From the desk of Roy Zimmerhansl,
Practice Lead, Pierpoint Financial
Just when you thought it was time to get back to business, along comes a meme stock and an arch ego.
Many securities finance market participants were looking forward to 2021. With the implementation of SFTR behind them and a deferral of the CSDR buy-in regime, it looked like the year would allow for a revenue-generation focus. A couple of our insights provided clues whose impact even we didn’t see at the time. Little did we know the full forthcoming impact of retail investors and securities lending that I predicted in my September animation as one of the three trends shaping the future of the business. Nor did we realise the prescience in our weekly blog post covering GameStop in October (where author Jeroen Bakker ended with a warning to short sellers suggesting they close their positions or ensure they had “very deep pockets”). Until then, GameStop looked like just another hot stock trade.
Fast forward to January 2021, with the peak price in the GameStop adventure (so far) followed not long afterwards by the collapse of Archegos, with ensuing losses for several prime brokers. Add into the mix a new US president and the appointment of a new chair of the Securities Exchange Commission, and unsurprisingly we have a changed outlook.
New SEC Chair Gary Gensler announced last week that:
“To meet our mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation, the SEC has a lot of regulatory work ahead of us."
A big proportion of that work will affect securities finance with both obvious and less obvious topics on the SEC Agency Rule List. In today’s post, I will briefly comment on the issues I believe are most relevant.
The obvious targets
Short sale disclosure
The Dodd-Frank Act required the SEC to conduct a study on real-time disclosure of short sales. The study was published in 2014 and found the costs of doing so outweighed the benefits. What is reported to FINRA is a daily aggregate of short sales, not at the individual fund manager level.
Gensler also wrote: "Whenever there are major market events, it's a good idea to consider what risks they might have placed on the entire financial system,"
As I have written before, I don’t have an issue with regulators requiring disclosure from traders and investors, so long as they don’t favour or discriminate against any particular group. For example, existing regulations in Europe are heavily biased against short sellers increasing obligations and costs for short positions compared to long positions of the equivalent absolute size relative to a company’s free float.
Additionally, public disclosure regulations in Europe discourage short sellers from taking large positions, much to the relief of outright frauds and those merely “shading the truth” intentionally or unintentionally.
Most short activist campaigns target US companies, but in my view, it is not because US companies are less well-governed, rather because it is harder to hide questionable practices.
I'm not convinced that GameStop showed there was a 'risk placed on the entire financial system' given that the rules as they stand today allowed retail investors to identify a short squeeze opportunity, take action and prove the case. I think more disclosure is inevitable, but let’s hope it doesn’t hamstring the accountability that the treat short-sellers pose for ‘bad’ companies.
Securities lending markets transparency
I have often said that the historic opacity of securities lending leads to misunderstandings of the business and, frankly scepticism from non-market participants. The Wall Street Bets crowd might reasonably question why they can find near real-time prices on stocks but not for securities lending transactions.
An example of how the lack of general understanding of the business is the incredulous response from so many market commentators regarding how it was possible for more than 100% of the free float of GameStop shares to be on loan. It is easy to understand why so many people point to securities lending as a major contributor to the meme stocks' events. It is why I posted the explainer on YouTube and one reason why I have started a Saturday live stream on YouTube going through the fundamentals of the business.
I have argued that the price of an individual transaction in securities lending is not meaningful. For example, my view is that ‘Best Execution’ for securities lending transactions is not relevant as context for a given loan rate is absent. Securities lending trades are not a single point in time transactions; they are ‘living’ entities that are difficult to assess stand-alone.
Consider:
Different general lending trading strategies may result in more trading/fewer trading opportunities;
Counterparty execution choices are limited by agents but may be further limited by clients;
Trade execution opportunities are impacted by collateral accepted by agents, clients and availability/preferences from borrowers;
Trade opportunities are impacted by regulatory factors, including diversification/concentration;
Rates can and are often renegotiated throughout the transaction lifecycle
Securities lending is a combination of judgements, experience, market conditions, regulatory obligations and risk management. A price is meaningless without this framework. In other words, if a borrower pays the highest fee in the market and provides the ‘best’ collateral (however, a lender might determine that) with the highest margin, many might say that is 'Best Execution'. But what if the borrower was Lehman Brothers? Would it still be Best-Ex? Check out John Arnesen’s blog from August 2020 “Imagine there’s no collateral”
To be clear, however, I believe more disclosure would be a good thing. SFTR has resulted in firms understanding their businesses at a very granular level, and more than one firm has changed its business as a result. More information in the public domain would also be a positive if only to remove some of the misinformation and confusion about the practice. The ISLA semi-annual report has made an outstanding contribution to regulatory and public understanding at a high level. What degree of transparency and for whom?
The questions the SEC will no doubt be investigating are: what additional information, frequency and disclosure to whom?
Again, when proposing a response to the securities lending transparency issue, it may be useful for the SEC to refer to the Gensler quote above – what risks to the entire financial system does the current level of transparency in securities lending result in? I’m finding them difficult to identify.
Less obvious items
Disclosure Regarding Beneficial Ownership and Swaps
The Archegos debacle is not directly related to securities lending but is the driver behind this SEC Agenda item. The issue underlying this proposed rule inquiry with Prime Brokers financing long positions via a swap for investors. The dearth of regulatory obligations for Family Offices meant that Archegos was able to build significant positions in several companies using PB financed leverage and traded via swap.
For many PBs long financing via swap has been an important P&L item since the Lehman default and is the structure of choice for many short positions. Some of the preference is due to regulatory treatment, some is for ease of execution, some is economics, and the three are often interlinked.
Changes that discourage or limit swap activity would likely have an impact on profits but also on collateral pools used for securities lending and other collateral obligations.
Proxy voting
There is undoubtedly increased scrutiny on investors and fund managers over their voting activity resulting in ever-increasing pressure over disclosure. For their part, investors must determine the best interests of their stakeholders – generating lending income or exercising their ownership rights.
Many regulators are embracing ESG as part of their future agenda and pressing the governance and voting issue. This issue, of course, is also influenced by the huge positions amassed by passive funds, large suppliers of assets to the securities lending community.
More active voting, and by implication an increase in recalls, seems inevitable to me. Perhaps it may even go as far as we have suggested with a callable/non-call market evolving as is more common in some Asian markets.
Money Market Reforms
A substantial proportion of cash collateral is reinvested into money market funds, so every time there is a change to regulations, there is an impact on securities lending. Changes to regulation in this area often have a negative impact on investment returns. The FOMC meetings last week saw some recovery in rates on the short end, so it may be that the government gives with one hand and takes with the other.
Interestingly, last month Bank of England Governor Andrew Bailey gave a speech at the ISDA Annual General Meeting on the topic of making MMFs more resilient. It’s hard to argue with any of his well-made points.
SPACS
Special Purpose Acquisition Companies have been all the rage recently, with over $100 billion raised so far this year and two years of unprecedented activity. Yet growth has slowed since the SEC announced it was looking closely at SPACs, starting with suggesting that warrants issued by SPACs be considered liabilities rather than equity. My colleague John Arnesen wrote about SPACs earlier this year, where you can find growth and other data, highlighting some of the most shorted SPACs at the time.
Personally, I think the promotion of SPACs has been remarkable, seemingly fusing social media-style influencers and celebrities with capital raising. It seems inevitable that there will be many successes and failures, with most SPACs stuck somewhere in between. Last week, short activist Hindenburg Research issued its fifth SPAC short report. SPACs are adding income to lenders already to the extent that people believe the SEC will crack down on SPACs. It is likely to generate more lending opportunities for those investors that stick it out with their SPAC investments.
Summary
At a headline level, revenues are looking great compared to last year’s dismal results, which were dramatically impacted by the pandemic, economic lockdowns and most directly the short-selling bans imposed by many countries after the severe sell-off in February and March.
I think many were hoping for a back-to-business year, as countries emerged from the pandemic and post the multi-year focus on SFTR implementation. Yet second (and third) wave lockdowns have slowed recoveries, and the three-headed hydra of GameStop, Archegos and Greensill (not mentioned in this article but has added to general concerns from industry observers) have thrust unexpected new scrutiny from regulators, dampening the outlook.
On reflection, I think this is just the way it is and will be going forward. It seems that ‘C’est la guerre’ is more appropriate than ‘Back to Business’.
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