A securities industry regulator is looking at instituting disclosure and customer protections for retail investors lending their stock to broker-dealers to support short sales.
Richard Ketchum, chairman and CEO of the Financial Industry Regulatory Authority, said yesterday that a tight market for securities available for loan from investment management firms, coupled with increased pressure to find securities to borrow to meet regulatory obligations, has led to some "retailization" of the securities lending business. This is a "particular concern" for FINRA, which oversees broker-dealers, because it raises customer protection issues, he said. He spoke at a roundtable on securities lending arranged by the Securities and Exchange Commission.
Securities lending refers to the loan of securities by pension funds, mutual funds and other asset managers to broker-dealers and intermediaries to support short sales, often made by the hedge fund customers of prime brokers. Investors engaging in short sales must borrow securities to meet their settlement obligations. Institutions lend their securities to earn additional incremental income on their portfolios.
SEC Chairman Mary Schapiro described the retailiziation of securities lending as "a little frightening." Schapiro yesterday oversaw the day-long SEC roundtable that covered various aspects of the institutional securities lending market, including issues concerning transparency, and pricing and trading of securities, and guidelines involving collateral reinvestment on behalf of firms lending their securities. (Borrowed shares are collateralized by the borrower.)
Mark Faulker, head of data innovation at Data Explorers, a U.K.-based company that aggregates data on securities lending, noted at the roundtable yesterday that about $2 trillion in securities are currently out on loan globally. He estimated that these balances are about half that of the industry’s peak in May 2008.
For decades, securities lending has been an over-the-counter institutional marketplace. Transactions involve the institutional investors that hold the securities in their portfolios, the agent lender or custodian bank managing the securities lending program, and the prime broker borrowing the shares. Until recently, retail customers were rarely involved in lending their securities.
That may now be gradually changing. "In the new [regulatory] environment, and [given the] recent pullback in stock lending [by some investment management companies], firms are increasingly attempting to borrow from retail customers, who are seen as essentially the last large and last untapped source of additional securities," Ketchum said. He added that this is a new development and that disclosure and customer protection rules may need to be put in place for the benefit of retail customers. This would ensure that customers know how these programs work and what rights they do and do not have.
"An environment where there are retail participants, which has largely existed through unpublished rates and a lack of transparent dealings between counterparties, does not create an efficient, transparent model for persons to evaluate value in the securities lending marketplace," Ketchum said.
The biggest regulatory change spurring demand for borrowed shares is Rule 204 of Regulation SHO, which imposes penalties on firms that fail to deliver shares to settle short sales. Rule 204, instituted as a temporary measure a year ago, was made permanent this past summer.
In the wake of the recent financial crisis, some institutions pared back their securities lending programs. Many institutions discovered last year that their collateral reinvestments left them exposed to risks they hadn’t anticipated, costing them large amounts of money in programs that were meant to supplement their investments. As some of these institutions scaled back their programs or ceased lending altogether, broker-dealers turned to retail customers.
Leslie Nelson, managing director in the global securities lending business at Goldman Sachs, said his firm provides disclosures to its retail and wealth management clients when it borrows shares from them. The disclosure and customer protection standards are "quite strict," he said.
Nelson noted that a broker’s responsibilities are explicitly outlined in the SEC’s Rule 15c3-3, the SEC’s customer protection rule, adopted in 1972. The rule governs what a broker-dealer is able to do with a customer’s funds and what disclosures must be provided. "There’s a well-established regulatory framework that says when you’re borrowing from a non-broker-dealer, you have to do the things that 15c3-3 requires you to do," Nelson said. He did not say whether his firm thinks additional protections from FINRA should be put in place.
In recent years, Merrill Lynch, Goldman Sachs, UBS, Citigroup and many other broker-dealers have enabled some of their retail clients to loan securities in their portfolios.
Ketchum noted that brokers generally try to provide disclosures to their retail customers. However, he said, "we do see [the growing retailization] as sparking a need, and we are looking hard at the possibility of additional rulemaking in that area to ensure that firms understand their disclosure obligations."
In addition to concerns about retail customers being used as sources for borrowed securities, Ketchum said FINRA is also focusing on individuals who function as so-called finders for borrowed shares. Ketchum noted that regulators in recent years had uncovered problems associated with unregulated aspects of securities lending.
"We found problems with firms, particularly those firms that have used finders to help match borrowers and lenders," he said, referring to his time as CEO of NYSE Regulation, the regulatory arm of NYSE Euronext. He noted that some individuals who billed themselves as finders collected fees for services they had not performed. "These finders were not associated with a broker-dealer and were not required to be registered, unlike traders or registered reps in other areas of the business," Ketchum said. The problems uncovered in examinations led to NYSE Reg’s Information Memo 05-32, in 2005, outlining best practices for dealing with stock loan finders.
Faulkner of Data Explorers also weighed in on the subject at yesterday’s panel, challenging the "idea that some guy sitting in his boxers in his bedroom can find stock better than a broker-dealer." The notion that finders are necessary to locate securities for short sales is "completely misguided," he said, and the SEC should consider "prohibiting regulated firms from using the services of unregulated firms."
FINRA’s Ketchum agreed. "If they are finders, I see no reason for them not to be registered broker-dealers," he said.
