Outreach Blog

Monday, April 18, 2022

SEC Gets an “Earful” on Securities Lending and Short-selling Disclosure Proposals

And Another Thing - Longer Comment Periods, Please


Author: David Schwartz J.D. CPA

The Securities and Exchange Commission's controversial securities lending disclosure proposal (Proposal) sought public input on 97 questions and received a substantial body of feedback during the initial 30-day comment period. Drawing sharp rebukes, most responses from trade associations for lenders and borrowers focused on the ambiguous scope of rule 10c-1, the feasibility of the proposed 15-minute reporting regime, lopsided cost and technology burdens, and the risks of reverse engineering posed by the public disclosure provisions. Acquiescing after a month of consideration to the desires of a host of commenters for more time to respond, the Commission extended the Proposal's comment period from January 7, 2022, to April 1, 2022.[1] The securities lending industry took advantage of the extra time to amplify prior criticisms and raise new issues with the Proposal, giving the SEC yet another earful. Advanced Securities Consulting and CSFME used the additional comment time to expand upon a comprehensive alternative to remedy the Proposal's weaknesses. 

 

Scope and Clarity

Commenters from across the industry said that the Proposal fails to provide securities lending market participants with clarity regarding the specific types of transactions subject to the rule 10c-1 disclosure regime. They also pointed out substantial uncertainty about the territorial scope of the 10c-1 reporting obligation. Commenters used the extended comment period to offer specific suggestions for narrowing the scope of the disclosure requirements. Citadel and the Alternative Investment Management Association (AIMA) pointed out that the rule 10c-1 proposal is overly-broad and sweeps into its ambit securities transactions made to fulfill delivery obligations arising from customer short-sales (referred to as "retail" securities lending in the release). Complicating matters further, the SEC's separate rule 13f-2, "Short Position and Short Activity Reporting Proposal," issued in February 2022, proposes to cover similar "retail" transactions. State Street requested that the Commission exclude GC securities from the final rule due to the fungibility of GC securities, saying, "[i]n our experience, the details of loan activity involving GC securities are unlikely to be of informational value to the market." 

 

Disclosure Contradictions

According to some commenters, the SEC's philosophy for short-selling disclosure seemingly contradicts its philosophy for securities lending disclosure. Citadel pointed out that the Commission's calculus for each of their respective proposed disclosure regimes is illogically inconsistent: 

 

"Importantly, ignoring all of these significant costs in favor of a transaction-by-transaction short sale public reporting regime contradicts the Commission's own reasoning in its recent rule proposal regarding 'Short Position and Short Activity Reporting by Institutional Investment Managers' (the 'Short Position Reporting Proposal'), which was issued after this Proposal and in which the Commission concluded that aggregate and delayed disclosure of short sale positions was preferable to transaction-by-transaction and intraday disclosure."

 

AIMA further hammered this point home by contrasting the Commission's "thoughtful" examination in the 'Short Position Reporting Proposal' of "the negative market impacts that can materialize from too much granular disclosure" against the Commission's failure to assess the similar effects in the context of securities lending. 

 

The Managed Fund Association took the Commission to task for the inconsistent reasoning in the two proposals as well.

 

"Even more troubling is that the economic analysis of the proposed loan disclosure rule purports to treat the public disclosure of loan by loan information as an unmitigated benefit to the short selling market, even though the Commission concluded the opposite in the proposed Short Position Disclosure Rule."

 

Deficient/Flawed Cost-Benefit Analysis 

Many comment letters, including our own, criticized the sufficiency and rigor of the Proposal's cost-benefit analysis. In the second round of letters, Citadel and former SEC Chief Economist James A. Overdahl, Ph.D., offered scathing critiques of the SEC's statutorily required cost-benefit analysis. Citadel went as far as pointing out that the Commission admits that the Proposal's analysis is deficient and that the SEC has merely waved away as impossible the real work of assessing the economic consequences of the Proposal. 

 

"By not quantifying the asserted deficiencies in existing data or any improvements that would be fostered by the proposed rule, the Commission has neglected its statutory duty to assess the economic consequences of the Proposal. The Commission admits that it has access to at least some securities lending data, but says that 'it is not practicable . . . to quantify certain economic effects' of the Proposal given the 'number and type of assumptions' that would be necessary. This is a notable shortcoming; the Commission admits that it did not make the type of 'tough choices about . . . competing estimates' that they Exchange Act requires the Commission to make, nor did it 'hazard a guess as to which is correct."

 

Former SEC Chief Economist and Director of the Office of Economic Analysis, James A. Overdahl, challenged the Proposal's foundational cost-benefit assumptions. Dr. Overdahl takes issue with the Commission's assumption that mandating disclosure in this context would positively affect the securities lending and short-selling markets. On the contrary, Dr. Overdahl says, "The effect of such rules on market quality is negative rather than positive, as traders adjust their behavior to avoid the adverse effects of disclosing their strategies." 

 

Dr. Overdahl also challenged the basis for the Commission's claims that the proposed rules would lower costs, stating that the Commission's reliance on TRACE studies as a model was inappropriate because secondary "bond market transactions are irrevocable and fungible." In contrast, securities lending transactions "are revocable and unique and more akin to primary market borrowing transactions." Consequently, any cost reduction predicted in the Proposal based on TRACE is simply inapplicable. Dr. Overdahl also points out recent empirical evidence that "is directly relevant to the proposed rule, and highlights some of the adverse effects that the proposed rule should be expected to have on the functioning of the stock lending market and on price discovery." 

 

Regulatory Arbitrage 

Dr. Overdahl says the Commission has failed to factor into the Proposal the potential consequences of regulatory arbitrage in the securities lending and short selling markets. Because of the lack of clarity around the Proposal's extra-territorial effect, other commenters may have overlooked this point as well. 

 

"The Commission's economic analysis contained in the Proposing Release treats the securities lending market in the United States as if it sits in isolation from the rest of the world. The analysis fails to account for the consequences associated with the fact that the securities lending market operates across several jurisdictions around the globe. A report from the International Organization of Securities Commissions ("IOSCO") describes the global growth of securities lending activity over many years and concludes that this growth has resulted in increased market competition and lower lending rates. In other words, the securities lending market in the United States does not sit in isolation from the rest of the world. The fact that the securities lending market operates across different jurisdictions is significant in understanding the economic impact of the proposed rule because it requires that the potential impact of regulatory arbitrage be considered. However, the potential consequences of regulatory arbitrage across jurisdictions are not addressed in the Proposing Release."

 

Cost Burden

State Street picked up on our earlier comments about lenders bearing the entire cost of compliance. It urged the Commission "to clarify in the final rule that the costs incurred by the RNSA to establish and operate the reporting system for securities lending transaction and related information should be equitably shared by borrowers and lenders, even if the actual reporting obligation remains single-sided."  

 

Longer Comment Periods, Please

The sheer volume of rule proposals issued by the SEC over the past year and a half, coupled with "serially short" comment periods, prompted a dozen securities industry groups to band together in a joint letter to petition the Commission to allow for sufficient time to respond meaningfully. The letter's authors cite the "roughly 3,570 pages and "roughly 2,260 individually identified questions" in fifteen open rule proposals issued in rapid succession. 

 

"Overlapping and serially short comment periods," the authors say, simply do not give the public "sufficient time for meaningful public input into individual proposals and more holistically on the Commission's rulemaking agenda and the possible interconnectedness of these proposals is vitally important and ultimately could have a significant impact on savers, investors, capital formation, and economic growth and job creation."

 

The joint letter urges the Commission to be mindful of the complexity of their rule proposals and their statutory responsibilities to solicit and consider public feedback and to tailor the lengths of comment periods accordingly. 

 

 

 

[1] In extending the rule 10c-1 proposal's comment period, the Commission also invited public comments on whether there would be any "effects of proposed Rule 13f-2 that the Commission should consider in connection with proposed Rule 10c-1."

Print

The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



Home