Saturday, January 22, 2022

Lenders and Borrowers Sound off on the SEC's Disclosure Proposal

Giving the SEC an Earful and Sounding the Alarm

Author: David Schwartz J.D. CPA

The Securities and Exchange Commission's (SEC) securities lending disclosure proposal has drawn sharp rebuke from both securities lenders and borrowers. Lending principals criticized the proposal on everything from cost, lack of clarity, and overbroad scope to the rule's general inequity. They also warned of a host of potential unintended consequences that could work against the very transparency the rule proposal was intended to foster. Some of the highlights are summarized below. 


Cost v. Benefits to Lenders


Lenders, who bear would bear the ultimate costs of the proposal, objected strongly to paying the proposal's steep price tag. They also objected to shouldering the burden of the rule's disclosures while enjoying almost none of the benefits, potentially driving lenders from the market:


". . . these costs ultimately will come directly out of the pockets of beneficial owners, including funds and their shareholders, to the detriment of their long term interests. Such costs may result in higher costs to administer a securities lending program or the potential decision by a fund that it no longer is economically worthwhile to operate a securities lending program, in either case lowering fund returns for shareholders." [1]


The proposed benefits of the rule postulated by the Commission, lenders say, also holds little use for anyone but the regulators:


"The potential benefits the SEC identifies appear to be speculative, at best, and it is fundamentally unclear from the Commission's analysis who, other than FINRA and the SEC, will clearly benefit from reporting of this data." [2]


However, in our comment letter, we pointed out that the data the SEC proposed to be collected would be of little help even to regulators. 


". . . even the elements proposed to be collected by rule 10c-1 are simply insufficient for effective regulatory market surveillance. The kind of market transparency contemplated by the Proposal, while potentially helpful to investors, would not have revealed to regulators the perilous risk-concentration in the Archagos situation."


Technology Burden on Lenders and Agents


The Risk Management Association  said that adopting 15-minute reporting for securities loans as proposed would require a wholesale rework of data collection and reporting systems for lenders and their agents.


"Real-time loan reporting would: (1) require each reporting institution to build fully-automated data capture and reporting systems; (2) limit flexibility around data capture and aggregation; (3) exponentially multiply the volume of reports generated; and (4) place high demands around the process and timing for data validation and reconciliation."


As Fidelity warned, lenders' technology resources and personnel are under pressure to move to T+1 settlement and implement other regulatory initiatives already in process. Adding rule 10c-1 to the mix would further stress lenders' resources and personnel.


"When finalized, a wide range of market participants will use technology resources to develop and code new and existing processes to implement rulemaking on securities lending transparency. These technology resources are already subject to heavy workloads due to a wide range of regulatory rulemakings currently under, or soon subject to, implementation including but not limited to, the Consolidated Audit Trail, anticipated industry move to T+1, and the requirements associated with the Commission's rule for use of derivatives by investment companies and fund of fund arrangements."


Overly Broad Scope 


Commenters across the board were in general agreement that the scope of the proposed rule was entirely too broad and posed an unintended risk to securities lending. Some suggested limiting the final rule's coverage to loans of U.S. traded equities only. [cite] Borrowers and some lenders indicated that the final rule should only apply to "wholesale" securities loans, that is, traditional securities loans with two counterparties governed by a securities lending contract. 


"In our view, only traditional securities lending market trades (i.e., transactions whereby a lender lends securities to a borrower in exchange for collateral but excluding repurchase transactions where the purpose of the trade is to provide cash financing in exchange for non-cash collateral) made on behalf of a U.S.-lender (including U.S. domiciled lending funds and accounts and entities subject to U.S. broker-dealer registration requirements)should be in scope for the rule." [3]


Reporting "Retail" loans, they said would "would effectively become a proxy for disclosure of actual short-selling activity and short positions. Such disclosure would, in turn, increase the costs and risk associated with engaging in short selling." [4] 


Frontrunning Risk


Hedge funds and other alternative investment companies warned that the overly broad and detailed disclosure regime proposed by the SEC would subject hedge funds to the real risk of front running. The Alternative Investment Management Association, representing hedge funds and other alternative funds, said:


"In addition, the proposal creates a significant risk that our members' investment strategies would be reverse-engineered. Our members tend to borrow from a limited number of broker-dealers, which are publicly disclosed in Form ADV. Rates also tend to correlate with both the size and type of investor involved in the transaction. Armed with this information and real-time transaction data, as contemplated in the proposal, sophisticated market participants or data vendors may be able to ascertain with significant specificity what actions our members are taking. Even in anonymized form, these disclosures, specifically regarding the securities fee or rate and the class of borrower, would reveal a  significant amount about the actions of individual market participants, an outcome not acknowledged in the proposal."


The Managed Fund Association echoed this concern, saying that the proposal would encourage and perpetuate GameStop frenzies rather than prevent them:


"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."


A Host of Other Objections 

Securities lending lenders and borrowers gave the Commission quite a lot to think about as the SEC staff formulates a final rule. Given the reactions that were hastily put together during the short 30-day comment period, many are hoping that the strong reactions will prompt the Commission to open the comment period again. The industry has just scratched the surface in providing answers to the proposal's 97 questions. 

[1] Investment Company Institute, p. 10


[2] Investment Company Institute, p. 9


[3] Blackock, Inc.,  p. 2

Blackrock also suggested a further reduction in scope: 


"Non-market trades such as reallocations of existing market loan opportunities by lending agents to different in-scope lending funds and accounts within their lending programs should be excluded as a reportable loan modification. Additionally, as securities lending market dynamics differ by the asset class, we recommend the Commission provide further clarity on which asset classes are in scope."


[4] Managed Fund Association, p. 2