Wall Street continues to turn up the heat against the US Securities and Exchange Commission’s proposal for transaction reporting on securities loans, citing its contradictory analysis on short position and short activity reporting as well as potential operational shortcomings.
The SEC recently reopened the comment period for its proposed securities loan reporting plan to adopt new Rule 10c-1 April 1 from January 7. The industry consensus remains that if implemented, the SEC’s requirements would increase rather than decrease the costs of short selling and harm rather than help investors. Noting that reporting would also be too difficult to fulfill, industry players urge the SEC to reevaluate its cost-benefit analysis and offer plenty of suggestions for how the SEC could amend its proposed reporting rule for securities loans to make compliance easier. Based on its analysis of 409 lenders and their agents, the SEC says its proposal would cost US$375 million to initially implement and US$140 million to follow annually.
In February, the SEC announced it wanted to require “institutional investment managers” to report monthly to the SEC on short positions above a certain threshold in individual equities. Citing potential harm in more granular and immediate disclosure, only monthly aggregate data would be published under the possible new Rule 13f-2. However, when it comes to securities lending transactions falling under the new possible Rule 10c-1, SEC wants lenders of securities or their agents report the economic and other details of individual securities lending transactions to a regulated national securities authority (RNSA), the broker-dealer watchdog Financial Industry Regulatory Authority. Reporting would be required within fifteen minutes of the completion of the securities lending transaction and be done by a FINRA member. Information on securities out on loan and available to be lent would also be reported, albeit at the end of the day. The RNSA, in turn, would make the information available to the public aggregated by security the following day.
Respondents to the SEC’s reopened request for comment on reporting securities loans, such as the Alternative Investment Management Association, the Managed Funds Association, hedge fund manager Citadel and the broker-dealer trade group Securities Industry and Financial Markets Association, criticize the regulatory agency for acknowledging the challenges of detailed transaction by transaction short sale and short position disclosure while wanting that same type of reporting on securities lending deals. Broker-dealers typically borrow securities on behalf of their hedge fund clients, while pension plans and other asset owners lend them through custodian bank agents.
The SEC may not think its two proposals are related, but market players insist they are. “The proposed loan disclosure would effectively serve as a proxy or actual short selling and short positions,” writes Jennifer Han, executive vice president, chief counsel, and head of regulatory affairs for the Washington D.C.-based Managed Funds Association in her letter to the SEC. The proposed short position disclosure rule and the loan disclosure rule aim meet the SEC’s mandate under the 2010 Dodd-Frank Act to increase transparency in the securities lending market. Securities lending is critical to short selling, because a broker-dealer needs to borrow securities to immediately sell them and repurchase them later at a lower price. Borrowers pay lenders plenty for the privilege; in 2021 the global securities lending industry generated US$9.28 trillion in revenue for lenders, according to DataLend, the securities finance data arm of New York-headquartered electronic securities lending and borrowing platform EquiLend.
Based on its own analysis when recommending its short position and short sale reporting rule, the SEC should limit the scope of reporting on securities lending transactions to the wholesale segment of the market, say respondents to the SEC’s reopened request for comment. “It would be arbitrary decision-making for the Commission to conclude that the costs of a transaction-by transaction short sale disclosure regime outweigh the benefits in one rule proposal, but not in another,” writes Jiri Krol, deputy chief executive officer and head of government affairs for the London-based Alternative Investment Management Association in his letter to the SEC.
In their letters to the SEC Stephen John Berger, managing director and global head of government and regulatory policy at Chicago-headquartered Citadel, and others cite a litany of pitfalls with transaction-by-transaction short position and short sale reporting that would apply to the SEC’s proposal on securities lending transaction reporting. Those are increased costs associated with establishing short positions; heightened risk of copycatting investment and trading strategies leading to diminished returns; potential issuer retaliation should the identity of a firm in a particular trading strategy be revealed; and heightened risk of short squeezes. “Ultimately the costs of reduced short selling [would result] in less fundamental research and an impaired ability to pursue fundamentally driven actively managed investment strategies,” writes Berger. Price discovery and market efficiency would be reduced and asset owners would earn less when lending securities.
Data on securities available to be lent and securities out on loan should also be eliminated from the information to be reported on securities lending deals, say the law firm of Linklaters and S3 Partners, a data and fintech firm, among others. In its letter to the SEC, S3 Partners explains that to measure the total number of shares on loan and the total number of shares available to be lent, information must be gathered from lenders of shares as well as intermediary agents and prime brokers. The problem is that there is no industry standard for how to define securities “available to lend” and prime brokers often use their internal inventory of shares to clear short sales. Therefore, no borrowing takes place. “By failing to take this internalization into account, approaches that use securities on loan routinely misrepresent the true number of borrowed shares,” argues Robert Sloan, managing partner of S3 Partners in New York.
In his letter to the SEC Steven Barry, senior vice president and head of regulatory, industry and government affairs at custodian bank State Street, recommends the SEC replace the requirement of reporting “securities available to lend” with reporting publicly available data on the issuer’s total share float. The definition of “available to lend” may accidentally overstate the quantity of securities if it were to include securities that may become restricted, he says. What’s more, lenders won’t want to give competitors an edge by disclosing proprietary information so they could decide to reduce their lending activity and harm liquidity.
As is the case with any new reporting requirement, who will bear the cost of creating new infrastructure to comply is a significant sore spot. State Street worries that custodians would be unfairly carrying most of the expense and would not be able to recoup even a portion of reporting costs from borrowers. As a result, custodians and their asset owner clients would earn lower revenues from their securities lending activities. A better approach, writes Barry, would be for the costs incurred by the RNSA to establish and operate the securities loan reporting system to be “equitably shared by borrowers and lenders even if the actual reporting obligation remains single-sided.” The RNSA would have no trouble accessing the names of any borrowers, because the data fields in the SEC’s reporting schema include the legal name of each counterparty to a transaction.
Barry also recommends that reporting on transactions in “GC” or “easy to borrow” securities be free or that GC securities should be omitted from the reporting requirement. Information on GC securities are unlikely to be of any value to determining supply and demand of securities, he argues suggesting that the SEC can define GC securities as those with fee/demand spreads below 25 basis points.
Expanding the scope of reporting agents to beyond broker-dealers registered with FINRA, say industry players, might also help relieve the operational and human resource costs of developing a reporting framework because financial firms could leverage their current connectivity to data vendors and others. “Staff training, given the complexity and scope of the proposal, may be significant and was not assessed in the [SEC’s] economic analysis,” explains S3 Partners’ Sloan in his letter to the SEC. S3 and EquiLend have thrown their hats in the ring as possible loan reporting agents. “As a provider of trading, data, post-trade and books and records services, EquiLend has the technology in place to support intra-day, end of day, or T+1 [next day] reporting using the existing services currently utilized by many participants in the securities lending market,” writes Brian Lamb, chief executive officer of EquiLend.
Among the potential operational challenges market players remain the most concerned about complying with the SEC’s plan for securities loan reporting, timing and identification of transactions remain top of their list. State Street, SIFMA, and other respondents to the SEC’s reopened request for comment on its proposal agree that the 15-minute window is impractical. The full range of information on a securities lending transaction can’t be consolidated so quickly because the details of securities lending transactions are not finalized until the end of the day and a large amount of cancel and rebook activity occurs intraday. Therefore, an end-of-day time frame is preferable. “The 15-minute reporting window proposed by the Commission would inevitably result in a high volume of false positive information on securities lending transactions that is more likely to confuse the market rather than to provide meaningful transparency,” writes State Street’s Barry.
Relying on the RNSA– FINRA– to create the unique transaction identifier for each reported securities lending deal, also isn’t a good idea, say respondents to the SEC’s reopened request for comment. It would be difficult for financial firms to adapt because of all the internal operational and technological changes they would have to make to incorporate all the data, explains Barry who suggests that reporting firms create the UTI. In his letter to the SEC Jim Kaye, Americas regional director for the FIX Trading Community, says that the SEC’s recommendation that the RNSA create UTIs for loan modifications could result in reporting delays and become problematic if the number of loans being reported were to change. He agrees with Barry that reporting firms should generate the UTI using an existing methodology approved by the global standards body International Organization for Standardization (ISO) for identifying securities transactions. The 2017 methodology calls for a UTI to consist of a legal entity identifier followed by an alphanumeric code.
While the focus of industry commentary on the SEC’s proposal on reporting of securities lending transactions remains on what changes the regulatory agency should make, a handful of respondents came up with what they think is a better mousetrap. S3 Partners proposes the SEC increase the frequency of short sale volume data provided by FINRA and the exchanges from twice a month the three times a month. The implementation costs of such a scenario would be minimal because the mechanisms for reporting and displaying data already exist. It would also be best to allow competition for the role of the RNSA rather than simply delegate the job to FINRA or allow firms to use a “data consolidator” other than an RNSA. “To the extent that data vendors are used even after the final rule, a competing consolidator model could reduce duplicative reporting,” writes Sloan, who cites S3 as a potential data consolidator.
David Schwartz, executive director of the Washington D.C. think tank Center for the Study of Financial Market Evolution, recommends that the SEC allow the end lenders of securities– the beneficial owners– to create a “data trust” that could provide a single feed to the RNSA in whatever format or frequency the regulatory agency wants. In his letter to the SEC, he warns that its proposed reporting plan would create a “free-rider” problem because lenders and their agents pay the costs while borrowers, or broker-dealers reap the benefits. The “data trust,” argues Schwartz, could reduce the startup costs for complying with Rule 10c-1 by $100 million and provide additional benefits for lenders and their agents. “If lenders can form a data trust, regulators as well as lenders’ advisors and custodians could improve their risk management systems by using encrypted subsets of data generated by Rule 10c-1 as well as know your customer, proxy voting, ESG and related contractual or policy restrictions,” he writes. “Those data have never been compiled in one place before.”
Schwartz urges the SEC to instruct its staff to assist forensic accountants from the European securities watchdog European Securities and Markets Authority (ESMA) to create a “proof of concept” to test a voluntary cross-border stock loan registry. “If the alternative is proven, then a scaled-up version would be equally effective in the proposed 10c-1 regime, but more efficient and far less costly,” he reasons.