Outreach Blog

Tuesday, November 30, 2021

Who Bears the Cost of the SEC's Securities Lending Disclosure Proposal?

The Winners and Losers in Mandatory Transparency


Author: David Schwartz J.D. CPA

The Securities and Exchange Commission (SEC) recently proposed a new reporting regime to increase transparency and efficiency in the securities-lending market. The SEC seeks to accomplish this by requiring anyone who loans a security on behalf of himself or another person to report material terms of those loans (and related information regarding the securities on loan) to a registered national securities association (RNSA), namely the Financial Industry Regulatory Authority (FINRA).  As we have discussed, the proposal is a sweeping change and a somewhat novel approach to bringing securities lending out of the dark. While the merits of the proposal's approach will no doubt be thoroughly scrutinized and debated, so too should its cost and who will bear that cost. 

 

The point of the SEC's proposal is to "supplement the publicly available information involving securities lending, close the data gaps in this market, and minimize information asymmetries between market participants." [1] While the potential benefits would seem to flow to all participants in the securities lending markets, the SEC's choice to place the reporting burden on lenders and their agents also burdens those loan participants (lenders particularly) with nearly the entire cost of compliance. 

 

Some gaps in the SEC's robust analyses.

 

The cost-benefit and economic analyses of a proposal are where the SEC attempts to quantify its reasoning process and reveal which aspects of the regulatory issue it has taken into account.[2] And since some regulations have been challenged successfully based on the quality of these analyses, the SEC takes care with them. But, the SEC found its assessments of this proposal hampered by some of the same siloed and incomplete data and opaque transaction chains the proposal seeks to remedy. 

 

"[B]ecause the Commission does not have, and in certain cases does not believe it can reasonably obtain, data that may inform the Commission on certain economic effects, the Commission is unable to quantify certain economic effects." [3] 

 

In other instances, like its analysis under the Paperwork Reduction Act, the Commission did not have data regarding the number of lenders, agents, or reporting agents as potential respondents and was forced to employ reports on Form N-CEN and other methods as proxies.[4] 

 

Despite these gaps in available data, the Commission concludes that the benefits of increased transparency in securities lending would be considerable, and would be supported by historical precedent. The Proposing Release cites the effect the introduction of TRACE (FINRA's Trade Reporting and Compliance Engine) had on the transparency and pricing efficiency of the corporate bond market as precedent for what could be in store for securities lending markets as a result of supplying market participants with better and more timely data.

 

"The Commission preliminarily believes that the proposed Rule would result in increased transparency in the securities lending market by making available the public portion of new 10(c)-1 information, which is more comprehensive than existing data, and by making such data available to a wider range of market participants and other interested persons than currently access existing data. This effect could be similar to what was observed with the implementation of TRACE in corporate bonds." [5]

 

Studies of the various implementation phases of the TRACE system provide some valuable evidence that mandatory transparency in financial market design can, indeed, increase market efficiency and reduce overall transaction costs.  

TRACE Figure 2 Weekly 7-Day Trading Cost per Round-trip Trade by Phase. Source: [6]

 

 

The proposed regime has a free-rider problem. 

 

In spite of the expected benefits, the start-up and ongoing costs are estimated to be considerable. But the proposed system also has a free-rider problem. As stated above, the bulk of the costs would be borne by lenders and agents, while the benefits of the new transparency would flow to all participants in the securities loan transaction chain. The Commission estimates that startup costs payable by just 409 lenders and agents could total $375 million, with ongoing annual costs of compliance totaling $140 million. 

 

Table [2]: Total Quantified Compliance Costs

 

It is true that the RNSA (i.e., FINRA) would incur some costs in establishing and maintaining both the methods of data collection from lenders and agents as well as the infrastructure necessary to make that data available for free to the public. The Commission, however, anticipates that even these charges will be "recouped by the RNSA from market participants who report securities lending transactions to the RNSA" (again, the lenders and agents).[7] In fact, the Proposing Release suggests that the RNSA could itself ask for permission to onsell this transaction information to other vendors (who, in turn, would sell performance metrics and analytics based on the data to market participants like lenders).[8] 

 

Lenders bear the ultimate cost. 

 

If Rule 10c-1 is adopted, FINRA will pass compliance costs through fees to lenders and agents. Lending agents, in turn, will pass the costs of compliance through to their lending clients. Most beneficial owners participate in securities lending to generate marginal income. If lenders are forced to bear the final cost of compliance with Rule 10c-1, they may find their margins so thin that they can no longer justify their lending activities, pulling their liquidity from the market. In addition, with the lenders dependent upon their agents for reporting to the RNSA, it could make it more difficult for lenders to switch agents. This inability to move between agents could weaken lenders' positions when negotiating fees with their agents. The SEC acknowledges each of these potential outcomes in its proposal in passing as "indirect costs," and indicates that they are mitigated by other factors like the increased competition between lending programs and between broker-dealers resulting from better access to information.[9] 

 

Cui bono? 

 

The compliance costs of the SEC's Rule 10c-1 proposal fall squarely on the shoulders of lenders. Will the added transparency and potential transaction cost savings promised by the proposal be worth those costs? If lenders are to benefit from this new transparency, they must realize some appreciable economic gains or material cost reductions to defray shouldering the entire compliance burden. 

 

 

 


 

 

[1] Rule 10c-1 Proposing Release, p. 10. 

 

[2] According the D.C. Circuit the agency must "apprise itself—and hence the public and the Congress—of the economic consequences of a proposed regulation before it decides whether to adopt the measure."

 Chamber of Commerce v. SEC, 412 F.3d 133, 144 (D.C. Cir. 2005)

 

[3] Rule 10c-1 Proposing Release, p. 105;  

 

[4] Rule 10c-1 Proposing Release, pp. 79 et seq. 

 

[5] Rule 10c-1 Proposing Release, p. 106.

 

[6] Asquith, Paul and Covert, Thomas and Pathak, Parag A., The Effects of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market (April 8, 2019). Available at SSRN: https://ssrn.com/abstract=2320623 or http://dx.doi.org/10.2139/ssrn.2320623

 

[7] Rule 10c-1 Proposing Release, p. 69; see also p. 72

"To fund the reporting and dissemination of data provided pursuant to this Rule, the Commission is proposing paragraph 10c-1(h), which would reflect that the RNSA has authority under Exchange Act Section 15A(b)(5) to establish and collect reasonable fees from each person who provides any data in proposed paragraphs (b) through (e) of proposed Rule 10c-1 directly to the RNSA."

 

[8] Rule 10c-1 Proposing Release, at note 119

 

[9] "This may pose indirect costs on these broker-dealers' and lending programs' customers. Such costs would include the cost of switching to a new broker-dealer or lending program, the loss of potentially more suitable options for such services if the exiting entity was highly specialized, and potentially higher prices associated with reduced competitive pressures." Rule 10c-1 Proposing Release, p. 146.  See also p. 149 et seq

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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



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