Monday, April 18, 2022

SEC Gets an “Earful” on Securities Lending and Short-selling Disclosure Proposals

And Another Thing - Longer Comment Periods, Please

Author: David Schwartz J.D. CPA

The Securities and Exchange Commission's controversial securities lending disclosure proposal (Proposal) sought public input on 97 questions and received a substantial body of feedback during the initial 30-day comment period. Drawing sharp rebukes, most responses from trade associations for lenders and borrowers focused on the ambiguous scope of rule 10c-1, the feasibility of the proposed 15-minute reporting regime, lopsided cost and technology burdens, and the risks of reverse engineering posed by the public disclosure provisions. Acquiescing after a month of consideration to the desires of a host of commenters for more time to respond, the Commission extended the Proposal's comment period from January 7, 2022, to April 1, 2022.[1] The securities lending industry took advantage of the extra time to amplify prior criticisms and raise new issues with the Proposal, giving the SEC yet another earful. Advanced Securities Consulting and CSFME used the additional comment time to expand upon a comprehensive alternative to remedy the Proposal's weaknesses. 


Scope and Clarity

Commenters from across the industry said that the Proposal fails to provide securities lending market participants with clarity regarding the specific types of transactions subject to the rule 10c-1 disclosure regime. They also pointed out substantial uncertainty about the territorial scope of the 10c-1 reporting obligation. Commenters used the extended comment period to offer specific suggestions for narrowing the scope of the disclosure requirements. Citadel and the Alternative Investment Management Association (AIMA) pointed out that the rule 10c-1 proposal is overly-broad and sweeps into its ambit securities transactions made to fulfill delivery obligations arising from customer short-sales (referred to as "retail" securities lending in the release). Complicating matters further, the SEC's separate rule 13f-2, "Short Position and Short Activity Reporting Proposal," issued in February 2022, proposes to cover similar "retail" transactions. State Street requested that the Commission exclude GC securities from the final rule due to the fungibility of GC securities, saying, "[i]n our experience, the details of loan activity involving GC securities are unlikely to be of informational value to the market." 


Disclosure Contradictions

According to some commenters, the SEC's philosophy for short-selling disclosure seemingly contradicts its philosophy for securities lending disclosure. Citadel pointed out that the Commission's calculus for each of their respective proposed disclosure regimes is illogically inconsistent: 


"Importantly, ignoring all of these significant costs in favor of a transaction-by-transaction short sale public reporting regime contradicts the Commission's own reasoning in its recent rule proposal regarding 'Short Position and Short Activity Reporting by Institutional Investment Managers' (the 'Short Position Reporting Proposal'), which was issued after this Proposal and in which the Commission concluded that aggregate and delayed disclosure of short sale positions was preferable to transaction-by-transaction and intraday disclosure."


AIMA further hammered this point home by contrasting the Commission's "thoughtful" examination in the 'Short Position Reporting Proposal' of "the negative market impacts that can materialize from too much granular disclosure" against the Commission's failure to assess the similar effects in the context of securities lending. 


The Managed Fund Association took the Commission to task for the inconsistent reasoning in the two proposals as well.


"Even more troubling is that the economic analysis of the proposed loan disclosure rule purports to treat the public disclosure of loan by loan information as an unmitigated benefit to the short selling market, even though the Commission concluded the opposite in the proposed Short Position Disclosure Rule."


Deficient/Flawed Cost-Benefit Analysis 

Many comment letters, including our own, criticized the sufficiency and rigor of the Proposal's cost-benefit analysis. In the second round of letters, Citadel and former SEC Chief Economist James A. Overdahl, Ph.D., offered scathing critiques of the SEC's statutorily required cost-benefit analysis. Citadel went as far as pointing out that the Commission admits that the Proposal's analysis is deficient and that the SEC has merely waved away as impossible the real work of assessing the economic consequences of the Proposal. 


"By not quantifying the asserted deficiencies in existing data or any improvements that would be fostered by the proposed rule, the Commission has neglected its statutory duty to assess the economic consequences of the Proposal. The Commission admits that it has access to at least some securities lending data, but says that 'it is not practicable . . . to quantify certain economic effects' of the Proposal given the 'number and type of assumptions' that would be necessary. This is a notable shortcoming; the Commission admits that it did not make the type of 'tough choices about . . . competing estimates' that they Exchange Act requires the Commission to make, nor did it 'hazard a guess as to which is correct."


Former SEC Chief Economist and Director of the Office of Economic Analysis, James A. Overdahl, challenged the Proposal's foundational cost-benefit assumptions. Dr. Overdahl takes issue with the Commission's assumption that mandating disclosure in this context would positively affect the securities lending and short-selling markets. On the contrary, Dr. Overdahl says, "The effect of such rules on market quality is negative rather than positive, as traders adjust their behavior to avoid the adverse effects of disclosing their strategies." 


Dr. Overdahl also challenged the basis for the Commission's claims that the proposed rules would lower costs, stating that the Commission's reliance on TRACE studies as a model was inappropriate because secondary "bond market transactions are irrevocable and fungible." In contrast, securities lending transactions "are revocable and unique and more akin to primary market borrowing transactions." Consequently, any cost reduction predicted in the Proposal based on TRACE is simply inapplicable. Dr. Overdahl also points out recent empirical evidence that "is directly relevant to the proposed rule, and highlights some of the adverse effects that the proposed rule should be expected to have on the functioning of the stock lending market and on price discovery." 


Regulatory Arbitrage 

Dr. Overdahl says the Commission has failed to factor into the Proposal the potential consequences of regulatory arbitrage in the securities lending and short selling markets. Because of the lack of clarity around the Proposal's extra-territorial effect, other commenters may have overlooked this point as well. 


"The Commission's economic analysis contained in the Proposing Release treats the securities lending market in the United States as if it sits in isolation from the rest of the world. The analysis fails to account for the consequences associated with the fact that the securities lending market operates across several jurisdictions around the globe. A report from the International Organization of Securities Commissions ("IOSCO") describes the global growth of securities lending activity over many years and concludes that this growth has resulted in increased market competition and lower lending rates. In other words, the securities lending market in the United States does not sit in isolation from the rest of the world. The fact that the securities lending market operates across different jurisdictions is significant in understanding the economic impact of the proposed rule because it requires that the potential impact of regulatory arbitrage be considered. However, the potential consequences of regulatory arbitrage across jurisdictions are not addressed in the Proposing Release."


Cost Burden

State Street picked up on our earlier comments about lenders bearing the entire cost of compliance. It urged the Commission "to clarify in the final rule that the costs incurred by the RNSA to establish and operate the reporting system for securities lending transaction and related information should be equitably shared by borrowers and lenders, even if the actual reporting obligation remains single-sided."  


Longer Comment Periods, Please

The sheer volume of rule proposals issued by the SEC over the past year and a half, coupled with "serially short" comment periods, prompted a dozen securities industry groups to band together in a joint letter to petition the Commission to allow for sufficient time to respond meaningfully. The letter's authors cite the "roughly 3,570 pages and "roughly 2,260 individually identified questions" in fifteen open rule proposals issued in rapid succession. 


"Overlapping and serially short comment periods," the authors say, simply do not give the public "sufficient time for meaningful public input into individual proposals and more holistically on the Commission's rulemaking agenda and the possible interconnectedness of these proposals is vitally important and ultimately could have a significant impact on savers, investors, capital formation, and economic growth and job creation."


The joint letter urges the Commission to be mindful of the complexity of their rule proposals and their statutory responsibilities to solicit and consider public feedback and to tailor the lengths of comment periods accordingly. 




[1] In extending the rule 10c-1 proposal's comment period, the Commission also invited public comments on whether there would be any "effects of proposed Rule 13f-2 that the Commission should consider in connection with proposed Rule 10c-1."