Outreach Blog

Saturday, January 22, 2022

Lenders and Borrowers Sound off on the SEC's Disclosure Proposal

Giving the SEC an Earful and Sounding the Alarm


Author: David Schwartz J.D. CPA

The Securities and Exchange Commission's (SEC) securities lending disclosure proposal has drawn sharp rebuke from both securities lenders and borrowers. Lending principals criticized the proposal on everything from cost, lack of clarity, and overbroad scope to the rule's general inequity. They also warned of a host of potential unintended consequences that could work against the very transparency the rule proposal was intended to foster. Some of the highlights are summarized below. 

 

Cost v. Benefits to Lenders

 

Lenders, who bear would bear the ultimate costs of the proposal, objected strongly to paying the proposal's steep price tag. They also objected to shouldering the burden of the rule's disclosures while enjoying almost none of the benefits, potentially driving lenders from the market:

 

". . . these costs ultimately will come directly out of the pockets of beneficial owners, including funds and their shareholders, to the detriment of their long term interests. Such costs may result in higher costs to administer a securities lending program or the potential decision by a fund that it no longer is economically worthwhile to operate a securities lending program, in either case lowering fund returns for shareholders." [1]

 

The proposed benefits of the rule postulated by the Commission, lenders say, also holds little use for anyone but the regulators:

 

"The potential benefits the SEC identifies appear to be speculative, at best, and it is fundamentally unclear from the Commission's analysis who, other than FINRA and the SEC, will clearly benefit from reporting of this data." [2]

 

However, in our comment letter, we pointed out that the data the SEC proposed to be collected would be of little help even to regulators. 

 

". . . even the elements proposed to be collected by rule 10c-1 are simply insufficient for effective regulatory market surveillance. The kind of market transparency contemplated by the Proposal, while potentially helpful to investors, would not have revealed to regulators the perilous risk-concentration in the Archagos situation."

 

Technology Burden on Lenders and Agents

 

The Risk Management Association  said that adopting 15-minute reporting for securities loans as proposed would require a wholesale rework of data collection and reporting systems for lenders and their agents.

 

"Real-time loan reporting would: (1) require each reporting institution to build fully-automated data capture and reporting systems; (2) limit flexibility around data capture and aggregation; (3) exponentially multiply the volume of reports generated; and (4) place high demands around the process and timing for data validation and reconciliation."

 

As Fidelity warned, lenders' technology resources and personnel are under pressure to move to T+1 settlement and implement other regulatory initiatives already in process. Adding rule 10c-1 to the mix would further stress lenders' resources and personnel.

 

"When finalized, a wide range of market participants will use technology resources to develop and code new and existing processes to implement rulemaking on securities lending transparency. These technology resources are already subject to heavy workloads due to a wide range of regulatory rulemakings currently under, or soon subject to, implementation including but not limited to, the Consolidated Audit Trail, anticipated industry move to T+1, and the requirements associated with the Commission's rule for use of derivatives by investment companies and fund of fund arrangements."

 

Overly Broad Scope 

 

Commenters across the board were in general agreement that the scope of the proposed rule was entirely too broad and posed an unintended risk to securities lending. Some suggested limiting the final rule's coverage to loans of U.S. traded equities only. [cite] Borrowers and some lenders indicated that the final rule should only apply to "wholesale" securities loans, that is, traditional securities loans with two counterparties governed by a securities lending contract. 

 

"In our view, only traditional securities lending market trades (i.e., transactions whereby a lender lends securities to a borrower in exchange for collateral but excluding repurchase transactions where the purpose of the trade is to provide cash financing in exchange for non-cash collateral) made on behalf of a U.S.-lender (including U.S. domiciled lending funds and accounts and entities subject to U.S. broker-dealer registration requirements)should be in scope for the rule." [3]

 

Reporting "Retail" loans, they said would "would effectively become a proxy for disclosure of actual short-selling activity and short positions. Such disclosure would, in turn, increase the costs and risk associated with engaging in short selling." [4] 

 

Frontrunning Risk

 

Hedge funds and other alternative investment companies warned that the overly broad and detailed disclosure regime proposed by the SEC would subject hedge funds to the real risk of front running. The Alternative Investment Management Association, representing hedge funds and other alternative funds, said:

 

"In addition, the proposal creates a significant risk that our members' investment strategies would be reverse-engineered. Our members tend to borrow from a limited number of broker-dealers, which are publicly disclosed in Form ADV. Rates also tend to correlate with both the size and type of investor involved in the transaction. Armed with this information and real-time transaction data, as contemplated in the proposal, sophisticated market participants or data vendors may be able to ascertain with significant specificity what actions our members are taking. Even in anonymized form, these disclosures, specifically regarding the securities fee or rate and the class of borrower, would reveal a  significant amount about the actions of individual market participants, an outcome not acknowledged in the proposal."

 

The Managed Fund Association echoed this concern, saying that the proposal would encourage and perpetuate GameStop frenzies rather than prevent them:

 

"we are strongly concerned that transaction-by-transaction financing data even in anonymized form would provide the market with sufficiently detailed information as to allow market participants to reconstruct and/or reverse-engineer investment and trading strategies, leading to situations similar to the GameStop and AMC market events."

 

A Host of Other Objections 

Securities lending lenders and borrowers gave the Commission quite a lot to think about as the SEC staff formulates a final rule. Given the reactions that were hastily put together during the short 30-day comment period, many are hoping that the strong reactions will prompt the Commission to open the comment period again. The industry has just scratched the surface in providing answers to the proposal's 97 questions. 


[1] Investment Company Institute, p. 10

 

[2] Investment Company Institute, p. 9

 

[3] Blackock, Inc.,  p. 2

Blackrock also suggested a further reduction in scope: 

 

"Non-market trades such as reallocations of existing market loan opportunities by lending agents to different in-scope lending funds and accounts within their lending programs should be excluded as a reportable loan modification. Additionally, as securities lending market dynamics differ by the asset class, we recommend the Commission provide further clarity on which asset classes are in scope."

 

[4] Managed Fund Association, p. 2

 

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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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