“The best trader I ever knew was broken when he took over a dying friend’s book. Everyone knew the book and turned on him.” Born in 1899, Henry Goldberg was the oldest trader on the floor of the New York Stock Exchange when I interviewed him in 1985. He answered my questions about trading expertise during an NYSE-sanctioned survey to find possible use cases for artificial intelligence.[1]
Mr. Goldberg told me that the trader’s counterparties squeezed him. They all knew his fails and shorts from the book that he inherited. After all, they were the friend’s counterparties. So they knew how to make the trader’s positions bleed out capital.
Trading has always been a hard business. So traders expect confidentiality from their brokers. But they also don’t want to be blindsided, as hedge funds were during the GameStop squeeze. Yet, unless the proposed 10c-1 disclosure rule is amended, the U.S. Securities and Exchange Commission is about to force traders to expose the details of their own short positions to the world.
Real damage may be inflicted on the U.S. market, borrowers’ trade associations told the SEC. Lawmakers have also weighed in. As a political matter, regulations which damage the most liquid markets in the world are inconsistent with the Biden administration's global ESG mandate. It seems inevitable that changes will have to be made to the 10c-1 disclosure regime.
Traders fear exposing the vulnerabilities of their open positions.
The 2010 Dodd-Frank Act directed the SEC to reveal the hidden leverage in shadow banking, especially in securities finance. For that reason, the SEC has proposed a broad mandate to disclose securities loans made to borrowers. At an estimated $375 million for the lenders to set up the 10c-1 disclosure system, the rule has been promoted as a benefit to borrowers.
Yet even with expenses covered by lenders, borrowers don’t like the proposed disclosures.
- We are strongly concerned that transaction-by-transaction financing data even in anonymized form would provide the market with sufficiently detailed information as to allow market participants to reconstruct and/or reverse-engineer investment and trading strategies, leading to situations similar to the GameStop and AMC market events. (Managed Funds Association, January 7, 2022)
- The Proposal creates a significant risk that our members’ investment strategies would be reverse-engineered [by] sophisticated market participants or data vendors [able to] ascertain with significant specificity what actions our members are taking. (Alternative Investment Management Association, January 7, 2022)
The growing sophistication of machine learning algorithms, today’s version of Artificial Intelligence, has taught traders to be wary of making security-specific disclosures while their positions remain open.
Intraday loan disclosures would be inaccurate.
Current market practices are based on a dynamic working relationship between lenders and borrowers.
- Publication of loan-by-loan data every 15 minutes could also be misleading because loans are not reconciled; the data is not simple enough to be adequately scrubbed and cleaned in this time frame. Individual loan characteristics are quite complex and certain key aspects of loans are not determined until they are batch-processed hours or days later. (Alternative Investment Management Association, January 7, 2022)
- Investors do not negotiate each transaction over the course of the day, but rather review overarching contractual terms infrequently as well as fees or rebates periodically based on broad trends in the supply and demand for specific securities, the credit risk of the entities, and other general market conditions. (Managed Funds Association, January 7, 2022)
Traders would accept a segmented and lagged system for public loan disclosures.
The initial SEC proposal divided the disclosure regime into public and regulatory segments. Traders have not rejected the regulatory disclosures and have suggested that public disclosures could be useful if limited to the ‘wholesale’ agent-broker level, but not to the ‘retail’ principal levels.
- Implementing rules governing transparency in the wholesale market would be beneficial because such a regime could create a low-cost, comprehensive and consistent data set that is available to all investors… a reporting regime published T+1 and based on aggregate, wholesale market loans and weighted averages would achieve the Commission’s transparency objectives more efficiently and with significantly better data quality. (Alternative Investment Management Association, January 7, 2022)
- We believe aggregate blended rate information that is disseminated on a weekly basis will be more useful information to investors without having adverse repercussions to other market segments. Similarly, aggregate trend information will better serve investors due to the non-fungible nature of the securities lending market. (Managed Funds Association, January 7, 2022)
A bad disclosure regulation could impair market liquidity.
The securities lending market is demand-driven, so borrowers’ concerns must be given great weight. A borrower concerned about risks from position exposure may pass up trading opportunities. If many borrowers become concerned, the market could lose those trades and liquidity would suffer.
Sophisticated traders may take their settlement requirements (“needs files”) to lending counterparties in the offshore, synthetic or even the crypto markets. As a result, on-shore trading costs could rise and cross-border linkages could cause systemic instabilities, all as unintended consequences of the proposed 10c-1 disclosure rule.
Ultimately, traders may avoid lenders who place their positions at risk. Over time, those lenders may leave the securities financing marketplace, further reducing liquidity. With fewer lenders, service providers may find their fixed costs rising beyond breakeven. They may also leave the marketplace.
Fair disclosure requires a balance of interests.
The global code of ethics driving the ESG movement, embodied in ‘Do Not Harm,’ does not exempt regulators. No rule should be a net negative to markets or else Society will be harmed.
A lagged, segmented disclosure regime should be considered by the SEC, perhaps limited as to the details and scope of loans subject to public disclosure. These are among amendments to the disclosure rule that might be acceptable to borrowers and still benefit the overall market.
Securities finance is a relationship-based market that likes translucency but will never support pure transparency.
[1] Henry Goldberg was skeptical about machine learning even before there was a name for it.
He believed that expert systems, i.e., Artificial Intelligence in the 1980s, would always fail because the programs couldn’t factor emotions into their decision tables.