Out of the dark, into the fog?
In the first of two articles, Bob Currie examines the SEC’s push for securities lending transaction reporting through Rule 10c-1 and the industry’s reaction through the consultation process
The Securities and Exchange Commission (SEC) published a proposed rule at the end of 2021 that will, if enacted, require lenders of securities to report the material terms of securities lending transactions to a registered national securities association (RNSA).
The proposed Exchange Act Rule 10c-1 (the ‘Proposed Rule’) upholds a Congressional mandate in the Dodd-Frank Act to promote transparency around securities lending transactions. This requires that market participants, financial supervisors and the public have access to fair, accurate and timely information relating to loan transactions.
Few will argue with SEC chair Gary Gensler’s assertion that securities lending and borrowing “is an important part of our market structure”. However, some may question his claim that currently “the securities lending market is opaque”. Others may feel that the SEC is embarking on a well-intentioned drive for transparency in a rather convoluted way — and one that does not fully align with the current operation of securities lending markets.
In commenting on the Proposed Rule, Gensler says: “In today’s fast-moving financial markets, it’s important that market participants have access to fair, accurate and timely information. I believe this proposal will bring securities lending out of the dark.”
Outlining the case for a new reporting regime, the SEC argues in its 10c-1 Fact Sheet that “there is limited information available to market participants, the public and regulators about securities lending in the US. Data on the market is incomplete, unavailable to the general public and not centralised.” The gaps, it believes, create inefficiencies in the securities lending market and make it difficult for borrowers and lenders to know whether the terms of their loans are consistent with market conditions.
Under the proposed new rule, any person that loans a security on behalf of itself or another person would be deemed to be a “lender”, including banks, insurance companies and pension plans, and thereby required to report.
To track the transaction, the RNSA will assign a unique transaction identifier to each reported securities lending trade. Modifications to the trade must also be reported to the RNSA.
Under this proposal, the RNSA will publish selected data relating to each transaction, along with any subsequent modifications. It will also publish aggregated data providing details of on-loan securities and securities that are available to loan.
Currently, one organisation, the Financial Industry Regulatory Authority (FINRA), has been approved by the SEC as a RNSA.
The Proposed Rule was published in the Federal Register, the daily journal of the US government, on Wednesday 8 December (File No: S7-18-21), giving industry participants a 30-day consultation period to provide feedback on the proposal.
FINRA says that it strongly supports the proposal, endorsing the Commission’s view that public dissemination of securities lending information will, among other benefits, improve price discovery in the securities lending market, reduce information asymmetries, close data gaps, and increase market efficiency.
In fronting FINRA’s response to the SEC 10c-1 consultation, Marcia Asquith, FINRA’s executive vice president, board and external relations, says that the proposal will provide data that could be used for important regulatory functions, including facilitating and improving FINRA’s monitoring of member activity and surveillance of the securities markets (see below).
Ready, willing and able, FINRA says
The Financial Industry Regulatory Authority says that, among other benefits, 10c-1 data would be valuable to help regulators reconstruct market events
In fronting FINRA’s response to the SEC 10c-1 consultation, Marcia Asquith, FINRA’s executive vice president, board and external relations, says that the 10c-1 Proposed Rule will provide data that could be used for important regulatory functions, including improving FINRA’s in-depth monitoring of member activity and surveillance of the securities markets. This additional data would “facilitate better surveillance by FINRA for regulatory compliance by its members” and “improve its ability to enforce” relevant regulations, including providing FINRA with the ability to “notify another regulator as appropriate.”
FINRA indicates, in line with the SEC’s position, that the data would be valuable to help regulators reconstruct market events in the future, for example by providing a “more timely and fulsome view of who was entering into new loans and who was no longer borrowing securities” during a market event.
FINRA also expects that reported information relating to the aggregate quantity of shares on loan and available to loan would be useful in monitoring levels of short selling activity occurring in a security and determining when a security is hard to borrow.
As the only current RNSA, FINRA says that it stands “ready, willing, and able” to facilitate this important initiative to improve transparency and enhance the regulatory audit trail in the securities lending market. It indicates, in its response to the SEC consultation, that it has extensive experience in establishing and maintaining systems that are designed to capture and disseminate transaction information — similar to the system contemplated by the Commission under the Proposal.
But will 10c-1 achieve those objectives? Many respondents to the SEC consultation confirm they are supportive of additional transparency, but some question the current design of the reporting regime. A number of market participants have privately questioned whether FINRA — as a government-authoritised regulatory organisation that oversees US broker-dealers — is an appropriate agency to serve as RNSA in gathering and publicly reporting securities lending data. Others question the abbreviated timeframe for public consultation, giving respondents just 30 days to share their feedback.
The Risk Management Association (RMA), for example, indicates that it supports the SEC’s efforts to increase market efficiency and deliver enhanced regulatory monitoring that may boost market integrity. However, in general terms, it believes that the Proposed Rule is unduly broad and unclear in scope. Some proposed reporting elements may be unavailable or operationally impractical to gather and report within the proposed timeframes. The Proposed Rule will also present an unnecessary transition burden in delivering pricing transparency and meaningful regulatory oversight.
The RMA says that it appreciates the SEC’s desire to move forward quickly with this proposal and to avoid undue delay. However, given the scope, significance and breadth of the Proposed Rule, the RMA believes that the 30-day comment period is inadequate, particularly given this coincided with the year end and the holiday season. Some RMA members registered their concern that they did not have adequate time for data gathering or analysis to provide the Commission with meaningful and well considered feedback.
BlackRock, the US-based asset management giant, indicates that it is supportive of the SEC’s efforts to bring more transparency to the securities lending markets. However, it identifies areas where it believes the proposal should be modified to ensure any new reporting requirements align with the structure and operational framework of the securities lending markets.
The asset manager advises that the SEC should amend the proposal to make the implementation timeline and costs more manageable, to extend access to publicly available data, and to meet the regulator’s ambition to simplify and harmonise transaction reporting standards.
Reporting timeframe
A focal point for respondents’ attention in the 10c-1 consultation is the requirement that lenders report trade details to an RNSA within 15 minutes of the time of the trade.
Fran Garritt, RMA director of securities lending and market risk, and Mark Whipple, chair of the RMA’s Council on Securities Lending, recommend that the SEC should revise the 15-minute reporting requirement in favour of end-of-day reporting on a next day (T+1) basis. The RMA believes that the nature of the market makes 15-minute reporting inappropriate for several reasons.
Specifically, the RMA Council advises that reporting on an intraday basis for securities lending transactions is operationally impractical and is likely to deliver little or no additional value compared with end-of-day reporting. This will exponentially increase the number of execution and modification reports, potentially resulting in the submission of incomplete or erroneous data. Additionally, it will limit time for reconciliation and require that firms invest in expensive real-time data capture and reporting systems to fulfil reporting obligations.
With this in mind, the RMA indicates that a T+1 standard will address the SEC’s transparency concerns at a lower implementation cost and will align more closely with the existing Securities Financing Transactions Regulation (SFTR) reporting regime operating in the EU and UK. To reinforce this recommendation, it states that real-time reporting would be inappropriate, or at least highly burdensome, given that many terms in the securities loan trade are subject to intraday revision or are not finalised until end of day.
BlackRock also advises that the Commission opt for T+1 securities lending reporting instead of the proposal’s requirement to report within 15 minutes of the time of trade. Intraday reporting will be of “low informational value” that is unlikely to achieve the potential benefits that the SEC highlights, the fund manager says, given the majority of securities loans are at stable pricing levels throughout the day.
The additional cost borne by lenders of meeting the 15-minute reporting window is significant compared to next-day reporting on both an initial and ongoing basis, BlackRock notes. Additionally, the nature of the securities lending markets poses a number of logistical hurdles that will make intraday reporting impractical.
Pirum COO and head of Americas Robert Zekraus says that while near real-time data may be warranted in other financial markets where the price of the transaction is generally fixed at point of execution, it is not appropriate in the context of securities lending.
For securities lending transactions, it is typically the fee or rebate rate that primarily determines the earnings of both parties and, although an initial rate will be agreed, this rate can be renegotiated at any point during the lifetime of the loan. These ‘re-rates’, Zekraus says, can take place daily and are driven by the natural supply and demand dynamics of the on-loan security. Consequently, there is not a strong correlation between the time that the securities loan is first executed and the economic outcome for both parties over the lifecycle of the trade.
With this in mind, Zekraus believes that the proposed 15-minute reporting window would add substantive operational burden and additional cost to all market participants, without providing any significant transparency benefits. Accordingly, in the EU Markets in Financial Instruments Regulation (MiFIR) securities financing transactions were classified as “non-price forming” and were excluded from pre and post-trade transparency reporting requirements.
Boaz Yaari, CEO of securities lending fintech Sharegain, indicates that it is no trivial task, particularly from a technological standpoint, to collect the relevant data required by the proposed 10c-1 Rule and to deliver it to the RNSA in a consumable format that will enable a unique identifier to be assigned to the loan transaction. This must then be communicated back to the reporting entity with an assigned identifier and updated on the reporting entity’s system.
Sharegain accepts that some existing RNSA reporting requirements, such as FINRA’s TRACE timeframes for corporate bonds or agency debt securities, do contemplate a 15-minute turnaround from the time of execution. However, Yaari suggests that the number of data elements mandated by Rule 10c-1 makes reporting under the Proposed Rule substantially more complex, particularly since there are multiple factors to consider as part of a securities loan (see below). With these considerations in mind, Sharegain recommends decreasing the frequency of reporting to twice-a-day or end-of-day reporting.
Price formation
The SEC also proposes that RNSAs should publish price information and other details of securities lending transactions on an intraday basis, comparable to a consolidated tape employed to publish intraday pricing for liquid securities traded at certain cash market securities execution venues for example.
RMA’s Garritt and Whipple comment that, unlike cash market sales of securities, securities lending transactions are open or term-based credit exposures that are typically managed and negotiated as part of broader credit relationships documented under master agreements. “The pricing arrangements are commonly party specific, contract specific and not directly dependent on the market price or the availability of the security being loaned,” they say. These may also be shaped by the counterparty credit risk, type and amount of collateral provided, the ability to provide and deploy cash collateral and other factors specific to the relationship.
With this, pricing for two loans of the same security executed at roughly the same time may differ significantly. “There is no reason to believe that securities lending transactions are fully fungible or that pricing can be represented in a single “spot” market price,” says the RMA.
Building on this point, Adrian Dale, head of regulation, digital and market practice at the International Securities Lending Association (ISLA), observes that “fee and rebate data, without consideration of firm(s) collateral requirements, counterparty/asset exposure(s), applied lending restrictions or jurisdictional obligations, may create an unrealistic and misleading portrayal of prevailing rates.” ISLA is clear in its response to the 10c-1 consultation that fee/rebate data could not be relied upon to support price discovery in the same manner as other markets. “Indeed, when we discuss other regulations, our position has been that securities lending fee data does not support price discovery,” says Dale.
In elaborating, Dale tells Securities Finance Times that the SEC’s objective, in constructing a consolidated tape for securities lending transactions utilising a 15-minute reporting regime, may provide an incomplete or misleading view of securities lending pricing dynamics to regulators and investors. As noted, price determination in a securities lending transaction may be shaped by a range of factors specific to the individual lending relationship — including counterparty exposure and collateral selection. There is a danger that these factors are not captured fully by the 10c-1 reporting exercise. In this regard, a consolidated tape utilising published fees and rebates is unlikely to provide an accurate and effective aid to price discovery for securities lending markets.
BlackRock’s managing director of the global public policy group Elizabeth Kent and managing director of securities lending Roland Villacorta indicate that, in general terms, most of the securities lending market encompassing general collateral (GC) lending does not exhibit intraday pricing changes. Given the supply of GC lendable securities is more than sufficient to satisfy borrowing demand, the pricing of such securities loans is unlikely to change significantly intraday or even day-on-day.
“For GC securities, which account for 79 per cent of transactions and 87 per cent of market value of those transactions in the US equity lending market, when the terms of the loan transaction are agreed by the parties on the loan’s trade date, such terms virtually always remain valid for at least that day,” say Kent and Villacorta (see box, p 18).
Reflecting on these points, the RMA notes that while the SEC may look to existing reporting regimes as reference points for its newly proposed reporting system, important differences in how prices are formed in securities lending and in cash markets for securities dictates that the Commission needs to seek a different approach to transaction reporting to that outlined in the Proposed Rule.
Cost-Benefit Considerations
In the Proposing Release, the SEC predicts that implementing 10c-1 will involve an initial implementation cost of US$371,000,000, for just 409 market participants, and annual direct compliance costs of US$140,000,000 thereafter (Fig 1).
Additionally, for the RNSA (namely FINRA, the only confirmed RNSA) this will impose a one-off cost of US$3.5 million, along with annual ongoing expenses of US$2.48 million. This includes costs associated with creating and maintaining the reporting infrastructure, entering into written agreements with lenders, and smaller costs deriving from disseminating this reported information to the public (SEC, Proposing Release, Release No. 34-93613; File No. S7-18-21, p 143).
However, these forecasts may be an underestimate. Edmon W Blount, executive director at the Centre for the Study of Financial Market Evolution, indicates that these predictions are unlikely to reflect the full cost since the RNSA is also entitled to recover its costs from market participants that report securities lending transactions (typically, the lenders and agents).
If Rule 10c-1 is adopted, Blount anticipates that FINRA will pass compliance costs through to lenders and agents in its fees. In turn, lending agents will pass the costs of compliance through to their lending clients.
Moreover, under the terms of the Proposing Release, the RNSA may ask for permission to sell this transaction information on to other vendors — and these vendors, in turn, may sell performance metrics and analytics based on the data. A full evaluation of these anticipated costs has not yet been released by the SEC.
Blount’s message, however, is that these cost implications may have detrimental consequences for liquidity and for the breadth of lending options available in the market. “Most beneficial owners participate in securities lending to generate marginal income,” says Blount. “If lenders are forced to bear the final cost of compliance with Rule 10c-1, they may find their margins so thin that they can no longer justify their lending activities, pulling their liquidity from the market.”
The RMA similarly questions whether this is a cost that can and should be borne by the securities lending market, and principally its lender and lending agent communities. “As the Commission acknowledges in the Proposing Release, securities lending in the US is already a low-margin business, and this is true in particular for lending agents that are subject to bank capital requirements and typically guarantee beneficial owners against borrower defaults,” says the RMA.
According to Ed Blount, beneficial owners are the most at risk and yet the least well-served by the proposed 10c-1 disclosures. “The free 10c-1 public disclosure, as specified, lacks critical fields for benchmarking the risk-adjusted returns of securities lenders,” he observes. “As a result, the 10c-1 data, though perhaps more expansive, will not be useful to beneficial owners. Boards of directors and trustees will still expect monthly benchmark reports and agents will still have to subcontract for solutions.”
Consequently, beneficial owners are unlikely to feel the advantage of the 10c-1 data, Blount believes, despite subsidising its collection and dissemination to regulators and borrowers. As such, a free-rider problem may arise if the new data flows mainly benefit borrowers in the lending chain and not lenders. Only an alternative system, he believes, can close the gaps to avoid the imposition of a costly and ineffective disclosure rule.
Closing thoughts
Respondents to the SEC consultation on Proposed Rule 10c-1 have in many cases indicated that they are supportive of the Commission’s ambitions to enhance transparency of securities lending markets, to increase market efficiency and to close data gaps.
However, respondents — in their consultation responses to the SEC and in discussion with Securities Finance Times — have recorded that fundamental changes to the existing design of the 10c-1 reporting framework are necessary to achieve these objectives.
In the first part of this article, respondents have focused on pricing dynamics in SBL markets, the value of intraday reporting (and particularly a T+15 minute reporting window for SBL transactions) and the potential cost implications of 10c-1 implementation. A number of respondents also say that the timeframe for public consultation was unnecessarily short.
As one senior industry figure told SFT, the 30-day consultation window for 10c-1 was significantly shorter than its standard consultation timeframe, presenting an air of ‘fait accompli’ around the proposal and prompting concerns that the SEC will not take full account of the industry’s recommendations in moving the Proposed Rule through to implementation.
In the second part of this article, published in SFT 297, market participants will reflect on the need to clarify the scope of the 10c-1 reporting regime (in terms of what constitutes a securities loan, in terms of extraterritorial reach) and the requirement to report on-loan and available-for-loan securities. They also discuss options for delegated reporting, application of technology, and the lessons that can be learnt from implementation of SFTR in the EU and UK. Alongside this, respondents highlight the need for delineation of ‘wholesale’ and ‘retail-driven’ elements of the securities lending market in finalising the 10c-1 reporting requirements.
There seems little doubt the 10c-1 reporting regime will be implemented. The priority for market participants is to ensure that the 10c-1 design facilitates a transparent and efficient securities lending market in line with the transparency objectives that the SEC is trying to achieve.
The SEC intends, among other objectives, that 10c-1 should improve price discovery in the securities lending market and reduce information asymmetry. FINRA indicates, in line with the SEC’s position, that the reported data will be valuable to help regulators reconstruct market events — for example by providing a more timely and complete view of who is entering into new loans and who is no longer borrowing securities during a market event. Important revisions to the existing 10c-1 design will be necessary to ensure it achieves its planned objectives.
Price formation in securities lending markets
Intraday data could mislead investors as to the source of GC pricing deviations, which may be misinterpreted as a byproduct of market dynamics, rather the broader negotiations between respective borrowers and lenders on GC, BlackRock says
BlackRock’s managing director of the global public policy group Elizabeth Kent and managing director of securities lending Roland Villacorta indicate that, in general, most of the securities lending market encompassing general collateral (GC) lending does not exhibit intraday pricing changes. Given the supply of GC lendable securities is more than sufficient to satisfy borrowing demand, the pricing of such securities loans is unlikely to change significantly intraday or even day-on-day.
“For GC securities, which account for 79 per cent of transactions and 87 per cent of market value of those transactions in the US equity lending market, when the terms of the loan transaction are agreed by the parties on the loan’s trade date, such terms virtually always remain valid for at least that day,” say Kent and Villacorta.
In fact, the pricing of general collateral loans between a lender and borrower often do not change over the course of months or even years. And while loans of “specials”, with a more limited supply and higher demand, will see more price movement day-on-day between a lender and borrower, they are also unlikely to see significant price movement intraday.
Additionally, since the vast majority of loans are “open” (i.e.,without an agreed upon termination date) and their initial terms are valid for just one day, the incremental value of intraday data relative to next-day is likely to be marginal at best for market participants. Lenders and borrowers will be able to use next-day reporting if they choose to renegotiate loan terms later in the life of the loan. With respect to loans of US Treasuries, the Commission should consider that the size of such loans is generally agreed during the first half of the trading day, notes BlackRock, with a single lending spread for all US Treasury loans of the same type between a specific borrower and lender set later in the day.
“As a result of these dynamics, we believe that by requiring next-day reporting the Commission can still achieve the benefits of enhanced transparency in the securities lending markets without unintended consequences,” BlackRock says.
Continued in Part 2 of article
