruments Regulation (MiFIR) & Directive (together MiFID or MiFID II);
• Insurance: The Solvency 2 Directive;
• Collective Investments: Undertakings for Collective Investment in Transferable Securities (UCITS) Directive;
• Alternative Investments (including hedge funds, private equity and real estate): Alternative Investment Fund Managers Directive (AIFMD); and
• Payment Services: Payment Services Directive (PSD2).

These passporting regimes are no longer available to UK-regulated firms since the UK is no longer an EU Member State and the transition period after Brexit has ended.  

What is Equivalence?

The EU has the power to recognise that the regulatory regime of a Third Country (non-EU/EEA) is equivalent to the corresponding EU regime. If equivalence is recognised, it makes the relevant services, products or activities of Third Country entities acceptable for regulatory purposes in the EU/EEA and allows regulators in the EU/EEA to rely on the entities’ compliance with equivalent rules in their home jurisdiction.  

Equivalence has been granted to various countries e.g., the USA, Japan and Australia in respect of various areas of EU legislation. A list of equivalence decisions by the EU in the form of an Overview Table is available as updated from time to time. Equivalence decisions can be unilaterally revoked by the EU at short notice or be time limited or subject to other conditions.

Equivalence and the UK

At the time of writing, the EU has adopted equivalence decisions post-Brexit in favour of the UK in two areas only: (i) the UK’s derivative clearing houses (Central Counterparties or CCPs) were given permission to continue to operate in the EU/EEA on a temporary basis (as Third Country CCPs) until 30 June 2022 to secure financial stability post-Brexit; (ii) similarly, a UK central securities depository (CSD) was recognised as a Third Country CSD and allowed to provide services in the EU/EEA on a temporary basis until 30 June 2021.

As a longstanding EU Member State before Brexit, the UK has helped shape and implemented most of the EU’s existing legislation including financial services regulatory rules. The current absence of more extensive equivalence decisions for the UK is almost certainly a political decision on the part of the EU. For the purposes of this article, we note that further financial services equivalence decisions by the EU for the UK are a possibility from a regulatory point of view. Also see ‘What’s Next? Things to Watch‘ below.

Considerations in relation to EU/EEA Market Access

In the absence of passporting, an EU-UK bilateral agreement on financial services and with limited adoption of equivalence decisions by the EU (so far), UK-regulated firms (like other Third Country firms) will need to consider the regulatory rules in each relevant EU/EEA Member State to determine if they will be able to provide financial services to clients in that country. Some of the major considerations are discussed below under various numbered headings.  

For the purposes of this article, we assume that UK-regulated firms will operate only on a cross-border basis.  Therefore, they will not have on-the-ground branches or subsidiaries in any relevant EU/EEA country and will not hold licences in the EU/EEA to enable them to use passporting rights from any EU/EEA Member State.

1. Transitional Regimes. Some EU/EEA countries have transitional regimes in place that allow various financial services activities commenced before Brexit to continue after Brexit. For example, in France, the loss of the EU/EEA passport would not affect the legality or performance of ongoing contracts entered into by UK-regulated firms with French clients prior to Brexit. According the French regulator (ACPR), such contracts would remain valid and must be executed in good faith.  Similarly, Spain has also provided for continuity of contracts.

2. Type of Client. In general, where there is EU/EEA market access for Third Country firms discussed below, it is aimed at sophisticated clients in the EU/EEA (e.g., ‘professional clients’ or ‘eligible counterparties’ under MiFID) and is unlikely to be available for non-sophisticated clients (e.g., ‘retail clients’).

3. National Equivalence. Some EU/EEA countries have their own equivalence regimes that apply where the EU Commission has not made a ruling or for a period (e.g., three years) after any such ruling. For example, Luxembourg’s regulator (CSSF) has published a list of countries that are considered as having equivalent supervisory rules in relation to investment services. This list includes Canada, Switzerland, USA, Japan, Hong Kong, Singapore and, from 1 January 2021, the UK. In order to benefit from these regimes, a Third Country firm would need to submit an application to the regulator.

4. Exemptions and Waivers. The Netherlands has permanently exempted firms from Australia, Switzerland and the USA from a licence requirement for investment services. UK-regulated firms may apply to the Dutch regulator (AFM) for this exemption on an individual basis. Similarly, the regulator BaFin in Germany may provide individual waivers to Third Country firms from German licensing requirements in some circumstances.

5. Passporting-type Local Legislation. Some EU/EEA countries (e.g., Belgium) have local law regimes for non-EU/EEA investment firms to provide investment services covered under MiFID to sophisticated clients in their jurisdiction on a cross-border basis. To take advantage of such regimes, the relevant non-EEA firm would need to be authorised to provide such services in its home jurisdiction (e.g., the UK) and would need to notify the local country EU/EEA regulator (e.g., FSMA in Belgium) of its intention to provide such services. Generally, there would also need to be mutual access for firms from the relevant non-EU/EEA country (e.g., Belgium to the UK).

6. Territorial Scope. Licence requirements would generally be triggered if a financial service is carried out within the territory of an EU/EEA country. However, where the ‘characteristic performance‘ of the service takes place outside the relevant EU/EEA country (e.g., in the UK) then it could fall outside the regulatory scope and not trigger licensing requirements in particular EU/EEA countries (e.g., Luxembourg or Spain). Conditions may apply: (i) the client needs to seek out the financial service provider (Reverse Solicitation – see below); (ii) the contract must be concluded and services performed outside the relevant EU/EEA country; (iii) there must be no marketing, travel or targeting of local residents; and (iv) no repayable funds (deposits) must be collected from the public.

7. Own Account Trading Exemption. In some EU/EEA countries, there is a licensing exemption for cross-border own account trading. Own account trading is the buying or selling of financial instruments for a firm’s own account without providing a service to a client. For example, in Germany (not available in English), the Netherlands, and France (not available in English) own account trading by Third Country firms with local counterparties does not trigger any licence requirements because of the absence of a service to a client (this is also called an inter-dealer exemption).

8. Trading on Exchanges. In addition to the above, a licence for own account trading is not required in some EU/EEA countries if the own account trading by a Third Country firm is done by it as a participant of local exchanges or trading venues (e.g., German exchanges). Similarly, in Spain, the regulator has clarified that own account trading and execution of client orders by Third Country firms as participants of Spanish exchanges would be permitted without a separate licence.

9. Deposit-taking. Some EU/EEA countries such as The Netherlands permit the financial service of cross-border deposit-taking to be carried out by UK-regulated firms post-Brexit on an unregulated basis for certain categories of clients. The Dutch client would need to be a professional market party (PMP) (e.g., bank, investment firm, insurer or pension fund). This exemption would not be available in relation to retail clients.

10. Asset Management Delegation. Even after Brexit, UK-regulated asset managers (as Third Country firms) can provide portfolio management services on a delegated basis to: (i) EU/EEA collective investment schemes – Undertakings for Collective Investment in Transferable Securities (UCITS); or (ii) EU/EEA Alternative Investment Funds (AIFs) and their managers (AIFMs). In order for such delegated services to occur, all parties must comply with the relevant delegation regime under the UCITS or AIFMD legislation. This is also confirmed in a joint notice by the FCA and EU regulators on 1 February 2019.  

11. Reverse Solicitation. What if an EU/EEA client seeks out a UK-regulated firm in relation to providing financial services to the client? This is called reverse solicitation (or reverse enquiry). Reverse solicitation is particularly relevant in relation to investment services under MiFID (the ‘own exclusive initiative’ of the client) but may also be available under other regimes. Services provided pursuant to reverse solicitation may be permitted in EU/EEA countries without triggering local licensing requirements but conditions may apply: (i) no marketing would be permitted; (ii) the client may only receive the service requested and, generally, no additional categories of services may be provided; and (iii) the enquiry from the client must be documented.

12. Unregulated Products. Some financial products are not regulated and transactions solely in such products may not trigger licensing requirements in some EU/EEA countries. For example, spot foreign exchange (spot FX) transactions are not regulated under MiFID because spot FX is not listed as a financial instrument under MiFID. With spot FX, underlying currencies are physically exchanged following the settlement date and delivery usually occurs within 2 days. It is worth noting that although unregulated, spot FX may be subject to best practice codes such as the FX Global Code.

13. Regulatory Expectations. Firms should be cognisant of regulatory expectations in the relevant EU/EEA country or, indeed, of EU regulators. Some regulators may expect Third Country firms to use locally-regulated branches or subsidiaries to provide services to certain EU/EEA clients rather than providing these on a cross-border basis from a Third Country. Any such EU/EEA subsidiary may need to be adequately capitalised and any branch or subsidary appropriately staffed. Extensive reliance on reverse solicitation as a business model may attract regulatory attention e.g., the European Securities and Markets Authority (ESMA) statement on the issue.

What’s next? Things to watch

• Teams from the UK Government Treasury Department and the European Commission have been in discussions about the future of financial services, in a bid to sign a Memorandum of Understanding (MoU). The MoU will establish the Joint UK-EU Financial Regulatory Forum, which will be a platform for dialogue on financial services issues. In March 2021 the UK Treasury announced that technical discussions on the text of this MoU had concluded and, after further steps on both sides, the MoU could be signed ‘expeditiously’.

• A new Third Country regime under MiFIR and MiFID II will allow Third Country (non-EU/EEA) firms to provide investment services to sophisticated clients in the EU/EEA without establishing a branch where the firm is included on the register of Third Country firms kept by European Securities and Markets Authority (ESMA). This regime is not live pending an equivalence decision by the EU Commission (i.e., the Third Countries that are equivalent) but is expected to apply from June 2021. The EU Commission has stated (see B.1.) that it will not make an equivalence determination with respect to the UK for the purposes of this regime in the short or medium term.  However, this is a future possibility.

END

The Flawed Joke

via https://www.pinterest.co.uk/pin/122230577374186076

LIBOR Transition: FCA and PRA Joint Statement

It has been five months since I published ‘A Guide to LIBOR Transition’ and I wanted to provide an update on where the London market is at this point.

Last week, the FCA and PRA provided a summary of feedback received by them in relation to their ‘Dear CEO LIBOR Letter’ sent in September 2018 to the largest banks and insurers in the UK.  The key findings and themes from this are as follows:

• Comprehensive Assessment: many firms undertook a comprehensive assessment of how LIBOR interacts with their business, involving a sufficiently diverse range of stakeholders.
• Quantification: some firms lacked the management information to provide a clear understanding of current LIBOR exposures, including where contracts mature after 2021. Firms should consider a range of quantitative and qualitative tools and metrics to monitor their exposure to LIBOR.
• Granularity and Governance: it is suggested that firms should nominate a senior executive covered by the Senior Manager Regime as the responsible executive for LIBOR transition. Firms should develop a granular project plan for transition, including key milestones and deadlines to ensure delivery by end-2021.
• Prudential Risks: some firms’ responses evidenced that a detailed risk assessment was completed, considering all risks that could be relevant to a firm’s operations, and had been subject to appropriate review and challenge.
• Conduct Risks: when forming and reviewing their LIBOR transition plans, firms should consider a range of conduct risks, including management of potential asymmetries of information and the potential for conflicts of interest.
• Planning Timeline 2021: the FCA and PRA have indicated that firms should plan based on the likely cessation of LIBOR at the end of 2021.
• Industry Groups and Proposed Solutions: firms should engage with various industry solutions (e.g. responding to consultation papers from industry groups) and consider the role they can play in establishing market standards.  However, firms should also consider what contingency plans they have in place if the proposed industry solutions do not materialise.
• Risk Free Rates (RFRs) and Fallbacks: firms may consider opportunities to proactively transact RFRs to reduce the risks from LIBOR discontinuation, or otherwise take steps to incorporate robust fallback language in contracts.

Other recent developments in this area have included the Financial Stability Board (FSB) publishing a Users Guide to Overnight RFRs; International Swaps and Derivatives Association (ISDA) publishing two consultations on benchmark fallbacks both open until 12 July 2019; and the Bank of England (BoE) working group on Sterling Risk-Free Reference Rates providing a Statement on Progress.

END

GDPR in Practice

Don’t worry.  Although 25 May 2019 marked a year from when the EU General Data Protection Regulation 2016/679 (GDPR) came into force, this isn’t an article rehashing  GDPR.  This piece is focused on some of the ways GPDR and data protection issues are actually being dealt with in practice by firms operating in the UK.

Even a year on, knowledge about the GDPR and the risk appetite for dealing with data protection and privacy issues, vary greatly from firm to firm.  For many firms, total GDPR compliance would be a significant chunk of work with a budget to match.  Understandably, even those firms prioritising GDPR and data protection issues do consider the risk of non-compliance or partial compliance.

Fines

The headline-grabbing aspect of GDPR and one that really focuses minds is the level of fines for infringing the core obligations, which is 4% of total worldwide annual turnover or €20 million, whichever is higher.  There are also fines of 2% of total worldwide annual turnover or €10 million, whichever is higher for infringing other obligations like record-keeping and notifying data breaches to regulators.  Note that according to a recent study published by the BBC, no fine has yet been issued under GDPR rules in the UK.

Controllers and Processors

In this piece, when we talk about controllers we typically talk about firms with client relationships (e.g. banks) who collect personal data of individual data subjects. Controllers shoulder the highest level of GDPR compliance responsibility.  Processors tend to be counterparties (e.g. consultants) providing services to controllers which may involve handling personal data.  Processors may, with the authority of the controller, sub-contract personal data handling to other firms who would be referred to as sub-processors.

Data Processing Agreements

GDPR requires that there must be a contract in writing between the controller and processor which clearly sets out the subject matter of the processing and its duration as well as the nature and purposes of processing, the types of personal data, any particular special categories of data and the obligations and rights of both parties.  This could take the form of a separate data processing agreement (DPA) between the parties or relevant provisions could be added into other contracts between them (e.g. Non-Disclosure Agreements, Master Services Agreements, etc.)

It is not unusual to find controllers seeking large (sometimes uncapped) indemnities from processors in relation to these data protection and privacy obligations in a DPA or other agreement. Also, given differing knowledge of and risk appetites in relation to GDPR, some firms may want to put in place DPAs with every counterparty as a measure of abundant caution regardless of whether any personal data is actually to be processed in connection with the provision of services by the counterparty.

Personal Data Breach Notifications

GDPR introduced an obligation on firms that are controllers to report personal data breaches to the relevant supervisory authority (ICO in the UK) without undue delay and where feasible within 72 hours of becoming aware of a breach.  If there is a delay, it needs to be accompanied by reasons.

In practice, this has meant that firms (controllers) who contract with counterparties (processors) will: (a) impose much shorter breach notification deadlines (e.g. 36 or 48 hours) in contracts with such counterparties so that they can meet their own obligations;  and (b) if there is a sub-processor then the processor will usually be obligated to replicate the data protection and privacy obligations in its own contractual arrangements with the sub-processor.

Data Subject Access Requests (DSARs)

GDPR strengthens the DSAR regime in favour of the individual (data subject).  Data subjects have the right to ask for a copy of the personal data a controller has about them.  If a DSAR is received, firms have to respond within one month.  Extensions to this period are only available in limited circumstances (complexity or number of requests) up to two further months.  Unlike pre-GDPR, no payment is needed from the data subject.  When responding, firms should consider how long it will take to provide a copy of the relevant personal data after redacting personal data of other data subjects or other confidential information if that is necessary.

Transfers of Personal Data Outside the EU/EEA

GDPR prohibits firms (whether controllers or processors) from transferring personal data of EEA data subjects outside of the EEA unless appropriate protections or safeguards are in place.  GDPR does allow Third Countries to be designated as providing such adequate protections. Currently, the following countries have been designated: Andorra, Switzerland, Jersey, Guernsey, Isle of Man, Faroe, Argentina, Uruguay, Canada, USA, Israel, Japan and New Zealand).

The designation in relation to the USA is limited to the Privacy Shield Framework.  The Privacy Shield Framework has been approved with an adequacy decision by the EU Commission since July 2016.  It is aimed at US companies and places stronger obligations on them to protect personal data of EU data subjects.  Brexit: if the UK leaves the EU, it will no longer be a party to the Privacy Shield Framework and would need to make separate arrangements.

Another commonly-used but older safeguard is the EU Standard Contractual Clauses (SCC) also called ‘model clauses’ which can be used to comply. They are standard sets of contractual terms and conditions in relation to personal data leaving the EEA, which the sender (in the EEA) and the receiver (outside the EEA) both sign up to.

Some Practical Approaches Taken by Firms

• Redact: If data is being sent by one firm to another it should only be sent after personal data is redacted.
• BCI: Ordinary course business contact information (BCI) is a sub-set of personal data. If BCI is being sent, the sender (controller) must have obtained consent from the data subject for sending it to the recipient (processor).
• Access: If personal data needs to be accessed in connection with the provision of services, it should ideally be accessed at the physical location or server infrastructure of the firm that is the controller.
• Advance Notice: Advance notice should be given by the controller firm to the processor firm before any personal data is transferred.
• Secure Servers: If personal data does need to be transferred by the controller firm to the processor firm then special arrangements should be made to receive it only on secure servers or other secure infrastructure of the processor.
• Breaches: If there is an inadvertent transfer of personal data to a firm, it must have a process in place for dealing with such an eventuality and making or assisting the controller with notifications to the regulator (e.g. ICO) if necessary.

END

The Flawed Joke

Life in the post-GDPR world.

via Exonar

How Stock Lending Works

Note: this article predates Brexit.

Stock Lending

In a stock lending trade a set of securities are loaned by one party (lender) to another party (borrower) in return for stock lending fees and collateral posted by the borrower.  At the end of the stock loan, the borrower returns equivalent securities to the lender who returns equivalent collateral to the borrower.  Stock lending is also called securities lending and stock lending trades are also called securities finance transactions (SFTs).

Short Sales

Stock is generally borrowed for the purpose of making a short sale.  Typically, the borrower would immediately sell the borrowed stock in the market and at the end of the stock loan trade (which may be kept open for a long time) it would buy equivalent securities in the market and return them to the lender.  If the stock price has fallen, the borrower will make a profit on the trade.

Major Players and Agents

Lenders of stock include buy-side firms such as mutual funds, insurance companies and pension schemes.  Typically, such firms would use custodian banks to hold their inventory of assets and the custodian would operate an agency stock lending programme to lend these out.  Major agent lenders are Bank of New York Mellon, State Street and Northern Trust.

Borrowers tend to be broker-dealers and other sell-side firms e.g. Goldman Sachs, Bank of America Merrill Lynch, J.P. Morgan acting in their own capacity or as prime brokers to hedge fund clients.  Many other banks and investment firms participate in stock lending in their principal capacity.

Legal Agreements

The main legal agreement used to document stock lending trades (outside the USA) is the Global Master Securities Lending Agreement (GMSLA) entered into between the lender (or its agent) and the borrower.  Where the lender appoints a stock lending agent, the lender and agent would enter into a separate agency agreement (e.g. a Securities Lending Authorisation Agreement).  The industry standard GMSLA is made available by the industry body ISLA (see below).

In the USA, the legal agreement used is the Master Securities Loan Agreement (MSLA) available from the industry body SIFMA (see below).

Stock Loan Fee

The stock loan fee amount depends on the difficulty of borrowing the stock – the more difficult it is to borrow, the higher the fee.  The fee is usually expressed in basis points (bips) e.g. 130 bips and accrues on a daily basis but is usually paid by the borrower monthly in arrears.

Title Transfer

Stock lending generally takes place on a title transfer basis – i.e. the borrower takes legal title to the stock on loan and the lender takes legal title to the collateral.  However, in the USA, the collateral is typically pledged to the lender (as opposed to a transfer of title) and this pledge collateral model is something that is also gaining traction in the global stock lending market outside of the USA.

Collateral

Collateral can be whatever the borrower and lender agree is mutually acceptable.  It tends to be liquid assets such as equity securities, bonds or other fixed income securities (e.g. US Treasury Bills) – collectively referred to as non-cash collateral or it could be cash collateral in various major currencies (typically US Dollar, Sterling, euro, or Yen).  If the borrower provides cash collateral, it is entitled to a fee (rebate) from the lender.  In practice, the rebate is netted off against the stock lending fee payable by the borrower.

Re-investment of Cash Collateral

Where a lender accepts cash collateral, it will usually want to generate incremental income from this and so it is invested.   Such investment is usually in highly liquid instruments such as money market funds (MMFs).  Larger more sophisticated lenders may appoint an asset manager to invest the cash collateral on their behalf under pre-agreed investment guidelines.

Repurchase Agreements (Repos)

Repos are typically used to invest short-term capital.  A repo is an agreement where a repo seller (e.g. a broker-dealer) sells fixed income securities such as bonds or government debt to a party investing cash (e.g. a lender investing cash collateral) with an agreement to buy them back at a future date.  The security in question functions as collateral.  The Global Master Repurchase Agreement (GMRA) is typically used to document a repo outside the USA and the industry standard GMRA is made available by ICMA (see below).

Margin, Mark-to-Market and Tri-Party Agents

During the term of a stock loan the value of the securities on loan compared to the collateral may fluctuate.  Therefore, the parties would agree that a margin (haircut) will be applied where the collateral value will be a certain percentage above the value of the stock on loan (e.g. if the stock loan is taken as 100% then the collateral could be 102%, 105%, 120%, etc. depending on the type of collateral).  Collateral is marked-to-market every day and if it falls below these margin limits, the borrower will need to put in more collateral.  Parties often appoint a Tri-Party Agent to manage collateral.  Bank of New York Mellon, J.P. Morgan, Euroclear and Clearstream are the main Tri-Party Agents.

Manufactured Payments

Although the stock is on loan, the lender still retains all economic interests in the relevant securities and therefore, if there are dividends or interest payments made in relation to them, they need to be credited to the lender.  However, since the stock lending trade usually takes place on a title transfer basis, the lender is not the legal owner of the stock and would not automatically receive these payments.  The borrower therefore agrees to pay a sum to the lender that is equal to any such entitlements.  This is called a manufactured payment.

Risk of Counterparty Default

The main risk in a stock lending trade is that the borrower may default (e.g. due to insolvency) and be unable to return equivalent securities representing the stock on loan.  If a counterparty default takes place, the relevant legal agreement such as the GMSLA contains a close-out process whereby the collateral posted by the borrower would be sold and replacement securities purchased with the proceeds to make the lender whole.  If the lender has appointed an agent, the agent may agree to indemnify the lender against any shortfall in collateral.

EquiLend

EquiLend is a stock lending platform owned by a consortium of leading financial services institutions.  Prospective lenders (or their agents) use EquiLend to show market participants (e.g. prospective borrowers) stock available for loan from their inventory.

Applicable Regulation

Since stock lending encompasses many types of regulated investment activities, market participants and financial instruments, various regulation could apply.  In the London market, the key regulation includes: Markets in Financial Instruments Directive and Regulation (MiFID/MiFIR), Short Selling Regulation, Securities Financing Transactions Regulation (SFTR), Central Securities Depositories Regulation (CSDR), Undertakings for Collective Investment in Transferable Securities (UCITS), Alternative Investment Fund Managers Directive (AIFMD) and all local law implementation of the above (e.g. FCA Handbook).

Industry Bodies and Netting Opinions

The International Securities Lending Association (ISLA) and the International Capital Markets Association (ICMA) are the two main industry bodies (outside the USA) in relation to stock lending and repos, respectively.

Both bodies also organise legal netting opinions in relation to the industry standard GMSLA or GMRA for various jurisdictions to be available to members.  These opinions are refreshed around March every year.  Netting entails offsetting the value of multiple trades between two parties to arrive at a single sum payable by one party to the other.

In the USA, the Securities Industry and Financial Markets Association (SIFMA) is the main industry body.

END

A Guide to LIBOR Transition

Note: you can use the hyperlinks below to jump straight to the section you need.  All major acronyms and jargon are set out in the Glossary at the end.

Note 2: this article predates Brexit.

• Summary
• Introduction 
• Why are LIBOR and IBORs not sustainable?
• Who is affected?
• Risk-free rates as a potential solution
• EU Benchmarks Regulation
• Brexit
• What’s next? Things to watch
• How firms should plan for a transition from LIBOR
• Glossary of terms

Summary

1. The inter-bank loan market that LIBOR is based on is not active enough and LIBOR in its current form is set to be discontinued after end-2021.

2. Regulators are keen that firms transition from LIBOR and IBORs to alternative reference rates such as SONIA, SOFR and ESTER and make appropriate changes to contracts currently referencing LIBOR or IBORs.

3. Firms need to plan and budget for the transition and involve their senior stakeholders. Firms also need to keep abreast of regulatory developments, new legislation and the impact of events like Brexit.

“The wise driver steers a course to avoid a crash rather than relying on a seatbelt. That means moving to contracts which do not rely on LIBOR.” (Andrew Bailey, Chief Executive of the FCA)

top

Introduction

Sometimes referred to as the world’s most important number, LIBOR is the benchmark interest rate for the amount that banks are willing to pay to borrow funds on an unsecured basis from one another in the London inter-bank market.  The British Bankers’ Association had produced a version of LIBOR since 1984 but, following the LIBOR scandal, ICE took over the administration of LIBOR from 1 February 2014.

LIBOR is produced for five currencies: USD, euro, GBP, JPY and CHF and seven tenors or term maturities (overnight or spot, one week, and monthly for one, two, three, six or twelve months). It is currently based on submissions from a reference panel of between eleven and sixteen banks for each currency.

LIBOR and other IBORs have received a lot of regulatory attention in the past eighteen months as regulators prepare and pave the way for a transition away from IBORs to alternative reference rates by the end of 2021 for reasons that we discuss in this Article. The LIBOR scandal following on from the 2008 financial crisis has been well documented and is not a topic for today.

top

Why are LIBOR and IBORs not sustainable?

In two landmark speeches given at Bloomberg London in July of 2017 and 2018, Andrew Bailey, the Chief Executive of the FCA, discussed the future of LIBOR and the transition to a world without LIBOR. The key messages from these speeches are as follows.

1. Banks have moved away from the inter-bank market. LIBOR was intended to measure the rate at which banks could borrow funds in the wholesale markets from each other on an unsecured basis. However, after the recent financial crisis, the way banks finance themselves has changed. Banks have moved away from the international inter-bank market, which has therefore substantially reduced and is unlikely to grow again.

2. Underlying markets are not active enough. Although significant improvements had been made to LIBOR, the absence of active underlying markets raises serious questions about the sustainability of the benchmark based upon these markets – especially since these markets are not likely to become substantially more active in the near future.

3. LIBOR submissions sometimes based on expert judgments instead of transactions. Since banks are not lending to each other on an unsecured basis in the inter-bank market, the panel banks making LIBOR submissions have to also provide submissions, in certain circumstances, based on expert judgment because of the scarcity of actual transactions in the market for a particular currency or tenor or, in some cases, even no actual transactions. Understandably, panel banks are uncomfortable providing such submissions and were doing so on a temporary basis.

4. LIBOR should never have been used to price derivatives. LIBOR was never a risk-free rate but it became a proxy for a risk-free rate plus a measure of bank risk over the relevant term (e.g. 3 months). However, LIBOR became the rate used to price derivatives even though the derivatives market expanded beyond interest-rate hedges for global money markets when a pure risk-free rate should have been used and this situation needs to be corrected.

5. System Vulnerability. The above factors make the current system for determining LIBOR vulnerable to future misconduct – even though there may be no evidence of such misconduct today.

6. Transition set to take place by end-2021. The FCA and and other regulators have requested panel banks to continue to support LIBOR until end-2021 but by that date, there is a regulatory expectation that the market would have planned for and smoothly transitioned from LIBOR to alternative reference rates based on actual transactions. LIBOR, in its current form, would then be discontinued.

The analysis in relation to LIBOR can be applied to other IBORs. For example, EURIBOR, which is administered and published by EMMI, is based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market (inter-bank market). EURIBOR should be distinguished from euro LIBOR, which is one of the currency variants of LIBOR. Other examples of IBORs are TIBOR (Tokyo), HIBOR (Hong Kong) and SIBOR (Singapore).

top

Who is affected?

The Economist (subscription required) notes that an estimated $260trn of loans and derivatives, from variable-rate mortgages to interest rate swaps are underpinned by LIBOR globally.  This is because LIBOR is used as a benchmark or reference rate in many markets, for numerous products and therefore in many types of contract or other binding documentation.  Some of these are outlined below.

Market	Products	Type of Contract or Documentation
Loan	Bilateral Loans; Syndicated Loans; Mortgages	Loan Agreements (LMA)
Derivatives	Equity or Commodity Derivatives; Interest Rate Swaps; Currency Swaps	ISDA Master Agreement
Securities Finance	Stock Loans and Repos	Global Master Securities Lending Agreement (ISLA); Global Master Repurchase Agreement (ICMA)
Debt Securities	Floating Rate Notes; Fixed Rate Notes (re-settable); Sovereign Issuances; Corporate Bonds	Debt issue prospectus and terms and conditions
Structured Finance	Asset-backed Securities; Mortgage-backed securities, Collateralised Debt Obligations	Prospectus and terms and conditions

Given the sustainability concerns and the widespread use of LIBOR (or other IBORs) in contracts, regulators are keen to ensure that work begins by all market participants on planning the transition from IBORs to alternative reference rates.

top

Risk-free rates as a potential solution

A group of alternative reference rates to IBORs are RFRs.

Whereas IBORs represent rates at which panel banks believe that they could borrow money in the inter-bank market and reflect the credit and liquidity risk involved in lending in that inter-bank market, RFRs are backward-looking rates calculated on actual historical transaction data. RFRs do not price credit risk or include a term premium since they are usually based on overnight borrowing, sometimes on a secured basis. Unlike IBORs, RFRs do not have a term maturity element (i.e. 1 week, 3 months, etc.) and are calculated on a currency-by-currency basis with no uniform calculation methodology across all currencies.

The key RFRs in use or which are being set up are described below.

1. SONIA. In the UK, the Bank of England administers SONIA on the basis of data submitted to it of unsecured, one business day maturity transactions of £25 million or more executed between 12 am and 6 pm UK time, settled that same-day. The SONIA rate for a given London business day is published at 9 am UK on the following London business day. SONIA is seen as the main alternative to LIBOR as the primary GBP interest rate benchmark in the loan, bond and derivatives markets. Indeed, as noted by Andrew Bailey, SONIA is now supported by an average of 370 transactions per day, which is a much higher transaction count than would potentially qualify as inputs to six month LIBOR – the most commonly used of the sterling LIBOR rates.

2. SOFR. There are $700bn-worth of repo transactions daily, which are reported to the New York Federal Reserve through the Depository Trust & Clearing Corporation and the Bank of New York Mellon. After processing vast quantities of data to produce a weighted average, the New York Fed publishes the result, SOFR, at 8 am New York. SOFR has been mooted as an alternative to US dollar LIBOR. However, as noted by The Economist (subscription required) so far, only a handful of bond issuances have used SOFR as the underlying reference price.

3. ESTER. Recently, an ECB working group on euro RFRs selected ESTER as the alternative to EONIA. ESTER will reflect the wholesale euro unsecured overnight borrowing costs of Eurozone banks and will be available by 9 am Central European Time on each business day, based on actual individual transactions from the previous day. Unlike SONIA and SOFR, ESTER is not currently available but the ECB expects it to be published from October 2019.

4. SARON. SARON represents the overnight interest rate of the secured funding market for CHF based on transactions and quotes posted in the Swiss repo market. It is calculated by SIX Swiss Exchange and published at 8:30 am Zurich. SARON has been suggested as an alternative to CHF LIBOR.

5. TONAR. In Japan, the LIBOR alternative identified by Bank of Japan is TONAR, which has served as the reference rate for the JPY overnight index swap market. TONAR is calculated by the Bank of Japan based on unsecured, overnight transactions using information provided by money market brokers.

Term Rates based on RFRs

As we have discussed, RFRs are backward-looking and do not have a term maturity element (as LIBOR does) since they are based on overnight borrowing. However, as noted by Andrew Bailey, some parts of the global bond, loan and securitisation markets may have economic or operational preferences for forward-looking term rates because current processes in these markets assume such forward-looking rates. As part of the transition from LIBOR, regulators, banking working groups and benchmark administrators are exploring the creation of term rates using RFRs as their foundation. In the UK for example, ICE has developed a preliminary methodology based on futures contracts data to derive a term rate for SONIA across one, three and six month terms.

top

EU Benchmarks Regulation

For firms in operating in the EU market, the transition from LIBOR or other IBORs should take into account the requirements of the EU’s regulation on benchmarks – BMR.

Under BMR Article 28, EU supervised entities* that are users of benchmarks must produce and maintain robust written plans setting out action that would be taken if a benchmark being used materially changes or ceases to be provided. Such plans will need to nominate one or several alternative benchmarks that could be referenced to substitute benchmarks no longer provided. These plans must also be reflected in the contractual relationship such entities have with clients or counterparties.

These requirements are likely to lead to contract re-papering exercises to refer to alternative benchmarks or include fall-back provisions in many types of financial contracts.

From 1 January 2020, EU supervised entities will not be permitted to use benchmarks unless the administrator of that benchmark is authorised or registered in the EU (BMR Article 29). ESMA maintains a public register of benchmark administrators and third country benchmarks.

Under BMR Articles 30-33, non-EU benchmark administrators will need to fall within the EU’s third country regime to qualify (i.e. equivalence, recognition or endorsement).

Benchmarks used in the EU (including IBORs) will likely cease being used by the end of 2019, if they do not comply with these requirements.

 

*under BMR Article 3(17) ‘supervised entities‘ include banks, investment firms, insurance or re-insurance companies, occupational pension providers, undertakings for collective investments in transferable securities (UCITS) or their management companies, alternative investment fund managers (AIFMs), market operators, central counterparties and trade repositories.

top

Brexit

No discussion is complete without considering the impact of Brexit. Brexit, set to take place on 29 March 2019, is likely to have a significant impact on LIBOR, other IBORs and other benchmarks. Assuming that Brexit results in the UK becoming a third country to the EU (much like the USA is currently), then the third country regimes mentioned above will come into play in relation to whether the UK benchmarks regime complies with BMR.

UK benchmarks being used in the EU by EU supervised entities and EU benchmarks being used by UK supervised entities will fall into different regimes and will require mutual recognition under the respective EU and UK regulatory regimes.

Non-EU benchmark administrators will also need to be recognised or endorsed in the EU if they had applied from the UK as their Member State of reference (BMR Articles 32-33). Similarly, if they had applied in the EU via any other Member State they may have to apply again in the UK.

To address the potential loss of the EU/EEA financial services passporting regime by incoming EEA firms after Brexit, the UK Government has legislated for a temporary permissions regime for a period of 3 years for such firms in the UK.  At present, under the EU’s Brexit contingency plans, it has not extended similar permissions to UK firms who have passported into the EEA apart from measures in relation to the central clearing of derivatives, novation of over-the-counter derivatives contracts between the UK and EU27 countries and for central depositaries services. No special measures in relation to benchmarks have been proposed in the context of Brexit and it remains an area to watch closely.

top

What’s next? Things to watch

Below is a summary of some recent and upcoming action taken by central banks, regulators, administrators and industry bodies in relation to the transition from LIBOR and IBORs. Firms should look out for any further developments in relation to these or similar initiatives.

1. • The FCA and PRA sent a “Dear CEO Letter” on LIBOR transition to the largest banks and insurers in the UK and the firms were given until mid-December 2018 to respond with a board-approved summary of their assessment of key risks relating to LIBOR discontinuation and identify the relevant senior manager function within the firm that would oversee the implementation of the transition.

   • ISDA announced on 20 December 2018 that as a result of a recent consultation, it is amending its standard documentation to implement fall-backs for certain key IBORs. The fall-backs will apply if the relevant IBOR is permanently discontinued, based on defined triggers. The fall-backs will be to alternative RFRs that have been identified for the relevant IBORs as part of recent global benchmark reform work.

   • The Bank of England’s Working Group on Risk-free Reference Rates has published a paper (21 December 2018) on the considerations for loan market participants in relation to new and legacy transactions referencing LIBOR to aid in the preparation for a transition from LIBOR to SONIA.

   • On 4 December 2018, ICE launched a survey on the use of LIBOR. Market participants are invited to take the survey by the deadline of 15 February 2019.

   • On 24 January 2019, ICE published a paper proposing a new benchmark as a fall-back to LIBOR, the USD ICE Bank Yield Index (IBYI). IBYI is designed to measure the yields at which investors are willing to invest USD funds in large, internationally active banks on a wholesale, unsecured basis over 1, 3 and 6 month periods. IBYI would be based wholly on primary and secondary market bank funding transactions (e.g. commercial paper, bond market trades, etc.) If there was interest in the market for IBYI, ICE proposes to make it available in Q1 2020.

   • In January 2019, the ECB published a paper entitled “Guiding principles for fall-back provisions in new contracts for euro-denominated cash products” providing a set of principles in relation to fall-back provisions that could be included in new retail and wholesale contracts referencing the benchmarks EURIBOR and EONIA.

   • On 21 February 2019, Megan Butler, Executive Director of Wholesale Supervision at the FCA, made a speech at the Investment Association, London on the progress made in the UK in relation to the transition from LIBOR to overnight risk-free rates (particularly SONIA).  She noted that, so far in 2019, 15 sterling bond issues have referenced compounded SONIA, with a total value of about £8.7bn.
2.  

top

How firms should plan for a transition from LIBOR

1. Due diligence on existing contracts. As a suggested first step, firms should review existing contracts and templates that refer to LIBOR (or other IBORs) to identify the population of contracts that will need to be part of the transition.

2. Market developments. Firms should continuously keep abreast of regulatory and market developments in this area. Industry bodies are likely to play a key role in the transition.

3. Robust written plans. Firms operating in the EU market should note that any transition plans also include robust written plans of actions that will be taken in the event that a benchmark (e.g. LIBOR) materially changes or ceases. This would include nominating alternative benchmarks (e.g. SONIA).

4. New contracts maturing beyond 2021. Firms also need to keep an eye on any new contracts that are being issued that refer to LIBOR or other IBORs. Despite the issues that have been highlighted, the amount of contracts referencing LIBOR but maturing beyond end-2021 continues to grow according to the Bank of England. Any such contracts should have robust fall-back provisions in place that allow for a smooth transition to other benchmarks if LIBOR or another IBOR was discontinued during the contract’s term.

5. Re-papering exercises. Firms should note that it is likely that a large number of contracts identified will need to be re-papered either to replace LIBOR with an alternative benchmark or to include fall-back provisions that will allow for a future transition. Such contract re-papering is also envisaged by the BMR as discussed previously. Firms should give themselves as long a lead time as possible to carry out any such re-papering exercise and budget for this accordingly.

6. Expectations of regulators. Finally, firms should note that regulators will expect all of the planning and transition work in relation to IBORs to be led by a senior person (e.g. a person holding a senior manager function) at the firm and that the firm’s board of directors or governing body has approved these plans and is kept fully aware of these developments and associated risks. This is clearly evidenced from the recent “Dear CEO Letter” sent by regulators in the in the UK market as discussed in the previous section.

top

Glossary of terms

Term	Meaning
BMR	EU Benchmarks Regulation (EU) 2016/1011
CHF	Swiss Franc
ECB	European Central Bank
EEA	European Economic Area
EMMI	European Money Markets Institute
EONIA	Euro Overnight Index Average
ESMA	European Securities and Markets Authority
ESTER	Euro Short-term Rate
EU	European Union
EU27	EU without the UK
EUR	euro
EURIBOR	Euro Inter-bank Offered Rate
FCA	Financial Conduct Authority in the UK
GBP	British Pound Sterling
IBORs	Inter-bank offered rates including LIBOR and EURIBOR
ICE	ICE Benchmark Administration part of Intercontinental Exchange, Inc.
ICMA	International Capital Markets Association
ISDA	International Swaps and Derivatives Association
ISLA	International Securities Lending Association
JPY	Japanese Yen
LIBOR	London Inter-bank Offered Rate
LMA	Loan Market Association
PRA	Prudential Regulation Authority in the UK
RFR	Risk-free Rate
SARON	Swiss Average Rate Overnight
SOFR	Secured Overnight Financing Rate
SONIA	Sterling Overnight Index Average
TONAR	Tokyo Overnight Average Rate
USD	United States Dollar

END

top