Outreach Blog

Tuesday, December 1, 2020

Banking Leaders set to Control 'Shadow Exposures'

Supply Chains in Securities Finance to be Clarified and Stabilized


Author: David Schwartz J.D. CPA

Shadow banking is history, say banking leaders, a thing of the past. New compliance and risk management systems based on the Securities Finance Transaction Regulation (SFTR) and the industry’s evolving Common Domain Model (CDM) will enable financial service providers to regulate their clients' exposure to counterparties with far more specificity than ever before possible. Originally accepted as a regulatory imposition, bankers are now viewing the SFTR reports of their loan principals as a platform to help state pension funds and others meet their ESG and tax compliance goals with unprecedented precision — along with proof of funding.
 
The data in SFTR reports is shining a light on formerly opaque markets and could spark a renaissance of innovative financial services. By matching the transaction records of lenders and borrowers, prime brokers and lending agents can now offer a modular array of sophisticated add-on services that address some of the most pressing challenges facing securities borrowers and lenders (e.g., meeting the demands of ESG investing and regulators' new tax audit sweeps). These can be wrapped as a package or customized for the benefit of individual clients.
 
State Street’s Alpha front-to-back-office platform is one example of how a modular approach allows service providers to stay ahead of the curve on what institutional investors and their advisors need most so as to deliver in an integrated and seamless fashion. They are pitching a thesis that interoperability is the key to providing a captivating client experience, in every sense of the term. 
 
Other banks are known to be working toward the same goal of integrating fintech in innovative ways.  Even the Chinese government is working on a global blockchain to serve as the backbone of a financial services infrastructure. This Chinese initiative has received very little attention in the financial media. Western banking firms should be at the forefront of this technological revolution in finance. The question is, who among the banks will seize these opportunities first?
 
End-to-end Principal Matching
 
SFTR data is bringing a new level of transparency to securities finance, by clarifying a supply chain previously criticized as "shadow banking” and heavily litigated since the financial crisis. This new data makes it possible to infer principal-to-principal loans, even when made through financial intermediaries, by matching Unique Transaction Identifiers (UTI), ISINs, and related data from principal lender and borrower SFTRs. On the most basic level, securities loan tracing is impossible due to the fungibility of modern securities that are cleared through central counterparties for prime brokers with fluid stock record systems. But principal matching can achieve the same end-to-end clarity when a shared ledger is derived from a permissioned blockchain, populated with the contractual loan details of their cooperating lenders and trusted borrowers. Such a distributed system's applications are legion, opening the door to a broader value proposition in securities finance. 
 
At present, end-to-end matching is merely a concept in the world of securities finance. But soon, it may become a necessity. Indeed, regulators like ESMA, the U.S. Department of Labor, and the U.S. Securities and Exchange Commission are already creating compliance hurdles that can only be met by employing this kind of end-to-end matching. The good news is that securities lending agents and prime brokerage firms are already rising to the challenge and developing a whole new menu of value-added services. For example, over the summer, securities lending intermediaries quickly stepped up and added SFTR compliance services to their offerings. Now, with investors' ever-increasing appetite for ESG investing and renewed efforts by the EU to police withholding tax refund schemes, lending agents and prime brokers should start thinking about what role they can play to help their clients meet these new challenges.  
 
Fintechs with strong blockchain and distributed ledger technology (DLT) capabilities can play a role as well. A central feature of shared ledger technologies like DLT is their end-to-end, supply chain tracking capability, widely publicized in IBM’s Walmart and Maersk projects. Controlled transparency, as well as tracking, is also a major attraction in the planned TIW shared ledger at DTCC. Nearly instantaneous updates are a sina qua non for peer-to-peer blockchains, which should lower the costs of resolving breaks in the trade reconciliation and proof process.  
 
More and more financial firms are discovering the benefits of adopting blockchains and DLT into securities lending supply chains. Developers point out that permissioned blockchains are no more complex than web servers, although designing for a consortium of users is a challenge. 
 
Recognizing Opportunities
 
Securities lending intermediaries are evaluated based on their ability to meet clients' unique needs and transaction flows. Indeed, a customized package of services is the very heart of the client relationship in securities finance. Now that higher capital charges have forced many lending clients out of the market for borrower default indemnification, it is incumbent on agents to offer new risk management services. Similarly, balance sheet constraints have forced prime brokers to prioritize the posting of non-cash collateral for their hedge funds’ securities loans. Thus, an ability to direct loans from reliable lenders with collateral flexibility through to preferred and trusted counterparties will become an imperative for lending agents and prime brokers alike. End-to-end matching can achieve those mutually complementary goals. 
 
SFTR reporting was just one way agents and prime brokers can help reduce their clients' regulatory burden. Now with the EU proposing sweeping audits of securities lending data around dividend record dates in search of tax cheats, agents have an opportunity to help their lending clients certify to regulators the validity of their loans and avoid the risk of time-consuming and unnecessary audits.   
 
EU Audit Compliance Services
 
New techniques that employ SFTR data make it possible to map securities lending transactions end-to-end, as described above. Applying these methods and tools to SFTR data for spike periods, intermediaries can certify their clients' benign activity, allowing NCAs and taxing authorities to concentrate on the remaining data for further investigation. It is tough to see how lenders in the EU could fail to see value in having their loans culled from potentially suspicious trade data.  
 
Meeting Clients' ESG Needs
 
As ESG investing becomes more critical to lending clients, clients' RFPs will evaluate service providers to the degree their programs can manage and report compliance. 
 
How can lending agents and prime brokers help their clients with ESG investing? Some have already expanded their services to include screens and procedures to foster their clients' ESG goals, including:
  • approval of counterparties 
  • non-cash collateral filtering
  • recalling loans for proxy votes
  • collateral reinvestment restrictions. 
 
But those services are just the beginning. Knowing for what purposes borrowers are using lent securities will become critical to ESG investors. Agents that can verify that borrowers are not putting clients' securities to uses that violate their ESG principles will have quite an advantage. 
 
Conclusion
 
SFTR and CDM present the securities finance industry with powerful tools to banish shadow banking to the history books. For those willing to embrace the new transparency of securities finance afforded by this new flood of data, coupled with fintech like blockchain and DLT, the competitive advantages are obvious.  

 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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