Friday, September 24, 2021

Reddit Trading and Resilience in U.S. Equity Finance

Part 4. ESMA expands short sale disclosures and rules for borrower locates

Author: Ed Blount


Short selling

Paris, September 24, 2021 - The next shoe has fallen in reaction to the January 2021 GameStop short squeeze, by which certain online brokers interpreted clearinghouse rules to necessitate the suspension of their retail customers’ ability to buy “meme stocks”. Today, the European Securities Markets Authority (ESMA), citing SEC and EU data for January 2021 on suspiciously high levels of failed meme stock settlements, asked for public comment on rule changes to avoid future short squeezes in the EU. This ESMA consultation on systemic risk management will surely propel industry leaders to advance their previously-announced plans for a block-chained securities market infrastructure to add even more robust operating and disclosure protocols. [1]

ESMA, observing that the settlement fails “could be due to uncovered short selling and failure to comply with the locate rule,” has proposed a requirement for short sellers to secure stronger third party commitments for shares available to borrow (“locates”) and to retain a rich range of details on those locate confirmations for at least five years. As proposed, ESMA will require that “locate arrangements adequately address the risk of non-delivery at the settlement date, and not just provide a ‘reasonable expectation’ that settlement can be made when it is due.” The SEC has not commented publicly on the possibility of Reg SHO locate violations during the meme stock frenzy.

Smart contracts on settlement blockchains can satisfy all of ESMA’s proposed rule changes, so long as designers at member firms can adapt their legacy enterprise systems to interface with the shared online ledgers that will be needed for the new T+1 and ESG-validated infrastructure. [2] If the SEC concurs with ESMA’s views on existing locate and short sale rule deficiencies, then IOSCO may recommend similar rules for its membership. Therefore, global service providers should take note of the proposed ESMA rule changes in their system development plans.

We answer “Yes,” in response to ESMA’s question #10: “Do you agree with introducing a five-year-long record-keeping obligation for locate arrangements?” Moreover, we believe that a cross-border, voluntary compliance (XBC) blockchain could include a field enabling a smart contract to record the locate as a contractual-match of the short-sellers’ need files to the availability files from an agent-lender or custodian bank. Although loan contract matches are conducted today before bilateral settlements by primes and agents on an aggregated, daily basis, the acceptance of DLT as practical means that borrowers and lenders could be matched at the account level through a link to the global XBC. As a practical matter, the DLT solution will depend on the prime broker’s ability to guide the locate sourcing from external lenders to those of its customers holding preferential, or even exclusive borrowing contracts with the same group of lenders. However, if possible, such an account-level linkage can also be used to validate the legitimacy of cross-border, dividend-record-date loans to the satisfaction of EU tax auditors responding to reports of suspected WHT abuses.

Part 1: Risk Mitigation Dynamics of the U.S. Clearing and Settlement Systems
Part 2: Heated Debates Begin about Trading Suspensions
Part 3: Real-time in GameStop: Realistic, ask Operations Experts?

[1] The DTCC has announced that the clearinghouse would develop a distributed ledger system in order to move from T+2 settlement to T+1. On January 29, 2021, the SEC promised a robust public comment period on infrastructure changes. Third, NSCC said the central clearing system would be extended to net out overnight equity financing trades that are submitted to their new SFT clearing system on a paired and locked-in basis. Now, ESMA’s proposal for rule changes has linked the failed settlements to weak locate rules in both the U.S. and E.U. short sale rules. Included in their March 2 examination priorities, the SEC announced that the SEC's investigators would be scrutinizing mutual fund ESG policies and disclosures.

[2] DTCC’s announcement of DLT-based settlement on T+1, noted in FN 1 above, is a game-changing development for securities finance managers. Legacy systems at member firms will have to coordinate the disclosures to achieve loan mapping on an end-to-end basis.