What is LDV ?

Who benefits from LDV?

LDV benefits all participants in the securities finance industry.  Lenders are better able to exercise their corporate governance responsibilities and, since lenders recall fewer loans, overall securities lending volume and revenue increase.  Loan, borrow, and collateral portfolios are more stable, allowing agents and brokers to more effectively manage investment, counterparty, and operational risks.  Corporate issuers receive more proxy votes from long-term investors, allowing them to reach quorum more quickly and at lower cost, and counterbalance votes of short-term activists.  Higher loan volumes also improve financial market liquidity and price discovery.

 

What is Lender-Directed Voting, or LDV?

LDV is a new process that matches securities lenders' loaned shares to broker securities that would otherwise go unvoted, enabling lenders to direct proxies without recalling loans.  It substantially improves existing market practices, which require lenders to recall loan in order to vote proxies.  Recalls are inefficient in that they reduce overall lending and borrowing revenue, and create instability in loan, borrow, and collateral portfolios. 

Why haven't lenders voted on loaned shares in the past?

Historically, institutional securities lenders had to forgo voting rights on loaned shares because there was no mechanism to vote without recalls.  Recent technology and transparency improvements in securities finance markets, however, enable loaned shares to be matched with broker shares that would otherwise go unvoted.  In particular, the Agent Lender Disclosure Initiative made apparent the direct counterparty relationship between lenders and broker-borrowers and provided brokers with detailed loan data necessary to include lenders in their proxy allocation routines.

Are there enough unvoted shares to cover lender voting interest?

Approximately 60 billion U.S. equities go unvoted each year[1], while roughly 15 billion shares are on loan[2], suggesting that sufficient votes could be available to meet lender vote demand.  However, it is unlikely that lender voting interest will be fully covered for all issues, such as those with particularly contentious proxy events or that are hard-to-borrow in securities lending markets. 

[1] www.broadridge.com/investor–communications /us/Broadridge_Proxy_Stats_2010.pdf
[2] Data from RMA securities lending composite, assuming $20 average stock price

Does the broker have the lender’s shares on the proxy record date?

1.  U.S. Federal Reserve Regulation T (“Reg T”) defines the permitted purposes for the extension of credit in the borrowing and lending of securities. In general, all of these purposes involve settling trades through re-delivery of the borrowed securities. Most often, the broker’s need to borrow has arisen after failing to receive securities required for an impending trade settlement, either as the result of an operational breakdown or after a short sale.

2.  Given the broker-borrower’s mandatory compliance with Reg T, it can be argued that borrowed shares, which are re-delivered in the settlement of a trade, are not available on the broker’s books (as a technical matter, the position would be held at DTCC) in order to earn voting rights on the proxy record date. However, this argument would only be true per se if the settlement took place on the proxy record date, because an analysis of the ongoing process reveals that the proxy votes, not just the entitled shares, are properly treated as fully fungible on the broker-borrower’s books.

3.  Reg T does not require that the borrowed shares be returned to the original lender when a subsequent receipt of securities is used to offset the original failure-to-receive. At that point, the borrower can certainly return the securities to the original lender. Yet, an active borrower can also compliantly decide to close a loan of the same securities with a different institutional lender whose terms may have become less attractive or from another broker-dealer lender who may be viewed as more likely to recall shares at an inconvenient time in the future, especially if the shares were borrowed for an ongoing short position. Still another reason may exist to hold the securities if the broker considers the return on its cash collateral, received through a rebate from the lender, to be very attractive compared with other investment options. In all those cases, as well as for actively traded issues where there may be a high risk of ongoing settlement failures, the broker can simply keep the newly-received shares in its inventory, balanced against its obligation to the lender.

4. As a result of efficient management of its settlement obligations, a broker – perhaps all brokers – may well have borrowed positions on their books on proxy record dates. The brokers would have gained the right to assign proxies or even to vote at the next corporate meeting as a direct result of the original loans from institutional lenders. In effect, the proxies are fungible on the brokers’ books, along with the borrowed shares themselves subject, of course, to an equitable assignment of proxy rights in compliance with stock exchange rules. Yet, brokers are not expressly permitted to assign proxies to their institutional lenders. At this point, the Lender Directed Voting (“LDV”) argument gains relevance and substance.

5. As noted, in addition to holding the shares cum voting rights, the broker also retains an obligation to its original lender. Indeed, one could argue that an institutional lender's ownership rights are stronger than those of other “beneficial owners” to whom the broker owes shares in the same securities. That is partly due to the distinction that can be drawn between the institutional lenders, who do not receive proxy assignments, and the broker’s own margin customers and hedge fund clients, who do receive proxy assignments. The distinction resides in the timeline of their property rights: the former owned the shares fully prior to lending them to the broker, while the latter required broker-financing in order to acquire their positions. Although we have seen that the institution’s shares may now be on the broker’s books, it is very likely that the financing customers’ shares are out on loan, i.e., hypothecated as collateral to source the broker’s own funding needs. And, in such cases, those positions are truly not in the brokers’ DTC account, although the brokers may well be assigning proxy rights to their accountholders. One can ably argue that those proxies would more equitably be assigned to the institutional lenders.

How can lenders instruct broker shares?

Brokers administer proxy allocation routines to distribute proxies to their customers.  Since broker shares are held in fungible bulk and lenders have beneficial ownership to loaned shares, brokers can include lenders in their allocation routines.  After brokers allocate proxies to lenders, standard proxy processes are followed to garner and submit voting instructions and submit them to corporate issuers.  For example, proxies are assigned to Broadridge accounts designated for the lenders, then are instructed by lenders or ISS on the lenders' behalf.

Could lenders also instruct custodians' unvoted shares?

Regulatory and operational considerations may pose challenges to matching custodians' unvoted shares with lenders’ loan positions.  In particular, custodian shares are not held in fungible bulk, as are broker shares, which presents difficulties when considering custodial allocation of proxies across lender accounts. Furthermore, custodians are not counterparties on loans, so the lenders are not beneficial owners to any of the custodians’ unvoted shares.

Does LDV contribute to “over-reporting,” since lenders’ shares were delivered to new buyers who now have the associated voting rights?

Existing proxy reconciliation processes are sufficient to address any potential "over-reporting" issues.  For example, brokers already use post-reconciliation processes to mitigate the risk of over-reporting that may arise from assigning proxies to margin customers whose shares may have been loaned or rehypothecated.

How do brokers decide which lender(s) are assigned proxies?

Beneficial owners and regulators have expressed concerns about voting opportunities being directed to preferred lenders or leveraged for beneficial loan terms.  In the same way that agent lending queues are designed so that lenders get equitable access to borrower demand, brokers need pre-defined and algorithmic “proxy queues” to ensure equitable assignment of voting opportunities.  Furthermore, on-going auditing and validation of proxy assignments may be needed to ensure against development of a “market for votes.” 

What if proxies are not available from a lender's borrower, but are from another broker?

Reallocation of the loans to brokers with available proxies would increase overall lender voting opportunities.  However, numerous other loan factors would need to be taken into account, such as counterparty risk assessments and credit limits, loan prices, and collateral types and quantity.  Considering these factors, loan reallocations may not be in the overall best interest of lenders and borrowers, and will have to be considered on a case-by-case basis.

How can lenders know, before record date, how many proxies they will be assigned?

To the extent that lenders receive proxies through LDV, they will not have to recall loans to regain voting rights.  However, broker holdings change daily and varying numbers of investors vote, so the number of proxies that can be assigned to lenders cannot be known with certainty until just before the meeting date, which is typically two months after lenders must make record date recall decisions.   The number of available proxies must therefore be forecasted, taking into account factors such as each broker's customer base, the scarcity of shares in the securities lending market, and the expected materiality of proxy ballot items.

Corporate Governance Blog

Sunday, February 26, 2017

Fintech Poised to Create a New Financial World

IOSCO Report Looks at Intersection of Fintech and Financial Regulation


Author: David Schwartz J.D. CPA

“Fintech,” or financial technology," is a term that seems to be on everyone's lips these days, from bankers to global finance ministers.  Dramatic advances in computing power, speed, interoperability, and nearly instantaneous internet communication are changing the ways banks, brokers, and other financial institutions relate to their customers, investors, regulators, and each other. But what do these changes mean to the future of financial markets and regulation?  In February 2017, the International Organization of Securities Commissions (IOSCO) published a document that ambitiously charts the bewildering array of fintech innovations and describes how these innovations are beginning to intersect with securities markets regulation. Based on industry surveys, the report looks at the most important technological innovations affecting global finance and makes some observations about regulatory responses.

IOSCO based its study on a series of three surveys conducted by the organization’s various committees eliciting responses from financial firms spanning the globe.  The resulting data led IOSCO to examine fintech trends in five different areas:

  1. alternative financing platforms
  2. retail trading and investment platforms,
  3. institutional trading platforms,
  4. distributed ledger technologies, and
  5. the effects of fintech on emerging markets.

 

Alternative Financing Platforms

IOSCO believes that one of the more notable developments in recent years has been a trend toward disintermediation and the emergence of online alternative financing platforms, particularly peer-to-peer (P2P) lending and equity crowd funding (ECF). P2P lending employs technology to put vastly more borrowers and lenders in direct contact.[1]  Likewise, ECF brings together firms and individuals looking for capital and others that have money to invest, opening up equity investing opportunities previously only available to venture capitalists and angel investors to a much wider range of individual investors. 

According to the report, P2P lending has grown dramatically, propelled by a series of supply and demand factors including:

  • reduced technology costs,
  • demand for financing by borrowers previously underserved by traditional lenders,
  • low interest rates pushing investors to find alternative sources of return, and
  • opportunity for risk diversification afforded to P2P lenders.

IOSCO found that the growth of ECF, though smaller than P2P lending, was driven by similar factors.

Despite their novelty, P2P lending and ECF do not operate outside of regulatory oversight altogether. IOSCO points out that, "P2P lending platforms often are issuers of securities of interests in collective investment schemes, and consequently, often enter the securities regulatory remit.”  Firms employing ECF tend to be smaller than those taking the usual IPO route to raise capital. But they are still engaging in public offerings of securities, albeit in a non-traditional way, and regulators have taken notice.

IOSCO has determined initially that these alternative financing platforms are presently too small and insufficiently interconnected to pose systemic risks to the global financial system. But they warn that growth in P2P lending and ECF could in a short time create or transmit risks well outside their more local financial markets.

"As for interconnectedness with other parts of the financial system, securitization of P2P loans is increasing in certain markets such as the U.S., and bank involvement is growing. This opens the P2P lending market to new investment but also connects the rest of the financial market to exposure to packaged P2P loans that are often unsecured. While this segment of the market is still small, and therefore currently not a source of systemic risk, it may warrant continued monitoring."

 

Retail Trading and Investment Platforms

As technology becomes more ubiquitous and affordable, online investment and trading platforms have become more common as traditional brokerage firms compete to provide their clients with trading and distribution platforms. In addition to online brokerage, asset management, and exchange-based platforms, brokerage firms are now providing their customers with new analysis and comparison tools, automated or artificial intelligence (AI) driven investment advice, as well as ways to interact and share information with others via social media.

IOSCO warns that, as with any online or cloud-based platform, all of these are vulnerable to cybersecurity risks. They also warn that over-reliance on computerized or algorithmically derived investment advice could lead to recommending unsuitable investments on the part of their clients. Computers have come a long way, IOSCO seems to be saying, but they have not yet replaced the judgment of human advisers and brokers. Regulators, IOSCO found, are struggling to marshal the expertise necessary to evaluate investment advice algorithms and AI advice applications.

"As retail trading and investment platforms grow in number and size and the advice rendered and the automation involved becomes more complex, traditional sample audits may become less adequate. Regulators may need to hire specialized staff that understands and can assess the technology and algorithms driving the trading and advice. Regulators may also need to adopt a different approach towards surveillance, including asking for more frequent or different data filings."

 

Institutional Trading Platforms

IOSCO’s surveys revealed that institutional participants in fixed income markets are more and more employing fintech solutions for electronic trading. They note, however, that multiple and sometimes competing protocols are emerging to promote price discovery, including order books with live and executable orders, session-based trading, and platform-determined midpoint pricing. These new platforms and technology providers are increasingly focusing on identifying and matching firm orders (rather than quotes) and connecting all market participants (including buy-side to buy-side). This proliferation of market protocols and trading venues has introduced a buyer’s dilemma of sorts for institutional investors in the fixed income market, highlighting the need for ways to make these various systems communicate with one another:

"The recent proliferation of electronic trading platforms has created a set of challenges for market participants in identifying which are the best counterparties and platforms to utilize for any given trade. These challenges highlight the importance of addressing connectivity as a market infrastructure issue in order to provide access to appropriate platforms and counterparties, as well as to allow aggregation and search functions across individual liquidity pools.”

The fragmented nature of the fixed income market coupled with recently increased electronification has also raised the importance of integrating these many platforms in order to allow re-aggregation of liquidity across disparate liquidity pools.

IOSCO also notes that regulators’ market monitoring activities have benefitted from the electronification of fixed income transaction data. At the same time, however, regulators face the similar challenges that institutional investors do regarding how to access so many different fixed income trading platforms and how to assess the comparability of the data from each.

 

Distributed Ledger Technologies

Distributed ledger technologies (DLT) are yet another facet of the move toward disintermediation being driven by fintech. IOSCO’s report finds a dramatic increase in interest in and use of DLT systems by mainstream financial institutions, with 80% of banks predicted to have started DLT initiatives by the end of 2017.  The authors point out that there is not just one kind of DLT technology, and banks and financial institutions are still working toward finding and refining DLT systems to make them useful on a large scale. While DLT and blockchain have been functioning in the context of Bitcoin for some time now, application of DLT and smart contracts still need some customization to make them suitable to do things like settle OTC derivatives, track repo transactions and rehypothecation, trade short-term debt, etc.

DLT platforms theoretically could reduce settlement times and costs and increase reliability and traceability of records. They could even benefit regulators by allowing of instantaneous and automatic reporting and creating unalterable audit trails that regulators could monitor at will.  DLT is still a very immature technology. And while it may benefit them in the long run, IOSCO believes that most legislators and regulators will not begin to develop oversight policies and regulations unless or until DLT use is more widespread.

 

Fintech Developments in Emerging Markets

IOSCO found that firms in emerging markets are embracing fintech due to the cheap cost of technology and the proliferation of mobile computing devices. Financial firms in emerging markets no longer have to build an infrastructure to reach customers and potential customers.

"A trend particularly pronounced in emerging markets is the correlation between mobile-based innovation and Fintech development. Close to half of the respondents to the GEMC survey expect mobile and internet technology to drive the growth of digitalisation and innovation in capital markets."

The authors found that firms in these markets are able to harness mobile-based innovation through financial applications that are challenging traditional incumbents (such as banks) and offering online digital banking, investing and lending services. Among these services are P2P lending and ECM, which the surveys revealed were the fastest growing areas because they meet the needs of small and medium-sized entities that are traditionally underserved by banks and other lenders.  The report notes that regulators in these emerging markets are struggling to keep up with these new developments, observing a "high divergence of regulatory approaches, likely due to the still nascent nature of these business models and the fact that the full benefits and opportunities, as well as the risks and challenges, are not yet fully known.” IOSCO recommends a continued regulatory dialogue on the evolution of oversight in this area.

 

Conclusion

Rapid developments in technology and innovation make tracking the evolution of fintech an almost daily challenge. IOSCO’s report provides a thorough snapshot and accurately describes the profound effects that changes resulting from fintech are having on financial markets. They have also identified how fintech trends like disintermediation are pushing regulatory boundaries, bringing with it new risks and rewards as well as a potentially new and technology-driven regulatory landscape.

 

The full text of IOSCO’s report is available via:  http://www.iosco.org/library/pubdocs/pdf/IOSCOPD554.pdf

 

[1] The direct contact between counterparties in the P2P context is made possible by computer platforms using algorithms to match putatively suitable borrowers and lenders. IOSCO's research did not assess these platforms, and consequently the report expresses no opinions about their relative strengths and weaknesses.  

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Corporate Outreach Milestones

MILESTONES FOR LENDER DIRECTED VOTING

May 8, 2014: Council of Institutional Investors; - CII Elects New Board, Names Jay Chaudhuri Board Chair. http://www.bloomberg.com/news/2014-01-31/north-carolina-treasurer-may-cede-pension-control-5-questions.html )

February 2014:  Swiss Minder Initiative implies the value of LDV. http://www.ipe.com/switzerlands-minder-initiative-will-cripple-securities-lending-experts-warn/10000947.article.

January 2014 – FL SBA begins their SecLending Auction Program with eSecLending.

November 27, 2013 – CSFME staff call with Glass Lewis Chief Operating Officer. He gave his commitment for cooperation and support for LDV, and most importantly, he suggested that perhaps we should discuss with a Broadridge/State Street/Citi the scenario that permits Citi to forward an “Omnibus Ballot” of proxies to State Street, which State Street would then take and assign the proxies to their pension lenders/LDV participants, which would then be incorporated into a single ballot and sent to Broadridge. This eliminates the secondary ballot issue. While this description is oversimplified, Glass Lewis was fairly certain the parties involved could operationally create such a combined ballot. Responding to the question on cost, the Glass Lewis executive stated that the cost depends on the number of voting policies a fund has. Most funds have one policy; therefore, depending on the client, the cost would be $.75 – $2.00 per ballot.

October 21, 2013 – CSFME staff call with ISS Chief Operations Officer. He committed his cooperation and support to advance LDV’s implementation into the markets. He responded to the question about cost: “It depends on the client and the services they use. $6-7 per ballot on average.”

June 25-28, 2013 – CSFME staff attended ICGN Annual Conference in NY, NY. Spoke with executives of CalSTRS; ICGN Chair and Blackrock about LDV.  We received favorable comments and encouragement from each.

June 6, 2013: CSFME meets with Chief Investment Officer for NYC Pension Funds. While very much in favor of the LDV concept, the comments that the NYC Pension Fund Boards are for the most part followers in new initiatives and would prefer a roll-out by other funds first.

April 5, 2013: ‘SEC gives CSFME limited approval for LDV going forward’ providing brokers assign proxies only from their proprietary shares.

March 26, 2013 – CSFME and its legal team presented the case for LDV to SEC Commissioner Dan Gallagher. Present by phone and speaking on behalf of LDV were representatives of FL SBA who spoke about the difficulty of timely recall of shares on loan following release of record date and issues on agenda; and a representative from CalSTRS who spoke about their recall policy affecting income.

March 13, 2013 – CSFME meet staff of Senator Rob Portman and Congressman Steve Stivers of Ohio. These meetings were for the purpose of lining up political support, should the SEC resist the LDV concept. We also met and spoke with CII Deputy Director Amy Borrus for one hour and 15 minutes for a scheduled 30 minute meeting.  She expressed great interest in the value of LDV to long-term beneficial owners.

January 17, 2013 – CSFME conference call with CoPERA Director of Investments.  Among CoPERA’s concerns were: (1) How are agents/brokers notified re: LDV? (2) Who moves or approaches first lender to agent or agent to lender? CSFME responds  that a side letter is needed between lender, agent and broker.

November 8, 2012 – CSFME conference call with Council of Institutional Investors (CII) detailing LDV. Some in attendance were opposed to securities lending because of their desire to vote 100% of recall. This position would be irrelevant giving CalSTRS’ change to policy on proxy recall.

October 24, 2012, 2PM – CSFME presents LDV to Broadridge Institutional Investor Group. At this meeting, a representative of CalSTRS states: “We would view brokers willing to provide proxies more favorably than those who would not.” We were also informed by CalSTRS that they were looking to change their 100% recall policy. A representative of SWIB led a discussion on International Voting Issues, and apparently was chairing 3 meetings to determine the following: 1. who is voting internationally? 2. What are the issues in the international markets? 3. How do we increase and improve international processes?

October 24, 2012, 11AM – EWB/KT conference call with ICGN.  Executives stated that the argument for LDV may not be as strong in a non-record date market, and asked what would be the cost for LDV.  They further stated that they would like to see the U.S. go with LDV first and would need more information and operational detail.

October 13, 2012 email note from Elizabeth Danese Mozely to Broadridge’s Institutional Investor Working Group: “TerriJo Saarela, State of Wisconsin Investment Board, will provide commentary on their fund’s interest in international voting and an update on her participation in the Council of Institutional Investors’ working group on international voting.  Our discussion will include the differences in process for voting abroad, share blocking, attendance at the meeting via proxy or Power of Attorney (POA), best practices available through the various laws and regulations, etc.”

September 18, 2012: CSFME contacts Blackrock/ICGN Chair for a brief on LDV.

August 13, 2012 – CSFME conference call with OTPP.  Discussion of LDV was not timely in that their SecLending Program stopped lending securities through agents in mid-2006. State Street is their custodian and they were using a tri-party repo through Chase to Lehman, until the Lehman collapse. All the assets sat at Chase. It was not clear who had voting rights. At the time of this discussion in August 2012, OTPP was thinking formulating an SLA because they do not have the capacity to lend securities on their own. We have had no discussion with them since.

August 2, 2012 – CSFME contacts Ontario Teachers’ Pension Plan (OTPP) regarding LDV.

March 19, 2012 – CSFME conference call with executive in charge of securities lending for Franklin Templeton

February 22, 2012 – ICGN sends LDV letter of support to the SEC, signed by Chairman of the ICGN Board of Governors.

September 30, 2011 – CalSTRS sends LDV letter of support to the SEC, signed by Director of Corporate Governance Anne Sheehan.

July 18, 2011 – Florida SBA sends LDV letter of support to the SEC, signed by Executive Director and Chief Investment Officer.

November 2011 – CSFME introduces Council of Institutional Investors editor to LDV.

July 5, 2011 – CSFME sends a Comment Letter to the Securities and Exchange Commission regarding LDV.

October 2010 – CSFME releases report: Borrowed Proxy Abuse: Real or Not? This report and the SEC’s Securities Lending and Short Selling Roundtable prompted the question from beneficial owners and regulators regarding the need to recall shares on loan to vote proxies, why can’t lenders receive proxies for shares on loan when we get the dividends? From this question, the idea for Lender Directed Voting was born.

January 2010 – SEC issues rules that brokers no longer have the discretion to vote their customers’ shares held in companies without receiving voting instructions from those customers about how to vote them in an election of directors. http://www.sec.gov/investor/alerts/votingrules2010.htm. The rule, periodically, contributed to the difficulty of corporate meetings attaining a quorum.

Fall 2009/2010 – Four public pension funds join CSFME in Empty Voting studies/LDV initiative; FL SBA, CalSTRS, SWIB and CoPERA.

September 29-30, 2009 - SEC Announces Panelists for Securities Lending and Short Sale Roundtable; http://www.sec.gov/news/press/2009/2009-207.htm.