Outreach Blog

Thursday, March 3, 2022

Disclosure and Beyond: Restructuring the U.S. Equity Markets

BRIEFING GUIDE to the SEC's Aggressive Agenda to Head off the Next "Big Squeeze"


Author: David Schwartz J.D. CPA

On Friday, February 25, 2022, the Securities and Exchange Commission (SEC) proposed its latest round of GameStop rule proposals. In addition to enhanced public disclosures of short sales by institutional investors, the Commission announced a 30-day extension of the comment period on its sweeping securities lending disclosure proposal, Rule 10c-1, and technical amendments to the "consolidated audit tape" regulations. The comment period for the short-selling disclosure proposals will be either 60 days following publication of the proposing news release on the SEC's website or 30 days following publication of the release in the Federal Register, whichever ends later. The Rule 10c-1 comment period is extended to April 1, 2022. These separate but related disclosure proposals may well be the start of a much broader and far-ranging regulatory response to the kind of market disruptions epitomized by the Gamestop event.  

 

RULE 13f-2 - SHORT SALE DISCLOSURES

 

These new rules, if adopted, would increase the public availability of data on short sales. Proposed rule 13f-2 under the Exchange Act would require institutional investment managers to report on the proposed new Form SHO information on end-of-the-month short positions and certain daily activities affecting these positions. This rule targets short positions of at least $10 million or equal to 2.5% or more of the outstanding shares of an equity security, or short positions of at least $500,000 in an equity security of a non-reporting issuer.i  

 

The Commission would aggregate the submitted data by security and release the aggregates to the public while keeping the reporting managers' identities (including the managers' LEIs)ii confidential. This new data is intended to supplement the publicly available short sale data from the Financial Industry Regulatory Authority (FINRA) iii and the stock exchanges.iv 

 

Chairman Gary Gensler stated that these new short sale disclosures would benefit investors as well as regulators, particularly when faced with conditions like those in the GameStop squeeze. 

 

"This would provide the public and market participants with more visibility into the behavior of large short sellers. The raw data reported to the Commission on a new Form SHO would help us to better oversee the markets and understand the role short selling may play in market events. It's important for the public and the Commission to know more about this important market, especially in times of stress or volatility." 

 

REG SHO RULE 205 - "BUY TO COVER" 

 

Current Reg SHO requires broker-dealers to identify sale orders as either "long," "short," or "short exempt." v  Proposed Rule 205 would add a corresponding requirement for purchase orders, requiring broker-dealers to designate orders as "buy to cover" if a buyer has any short position in the same security when the purchase order is entered. The SEC says this change would be helpful in "reconstructing significant market events and identifying potentially abusive trading practices including short squeezes" like GameStop. 

 

"CAT" AMENDMENTS

 

In light of proposed Rule 205, the Commission also proposes amendments to the national market system plan governing the consolidated audit trail (CAT). The amendments would require CAT reporting firms to report "buy to cover" information to CAT and includes a provision that would require each CAT reporting firm to indicate when it is claiming the "bona fide market making exception" under Regulation SHO

 

EXTENSION OF PROPOSED RULE 10c-1 COMMENT PERIOD

 

The Commission voted to reopen the comment period for proposed Exchange Act Rule 10c-1. In particular, the Commission is soliciting comments on any potential effects of the proposed short sale disclosures under 13f-2 that the Commission should consider in determining whether to adopt the proposed securities lending disclosure rules under 10c-1.vi Rule 10c-1 was proposed by the Commission on November 18, 2021, to increase the transparency and efficiency of the securities lending market. It would require any person that loans a security on behalf of itself or another person to report the material terms of those securities lending transactions and related information to a registered national securities association within 15 minutes of closing. The initial 30-day comment period for proposed rule 10c-1 ended on January 7, 2022.  

 

As many commenters pointed out, a securities lending reporting regime as complex as the one contemplated under rule 10c-1 raises vital questions about its practical aspects, as well as who bears the start-up and ongoing cost burdens and who, if anyone, benefits besides the SECCommenters across the securities lending industry said the 30-day comment period was insufficient and requested additional time to perform studies, evaluate and estimate costs, and propose potentially more effective alternatives to the rule 10c-1 regime. While the Commission has heeded commenters' request for more time, it has only allowed another 30-day comment period following publication of the notice in the Federal Register, expiring April 1, 2022.  

 

WHAT'S NEXT IN THE POST-GME AGENDA? 

 

The GameStop squeeze was a complicated event that involved, among other things, short selling, securities lending, and broker behavior. The SEC has, at least initially, chosen to address each of these areas from the perspective of disclosure. But the Commission is working on an ambitious agenda of regulation to head off the next short-selling squeeze.  

 

1. Gamification of tradingSEC Chairman Gary Gensler has been vocal about investor protection concerns surrounding electronic platforms that encourage trading, making them more "gamelike." As Gensler said in an August 27, 2021 interview

 

“While new technologies can bring us greater access and product choice, they also raise questions as to whether we as investors are appropriately protected when we trade and get financial advice. In many cases, these features may encourage investors to trade more often, invest in different products, or change their investment strategy.” 

 

The SEC's report on GameStop highlighted gamification of trading as an area the SEC should focus on for regulation. 
 

“A number of features, which broadly include behavioral prompts, differential marketing, game-like features, and other design elements or features, appear designed to engage individual investors. These features, which have the potential to leverage large amounts of user data, raise questions about their effect on investor behavior.” 

 

"Consideration should be given to whether game-like features and celebratory animations that are likely intended to create positive feedback from trading lead investors to trade more than they would otherwise. In addition, payment for order flow and the incentives it creates may cause broker-dealers to find novel ways to increase customer trading, including through the use of digital engagement practices." 

 

 

2. Payment for order flowPayment for order flow (PFOF) may present a conflict of interest for broker-dealers who owe a duty of best execution to their clients. The SEC sums up this potential tension between PFOF and best execution in their 2000 Special Study on PFOF:  
 

“[P]ayment for order flow and internalization create conflicts of interest for brokers because of the tension between the firms' interests in maximizing payment for order flow or trading profits generated from internalizing their customers' orders, and their fiduciary obligation to route their customers' orders to the best markets.” 

 

The SEC's report on GameStop also listed the potential conflicts the practice creates as something the regulators are looking into closely.  

 

"Off-exchange market makers typically offer payment to the retail broker-dealer for the right to trade with its customer order flow (i.e., payment for order flow). These payments can create a conflict of interest for the retail broker-dealer." 

 

According to its latest public agenda, the SEC is considering proposing changes "to modernize rules related to equity market structure such as those relating to order routing, conflicts of interest, best execution, market concentration, and the disclosure of best execution statistics." These appear to be intended to address best execution issues raised by PFOF.  

 

3. Settlement CycleOn February 9, 2022, the SEC proposed rules to shorten the standard settlement cycle for most broker-dealer transactions from two business days after the trade date (T+2) to one business day after the trade date (T+1). Theoretically, shortening settlement times would wring some of the risk and leverage out of the market as retail brokerages would no longer be required to pay billions of dollars in extra collateral to guarantee trades if either party defaults. The Commission believes the move to T+1 will protect investors, reduce risk, and increase operational efficiency, and has proposed an aggressive effective date of March 31, 2024.   

 


In this context, a "non-reporting issuer" is one who is not registered pursuant to Section 12 of the Exchange Act or not required to file reports to the SEC pursuant to section 15(d) of the Exchange Act.  

 

ii Proposed Form SHO would require the disclosure of, inter alia, "the Name and active Legal Entity Identifier ("LEI") (if available) of each of the Other Managers Reporting for this Manager." See Rule 13f-2 Proposing Release at p. 212.  

 

iii FINRA makes two types of files available: (1) Daily Short Sale Volume Files; and (2) Monthly Short Sale Transaction Files (collectively, the Short Sale Files). The Daily Short Sale Volume Files provide aggregated volume by security for all short sale trades executed and reported to the ADF during normal market hours. See, https://www.finra.org/filing-reporting/adf/adf-regulation-sho#:~:text=FINRA%20makes%20two%20types%20of,ADF%20during%20normal%20market%20hours 

 

iv The TAQ Group makes available for sale a summary of short sale volume for securities on NYSE, NYSE American, NYSE Arca, NYSE National, and NYSE Chicago (starting late 2019) throughout the trading day. See https://www.nyse.com/market-data/historical/taq-nyse-group-short-sales 

 

v "Short exempt" refers to a short sale order that is exempt from the price test of the Securities and Exchange Commission's (SEC) Regulation SHO. The current regulation allows for a limited number of situations where "short exempt" is appropriate. https://www.sec.gov/rules/final/2010/34-61595secg.htm#:~:text=Rule%20201(c)%20of%20Regulation,order%20to%20a%20trading%20center. 

 

vi See https://www.sec.gov/rules/proposed/2022/34-94315.pdf at page 1. "The Commission is reopening the comment period for the proposed rule in light of the proposed Exchange Act rule regarding short sale disclosure. In particular, the Commission is soliciting comment on any potential effects of the proposed Exchange Act rule regarding short sale disclosure that the Commission should consider in determining whether to adopt the proposed Exchange Act rule regarding the reporting of securities loans." 

 

 

 

 

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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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