Outreach Blog

Monday, December 13, 2021

“Wisely and Slow; They Stumble that Run Fast.”

Finding a Better Value Proposition for the SEC's Sec Lending Disclosure Rule


Author: David Schwartz J.D. CPA

The SEC has proposed a radical and potentially very costly reporting regime for securities finance transactions to increase transparency "to brokers, dealers, and investors." Notably, the rule release's[1] extensive economic analysis section includes some potential alternatives to the proposed new reporting structure. While there is no requirement for the Commission to discuss or examine the economic effects of regulatory alternatives[2], in this case, they have presumably listed these particular options to focus potential commenters on specific ideas they want explored.

 

By merely posing these potential alterations without further discussion, the proposal seemingly outsources the economic analysis of its suggested alternatives to industry commenters. Also, by doing so, the Commission has hinted it is interested in hearing about well-supported alternatives, and may even be inviting counter-proposals.  The alternatives offered by the Commission to its proposal fall into four broad categories:

  1. Options for the timing and scope of reporting and the extent of public disclosure;
  2. Alternatives for who is responsible for reporting;
  3. Alternatives to the entity to whom reports are made (i.e., RNSA, the Commission, or an NMS Plan entity); and
  4. The data holding period and financing options for RNSAs. [3]

 

In addition to these options, the Commission has posed 97 questions on every aspect of their proposed reporting and disclosure regime, including mechanics, potential costs, and benefits. An effective industry counter-proposal will have to be responsive to those questions, address the same disclosure aims as Rule 10c-1, and fall within the scope of the options the Commission has said it is open to considering. 

 

Lenders Should have their Say. 

 

Lenders bear the ultimate costs of implementing and maintaining the proposed 10c-1 disclosure regime. Modifying the proposal to increase the benefits lenders take from 10c-1 would be a fairer trade-off for the regulatory expenses they bear and perhaps offset to some extent the unfair distribution of compliance costs. Surely those who shoulder the brunt of the regulatory cost but little of the benefit of mandatory transparency are entitled to propose alterations of or alternatives to the proposed 10c-1 plan that may balance the benefits a little more or distribute the costs more equitably. 

 

Making Mandatory Transparency More Valuable to Lenders

 

The information disclosed under rule 10c-1 would be too limited to provide much additional value to lenders. The data collected by an RNSA would not be sufficient to build peer groups for performance measurement and is not granular enough to assist with counterparty credit risk management. Lenders currently pay data providers and consultants for these metrics in exchange for their transaction data. One option that meets the transparency aims of Rule 10c-1 while simultaneously increasing the benefit to lenders is to expand the scope of data reported for each lending transaction. At first blush, that may sound even more burdensome. But, if lenders could pool their data for their own uses while still meeting their obligations under Rule 10c-1, they could:

  1. stop paying data providers to aggregate and analyze their data,  
  2. use the pooled data to do end-to-end mapping,
  3. generate reliable proxy voting metrics
  4. create peer groups for performance metrics,
  5. employ the mapped data to integrate ESG strategies into their securities lending programs, and 
  6. validate the bona fides of their cross-border lending transactions

 

The potential reductions in the costs associated with counterparty risk alone would be valuable enough to lenders to make this option worth financing and pursuing. Once a competitive feature offered by lending agents, bank capital charges have made borrower default indemnification an add-on, with the premiums paid by the lenders

 

“Wisely and slow; they stumble that run fast.” [4]

 

With a 30-day comment period, the industry is working with one hand tied behind its back. Robust analysis takes time. And less than a month before the proposal's comment period closes, the industry groups representing the securities lending industry's biggest players have already petitioned the SEC for more time. 

 

"Given the breadth of the vast new requirements proposed for the securities lending markets and the potential costs that they may impose on a broad range of participants in these markets, the Commission by providing only a 30-day comment period does not afford the public enough time to properly evaluate the Proposal." [5]

 

The Commission has indicated that it is open to alternatives. Lenders and agents can make a case for a more evenhanded distribution of costs and benefits that still achieves the Commission's regulatory aims without a radical rewrite of Rule 10c-1. However, because the SEC's rule 10c-1 proposal has outsourced the economic analysis of alternatives to the industry, we will need a little more time to make the case.  

 


[1] Reporting of Securities Loans, Rel. No. 34-93613, 86 Fed.Reg. 69802 (proposed November 18, 2021),(codified at 17 CFR 240). ("Proposing Release"). 

 

 

[2] Executive Order (EO) 12866 states that agencies should assess the costs and benefits of regulatory alternatives. However, as an independent regulatory agency, the Commission is not legally bound by the requirements of EO 12866. Nonetheless, in some rule proposals, the Commission has discussed the costs and benefits of proposed alternatives. 

 

[3] Proposing Release, 86 Fed.Reg. 69802, at 69845-50

 

[4] William Shakespeare, Romeo and Juliet, Act 2, scene 2.

 

[5] The Securities Industry and Financial Markets Association, The SIFMA Asset Management Group, The Risk Management Association, The Managed Funds Association, The Investment Company Institute, The Investment Adviser Association, and The Security Traders Association, November 23, 2021, https://www.sec.gov/comments/s7-18-21/s71821-9402961-262828.pdf 

See also, Chris Iacovella, Chief Executive Officer, American Securities Association, December 2, 2021; and John L. Thorton, Co-Chair, Hal S. Scott, President, R. Glenn Hubbard, Co-Chair, Committee on Capital Markets Regulation, December 6, 2021. 

 

 

 

 

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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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