The about-to-be promulgated EU Securities Financing Transaction Regulation (SFTR) is another in a long line of new financial legislation emanating from Brussels that demonstrates how not to write law.

Drafting with one’s head in the sand

The whole dysfunctional process would appear to start with officials at the European Commission and policy-makers in the European Parliament, few of whom appear to have much, if any, experience of finance and many of whom give the impression of being prejudiced against markets. They (and the member states acting through the Council of Ministers) produce their own draft versions of a Regulation. These three texts will eventually be merged by negotiation to produce an agreed version.

A key problem is the Commission’s refusal to consult with anyone in the market before forging a near-final text. The origin of this head-in-the-sand approach to law-making seems to have been former EU Commissioner Michel Barnier. He reportedly forbade his staff from consulting externally before producing a firm draft in case they were ‘captured’ by dark forces. As a result, it seems that no one in the Commission dares to check their ‘facts’ with anyone in the market, that is, anyone who knows anything about the market.

The formal stage of public consultation is largely a sham. The Commission seems extremely reluctant to accept amendments, perhaps because this would be a loss of face and amendments might complicate the trialogue with the Council and Parliament. But there is also deep suspicion of the market.

The problem of “micro-drafting”

Another problem is that Regulations are currently being written at a level of detail which means the officials at ESMA and EBA, who have to implement the new laws, have little or no flexibility to fit the legislation to reality. When mistakes are discovered in the so-called Level 1 text, there is little that can be done by the supervisory agencies when drafting the Level 2 technical implementation rules. The Commission seems very reluctant to admit to mistakes. If the error is so utterly egregious that no one can disguise it, the supervisors have to agree to ignore the law (eg in the case of mandatory T+2 settlement preventing the trading of forward repo on regulated trading venues). In the case of the CSDR, ESMA may be hoping that a long delay in implementation will reduce the embarrassment for the Commission sufficiently to allow them to countenance a Level 1 amendment.

What went wrong with the SFTR

In the case of the SFTR, the most egregious product of the Barnier blind-drafting process has been the attempt to define a repo and, at the same time, distinguish between a repurchase transaction (classic repo) and a buy/sell-back. In this case, however, matters have apparently been made worse by the intervention of lawyers from all 28 EU member states. 11 of those countries do not have a repo market; and another 5 or 6 have very small markets. The rest have active repo markets but lawyers who seem to know little or nothing about them. So 16-17 of the cooks had no recipe: the rest had never cooked this dish before.

The table below analyses the definitions that the lawyers produced and inserted in Article 3(5) of the SFTR.

	buy-sell back transaction (5a)	repurchase transaction (5b)
how is collateral conveyed	counterparty “buys or sells” collateral	counterparty “transfers” collateral
collateral	“securities or commodities or guaranteed rights”	“securities or commodities or guaranteed rights relating to title to securities or commodities where that guarantee is issued by a recognised exchange which holds the rights to the securities or commodities and the agreement does not allow a counterparty to transfer or pledge a particular security or commodity to more than one counterparty at one time”
equivalent collateral	“securities, commodities or guaranteed rights of the same description”	“them [as above], or substituted securities or commodities of the same description”
repurchase price	“a specified price”	“a specified price”
repurchase date	“a future date”	“a future date specified, or to be specified, by the transferor”
documentation	“such buy-sell back or sell-buy back transactions not being governed by a repurchase agreement or by a reverse repurchase agreement as defined in point 5b”	“governed by an agreement”

The drafting in Article 3(5) is fundamentally incorrect. In fact, it is so incorrect that it could be argued the SFTR does not cover the repurchase transactions and documented buy/sell-backs which are actually used in the European repo market.

For example, the Regulation talks about “buy” and “sell” for buy/sell-backs but “transfer” for repurchase transactions? Does “transfer” means transfer of title, in which case, why was that word not used for both types of repo? Or did the lawyers’ conclave think that European repurchase transactions were pledge-based, as in the US? Note the use of the word “pledge” in the definition of collateral for a repurchase transaction. And is it significant that “equivalent” is defined as “of the same description”. This definition is only one facet of the GMRA definition (see paragraph 2(t)). Consequently, the question arises as to whether the SFTR’s definition is wide enough to ensure that no equity of redemption applies to the collateral, which would mean it was pledged, not sold? If the authors were under the misapprehension that repurchase transactions are pledge-based in Europe, presumably, actual title transfer repurchase transactions are excluded?

And given that the definition of the repurchase price is a specified price, might the SFTR exclude floating-rate repo, open repo and repos of index-linked and floating-rate collateral, where the repurchase price is not known at the start of the transaction?

Meanwhile, the definition of a buy/sell-back specifies that this repo type is undocumented. The authors seem unaware of the Buy/Sell Back Annex to the GMRA introduced in 1995. If all buy/sell-backs are assumed to be undocumented, are documented buy/sell-backs excluded from the SFTR?

However, even if the poor drafting of the SFTR does not provide an escape from its provisions, the regulation’s failure to recognise the essential fungibility of repurchase transactions and buy/sell-backs may have created hidden pitfalls for the market. Repurchase transactions are already problematic in jurisdictions with under-developed financial legal frameworks and inexperienced courts, which have a tendency to regard this type of repo as borrowing/lending rather than buying/selling, that is pledge-based rather than based on title transfer. Will the confusion underlying the SFTR’s definition amplify such re-characterisation risk?

Other problems may arise in due course from the unnecessarily complicated and obscure quality of the SFTR’s drafting. In the case of repurchase transactions, why is collateral further defined as “guaranteed rights relating to title to securities or commodities where that guarantee is issued by a recognised exchange which holds the rights to the securities or commodities and the agreement does not allow a counterparty to transfer or pledge a particular security or commodity to more than one counterparty at one time”. Do any exchanges hold securities or commodities and issue guarantees?

And why is collateral for a buy/sell-back defined differently, just as “guaranteed rights”?

It is also a mystery why the SFTR specifies an agreement for repurchase transactions that “does not allow a counterparty to transfer or pledge a particular security or commodity to more than one counterparty at one time”? That is “double-dipping”, in other words, fraud!

Finally, there is also curious requirement that the repurchase date for a repurchase transaction has to be specified by the seller rather than agreed between the parties. Why, oh why?