Regulators will push through a full agenda in 2022 designed to tighten market behaviour and to improve standards. But there are no new rules to encourage caveat emptor, or let the buyer beware, observes FIS’s David Lewis
It might seem unbelievable to some, but property prices can fall as well as rise. Among many memories from the most recent housing price crash here in the United Kingdom, there is one that draws parallels to issues that are now affecting the stock market and, by extension, the securities finance industry. All markets experience boom and bust cycles, whether that is equities, houses or COVID-lockdown puppies. Getting caught on the wrong side, selling or buying at the wrong moment can be painful. The recollection is of a couple suing a housing developer for losses incurred on an apartment they had purchased “off plan” (i.e., it had not yet been built but they had contracted to purchase it). Between the contract signing and completion, the market popped, resulting in a property worth significantly less than they were due to pay for it. Cue the legal action, blame apportionment and disgruntled faces in the paper.
Jump forward to 2021 and the GameStop episode. Many thousands of investors with brokerage fee free accounts are purchasing the shares of a brick-and-mortar PC game shop chain, ostensibly to punish the markets for some nefarious activity designed to keep them from making millions of dollars. However, some of those on the bandwagon were caught on the wrong side at the wrong time and lost significant sums of real-world money. There have been many articles regarding the gamification of the financial markets, and very few if any of them would have argued about the benefits of wider market access to everyone that wants to take part. What does seem to be lacking, however, is the explanation to those new entrants that “game over” in financial markets doesn’t simply mean that when you run out of money you can restart from the beginning, or from when you last “saved” the game.
To level the playing field between professional and retail market participants, the US Securities and Exchange Commission (SEC) has, among other initiatives, proposed a new disclosure rule for securities lending transactions: 10c-1. As a data provider in this space, FIS is, of course, supportive of market transparency but education is also vital to ensure appropriate use of the data available. The consultation period for this new rule has been very short, but has elicited some interesting results from a broad range of contributors. Some of these have rekindled old and inaccurate grievances, such as the claim from an esteemed professor of molecular and medical genetics that stock prices of innovative companies have been driven down by “naked shorting and market manipulation.” He does, however, acknowledge that “another PhD would be required to understand what happens when you buy a stock and place it in a brokerage account.”
Reading between the lines of this professor’s email to the SEC, it could easily be imagined that he has invested in a leading-edge biotech firm with a wonderful idea that sadly failed, while short sellers benefitted from the resulting fall. This complaint does not, however, present evidence of a conspiracy to “ruin those innovative companies” but instead shows a misunderstanding of risk and valuation. Shorting behaviour around such biotech firms and their binary performance has been the subject of previous articles (so it won’t be repeated here), but they can represent high risks to investors, long or short. Should this company have struck gold with their innovation, it is likely that the professor in question would have been pleased with an astute stock pick but less likely to be calling the SEC to congratulate them on the management of a true and fair market. Similarly, it is likely the apartment purchasers would have been toasting their strategy had the market not gone against them.
Asset pricing
The understanding of asset pricing is addressed in a long and thoughtful commentary delivered to the SEC by another professor, this time a finance professor with an impressive and relevant resume. The 12 pages of analysis and thought can be summarised into a short list of logical suggestions. The first is that all market participants must understand the depth of the book for a given security, how it works and how market prices are derived. The second, that the data to support that understanding should be accessible to all for a reasonable fee, aims some criticism at the previous administration’s (Redfearn/Cayton) plan for exchanges to sell data to consolidators and the confusion that followed.
The conclusion of these observations, that poor understanding can lead to poor decision making cannot, by any measure, be described as revolutionary. In this context, the concerns expressed by the professor are clear: poor understanding leads to ill-conceived reforms that may do more harm than good. The concerns raised by the highly educated medical professor led him to state that he “[has] no faith in the traditional stock market”. But will rule 10c-1 make that better, or is it there to satisfy and pacify those vocal critics of the financial markets?
Few would suggest that regulations are not needed to ensure orderly markets and to keep maleficence at bay from those that would take advantage — but there is also an argument for responsibility and ownership of informed decision making. The rise of ESG principles brings opportunities to support investments in socially and environmentally positive industries, investments that are for the long term both in terms of the monetary and environmental applications of the phrase. Perhaps it is time for such principles to be applied to the development and application of regulations? Regulations are rarely described as rushed — but when they are, there is significant risk that they harm more than they benefit, particularly when there are highly charged political influences at work.
There is a very full agenda for regulators and market participants in 2022, affecting the securities finance and collateral management industry directly as well as indirectly through other sectors of the market. These include updates to the complexities of SFTR, the application of Phase 6 of Uncleared Margin Rules and two rules developed in 2021 that apply in 2022 intended to address “undue speculation” (Rule 18f-4) and the management of “risks associated with fair value determinations” (Rule 2a-5). Together they represent a blend of improved margin and collateral cover (for when things really go wrong), increased transparency for regulators and stakeholders as well as improved risk controls to ensure providers use proven methods of asset valuations. All of these, and others on the slates of the SEC and other regulators for 2022, are clearly aimed at tightening market behaviours and improving standards. Unfortunately, however, there do not appear to be any new rules proposed around the principles of caveat emptor – let the buyer beware – and the requirement to take responsibility for when you buy or sell your shares or your home.
