Prime brokers harmed beneficial owners of securities by protecting their turf and sabotaging fledgling electronic securities lending platforms that could have helped buy-side firms earn more revenues from their loans.
That is the claim of four US pension plans and one trading firm that have sued six mega US prime brokers and securities lending platform EquiLend in a New York court for collusion in stifling competition in the securities lending market. According to the filing, these prime brokers also financially hurt Data Explorers, a securities finance data provider, by launching a competing service through EquiLend called DataLend in June 2012 and targeting its clients. Data Explorers was purchased by IHS Markit in April 2012 is now called IHS Markit Pricing Data.
“Absent a conspiracy, the stock loan market would have been far more competitive, efficient and transparent for the buy side,” allege the plaintiffs who cite Morgan Stanley and Goldman Sachs as the ringleaders of the stock lending cartel. “If market participants could meet in a central electronic marketplace, the liquidity and transparency that would result would drive down spreads. And the need for prime broker defendants to act as a middleman for every trade would be reduced and, in time, possibly eliminated altogether.”
Why is EquiLend also a defendant? The plaintiffs contend that EquiLend was launched in 2002 not to provide operational efficiency, but as a “convenient place for the prime broker defendants to meet and discuss how to protect their collective interests in the stock loan market.” Those interests were protected when EquiLend purchased AQS and SL-x for the sole purpose of shutting them down.
The plaintiffs describe AQS, operated by Quadriserv, as a platform that would match lenders and borrowers using a hybrid auction and continuous price-discovery mechanism with matched loans processed through OCC (formerly known as Options Clearing Corp.) acting as a central counterparty. Like AQS, SL-x offered an electronic platform for stock loans including real-time pricing and central clearing through Eurex.
The suit brought under US federal anti-trust laws asks for unspecified damages and a jury trial. In addition to Morgan Stanley and Goldman Sachs, Bank of America, Credit Suisse, JP Morgan and UBS are defendants. The original plaintiffs, the Iowa Public Employees Retirement System, Orange County Employees Retirement System, the Sonoma County Employees Retirement Association, filed their suit in August. The Los Angeles Employees Retirement Association and trading firm Torus Capital joined the class-action lawsuit filed in the US District Court for the Southern District of New York recently.
Agent banks and prime brokers facilitate securities lending and borrowing transactions for which they earn fees or a spread. Borrowers, such as hedge funds, typically use prime brokers to find securities they need to handle short sales or to meet their settlement requrements. Fund managers lend out the securities of their customers, such as pension plans, through custodian banks, to help them earn additional revenues. “The institutions that lend stock have no way to shop the universe of potential borrowers,” say the plaintiffs. “They, too, must rely on the prime broker defendants to find counterparties, often hedge funds, willing to borrow shares.”
The Alleged Misdeeds
The lawsuit against the prime brokers and EquiLend is far from being cut and dried. Nowhere in the lawsuit do the plaintiffs provide a detailed apples-to-apples comparison of how much more they would have earned in revenues by using AQS or SL-x. Instead, the plaintiffs say that in 2016, the prime broker defendants skimmed approximately 60 percent off a pot of some US$9.15 billion in total industry revenue. The pension plans and trading firm also cite academic studies in other securities markets showing that competition is beneficial to investors.
The plaintiffs conclude their argument by drawing heavily on the defendants’ past collusive conduct in other markets such as the municipal bonds, foreign exchange, LIBOR and swaps where they have paid regulatory fines. That collusive conduct, say the plaintiffs, is also evident in the securities lending market as shown by the bullying tactics of some high-ranking securities lending officials at the plaintiff firms.
If those actions are proven true, it won’t be too hard to believe that the prime brokers intentionally sabotaged AQS and SL-x. (FinOps Report could not independently verify any of the details of events cited in the suit, which also does not cite any EquiLend employees as participating in the alleged collusion).
The plaintiffs contend that the prime brokers tried to strongarm AQS into becoming a dealer-only platform rather than allowing lenders and borrowers access. When that failed they escalated to even worse conduct. Goldman Sachs in 2012 allegedly threatened BNY Mellon that, if it continued to support the AQS platform, Goldman would return BNY Mellon’s collateral and stop doing business with it. BNY Mellon abandoned activity on AQS and the prime brokers’ collective boycott of AQS starved it of liquidity. The plaintiffs allegedly prevented hedge-fund customers such as Renaissance Capital Technologies, DE Shaw and SAC Capital from accessing AQS. “This technique only worked because there was no viable elsewhere for the hedge funds to go because the prime broker defendants coordinated their competitive strategy,” say the plaintiffs.
The lawsuit cites William Conley, former head of global securities lending at Goldman Sachs, as preventing other units of his firm from using AQS. Ultimately, the lawsuit alleges, Conley and Thomas Wipf, former global head of bank resource management at Morgan Stanley also led a covert operation called Project Gateway to block OCC from buying AQS, leaving a financially drained AQS to sell itself to EquiLend for less than US$5 million. Following the acquisition, the AQS platform was shut down. (Conley left Goldman Sachs earlier this year, according to media reports which could not be confirmed by FinOps. A Google search of Wipf shows he is now a vice chairman of institutional securities at Morgan Stanley). Officials at Goldman Sachs and Morgan Stanley did not respond to emails seeking comment. JP Morgan and Credit Suisse declined to comment.
The plaintiffs allege that the prime brokers also used threatening tactics when it came to squashing SL-x which would offer central clearing through Eurex. “As they had done with AQS defendants refused to conduct significant transactions on the SL-x platform and prevented others from doing so,” says the suit. Conley allegedly told SL-x officials that Goldman wouldn’t use it. Morgan Stanley’s European prime brokerage division also allegedly told some hedge funds that they would lose other prime brokerage services if they were to “trade away” their securities lending business to venues such as SL-x.
While SL-x managed to ink a deal with Eurex to centrally clear transactions for European stocks it could not do so with the US’ OCC and DTCC because of the prime brokers’ alleged backstabbing actions. OCC refused an SL-x request to change its rules to allow agent lenders to become clearing members of OCC without providing any reason, says the lawsuit, pointing to Conley’s concurrent discussions with the OCC’s chief operating officer Michael McClain about central clearing for securites loans as being suspicious. The suit also said that DTCC’s managing director Murray Pozmanter told SL-x that DTCC could not offer the platform central clearing services unless Goldman Sachs and other prime brokers agreed. OCC in Chicago and DTCC in New York declined to comment for this article.
The prime brokers’ actions caused SL-x to shut down in 2014 only six months after it was launched, according to the plaintiffs. That year EquiLend purchased SL-x’s patents and intellectual property — including its pipeline for clearing at Eurex — for only £500,000 sterling in a fire sale. “EquiLend has never used the patents or attempted to commercialize the technology. Rather it put the patents on the shelf only to be used in the future to block the next would-be platform from using similar technology,” says the lawsuit.
In the case of Data Explorers, the plaintiffs allege that in June 2012 the defendants collectively agreed to create EquiLend’s DataLend, after they became concerned that the Data Explorers lending information service was enabling beneficial owners to know how much they were paying prime brokers to borrow securities. The prime brokers supposedly based their support of DataLend on on the condition the EquiLend unit would never release any of their pricing information to beneficial owners. The prime brokers, who reportedly had encouraged IHS Markit to buy Data Explorers in April 2012, then targeted Data Explorers’ agent bank customers saying that they would offer them pricing services for less or next to nothing. As a result, claim the plaintiffs, Data Explorers incurred huge financial losses and cut staff in 2013 and 2014, say the plaintiffs. (IHS Markit, which declined to comment for this article, does not break out its revenues by business line so the current financial status of IHS Markit Pricing Data could not be determined.)
“Because of the agreed-upon restrictions on the release of pricing data imposed by the prime broker defendants, a pension plan is unable to know how much hedge funds are charged for borrowing the securities they lend,” say the plaintiffs. They also contend that because there is no electronic trading venue for securities lending, any prices on transactions available to borrowers and lending agents are stale and of no value.
However, even if the plaintiffs were able to prove the prime brokers sabotaged any competition to EquiLend, can they prove that investors would have been better off if AQS and SL-x were still in business? It’s going to be a stretch, say securities lending analysts. “Saying that SL-x and AQS were going to reduce costs and introduce more competition and that investors were hurt as a result? That’s unclear,” says Josh Galper, managing partner of Finadium, a capital markets consultancy in Concord, Massachusetts, which has a practice in securities finance and collateral management.
If the pension plans think they were damaged because they would have lent more efficiently through an automated trading system and clearinghouse rather through a prime broker intermediary, think again. It is unlikely that they would have accepted either a hedge fund or a central counterparty service as their direct counterparty, according to Galper. The OCC is is still not set up to accept pensions as direct members or agent lenders to facilitate loans. What’s more, says Galper, pension plans rarely want to lend to the credit of a hedge fund. Therefore, prime broker intermediaries are still necessary to broker a deal.
Granted, prime brokers do earn a spread on securities lending transactions, but hedge funds also benefit from research, corporate access and the calendar of initial public offerings in return. “The lawyers [for the plaintiffs] will have to unbundle all of these costs to prove overcharging,” argues Galper.
While declining to comment on the merits of the lawsuit, operations managers at several hedge funds and pension plans not named in the litigation tell FinOps that the legal challenge has already prompted buy-side firms to question custodian banks and prime brokers about the quality of their services and fees. Whether such inquiries change what prime brokers actually earn for finding shares for hedge funds to borrow remains to be seen.
“The lawsuit won’t really alter the industry that much in the short-term,” predicts one US hedge fund manager. He doubts it will prompt prime brokers to unbundle fees for securities borrowing activities from other services or earn lower spreads. Other prime brokers, not named in the lawsuit, declined to comment.
What if the plaintiffs actually win or settle the case? Again, no one wanted to speculate on its effect on the securities lending market. “It’s years off,” was the consensus of hedge fund managers and prime brokers contacted by FinOps.