Securities lending in a changing world

Bill Kelly, Global Head of Agency Securities Finance at BNY Mellon considers what recent high-profile defaults and the rapid emergence of meme stock trading mean for securities lending, and reviews recent progress towards regulatory compliance by the industry.

How did the recent events related to Wirecard and Archegos impact the securities lending industry?

These two events brought about a renewed focus on securities lending and the role it plays in facilitating short selling. This re-ignited familiar debates with respect to short selling and its part in maintaining efficient markets, promoting liquidity, aiding price discovery, and exposing corporate irregularities.

Last summer, Wirecard highlighted the role short-sellers play in disseminating information. Their early alarms provided the first indications of malfeasance at the company and they can reasonably claim to have demonstrated their usefulness in promoting market transparency.

More recently, the Archegos default has increased attention on short positions established through the use of synthetics. Synthetic structures allow considerable short exposure to build up unseen, in contrast to when the same views are expressed through conventional transactions. The point has been made several times that, had Archegos expressed its views through physical short sales supported by borrowing the securities from agent lenders, it would have faced significant leverage limits that would have curtailed its exposure to a small fraction of what it eventually accumulated and may have averted its demise.

The lack of transparency with respect to synthetic short positions will no doubt be the focus of the post-mortem surrounding the Archegos event and the difficulties faced by its counterparties in liquidating positions in names that had suddenly become distressed. We are already beginning to see the regulatory response. FINRA recently issued Regulatory Notice 21-19 requesting comment on proposed enhancements to short interest and short sale reporting. Under the proposal, synthetic short positions would be included in short interest reporting along with customer borrows in arranged financing programs. In addition more granular reporting is being proposed that would require separating short interest between proprietary and customer positions as well as providing account level position reporting. Increasing the frequency of the reporting to either daily or weekly is another proposal. These proposals are likely the first step in addressing the limitations of short interest reporting which to date has been a lagging indicator and a fairly archaic signal when it comes to providing an early warning of problems. From a securities lending perspective increased transparency has been an ongoing theme since the 2008 financial crisis and was a central pillar of the work done by the Financial Stability Board which ultimately led to the SFTR reporting regime. I fully expect to see continued advancements in transparency especially as new technologies become available.

What consequences does the emergence of meme stock trading hold for securities lending?

Clearly it is early days in how the market and regulators treat the phenomenon of heightened market volatility involving stocks such as GameStop, Hertz or AMC. The phenomenon is clearly attracting close scrutiny – as demonstrated by the hearings held earlier this year by the US House Committee on Financial Services. Nevertheless, we are early in the journey towards a greater understanding of how social media and individual investors can impact markets that have traditionally been the purview of institutional investors.

Two things that are worth emphasising here. The first is that the market has without fail functioned efficiently through the price events surrounding these stocks. Clients could participate or withdraw from securities lending positions throughout the most severe periods of volatility. The second, which I think has been omitted from much of the coverage, is that we are seeing the democratization of securities lending with the rise of retail lending. Most retail brokers now provide retail clients with the ability to lend securities in their accounts and earn additional return.

What role do agent lenders have to play in smoothing the path towards regulatory compliance?

With the progress of the EU Securities Financing Transactions Regulation (SFTR) and its derivative equivalent under EMIR, it is clear that reporting regimes aimed at increasing transparency for securities financing will soon be adopted by other jurisdictions. Clearly, the documentation requirements of filling roughly 150 data fields as required by SFTR are considerable and hopefully the industry will be able to fashion sensible data exchanges to facilitate that process.

As the delegated reporting agent, it falls to us, in partnership with technology vendors, to deliver provide the required information to the data repositories. We recognize that this is a considerable responsibility and it is vital for us to reduce the associated burden. We must assist our asset owner clients on this journey so that they are still able to continue to earn additional alpha through their securities lending activities, while alleviating the regulatory friction for them.

By the same token it is clear that there is a benefit to providers of easing the transition through regulatory compliance for our clients. If we simply said ‘here are the rules and obligations’ and left them to get on with it by themselves we know where that would lead. Clients don’t need to do securities lending; they are choosing to do it. If it becomes too hard for them, they will could opt out. We have a responsibility to support asset owners in this transition towards greater transparency.

What have you learned from the slow progress towards building a successful cleared securities lending solution?

Operating models that work in this area are those that are buy-side friendly, make economic sense for both the agent and its client, and are easy to adopt. Eurex was the first central counterparty to develop a workable clearing model that preserved the existing relationships of the bilateral agent lending market without imposing the traditional obligations of a clearing member on buy-side participants. We were fully committed to the Eurex product and disappointed that it closed. At the same time, we, like other participants, recognize new structures take time to establish through an iterative process of learning and refinement. We continue to work with Eurex on adapting their existing repo clearing products to make them viable solutions for our program.

The FICC Sponsored Member Program is another clearing model that we utilize within our agency lending program as an additional distribution channel for cash and US government securities. In addition, we continue to follow new developments being made on new models at NSCC and the OCC.

Generally speaking, we are learning that each new proposed model has limitations and challenges. One of the main challenges is the question of how default fund contributions and transaction costs are allocated. In addition, there is the question of documentation and how that shapes adoption. Broadly speaking, the easier the industry can make it for clients to participate, the quicker liquidity will arrive to the platform. Cleared transactions also need to be resource efficient for both the counterparties involved and for facilitators like us.

From an agent lender’s point of view, our clients are bringing liquidity to these platforms that provide resource efficiencies to their counterparties and therefore they should be paid a premium. Without that premium, it will be harder to justify the costs associated with clearing in many of these models. Making the economics work for all participants needs to be the goal if these models are to succeed.

What does the industry need to do to assimilate the growing emphasis on ESG compliance?

When it comes to ESG a process of some degree of standardization needs to take place. Standardization is a pre-requisite in order for a set of consistent principles and definitions to be established that asset owners can employ and which can be used as a blueprint for securities lending providers to follow, whilst at the same time allowing flexibility for regional differences in regulatory frameworks and recognising the variation of transition pathways to sustainable outcomes.

The question of governance has been around in securities finance for some time, such as issues around proxy voting and the other means by which clients have been able to exercise their stewardship responsibilities. The environmental and social dimensions will be those that we look to for progress in the future. Achieving standardization when it comes to scoring on these ESG factors is a process that will rely heavily on industry bodies on the one hand and regulators on the other. In order to achieve this, it will be important for ESG ratings to be reliable, transparent and comparable. But I am confident that the industry will soon deliver the principles required for an efficient operating model. These, in turn, will provide the level of transparency required by boards or senior management teams that allow them to demonstrate that they are fully aligned with their declared ESG principles and provide validation to the fact that securities lending is compatible with ESG and furthermore, can be a helpful tool in advancing the sustainable finance agenda.

How can providers help buy side clients achieve UMR compliance?

Phases 5 and 6 of UMR will bring into scope more than 1,000 new entities required to comply with margin requirements for uncleared derivatives. This will create considerable responsibilities for them, and they are looking to providers like us for solutions. The buy side will need a comparable set of utilities and solutions to those developed for the sell side – harnessing structures such as pledge. These have the potential to provide highly financial resource-efficient ways to address the compliance challenge.

But UMR is part of a wider shift toward increasing emphasis on transforming and optimising collateral across the entire enterprise. In some cases this will provide the buy-side with additional revenue opportunities by employing surplus HQLA or cash that is not immediately needed. Aggregating information and optimising these assets across the business provides a valuable way for a firm to meet its regulatory obligations as well as unlocking the revenue opportunities associated with assisting other counterparties.

As cleared transactions become another part of the opportunity set, it is important to remember that they may not be appropriate in all cases. Sometimes, they may not offer exactly the hedge that a client is after and an uncleared product may be more suitable. But importantly they will now have a clear choice concerning the venue and product best suited to their needs at that time. Armed with the tools and understanding we can supply, clients can make an informed choice between the cleared and uncleared derivative route, unencumbered by concerns of how efficiently the pre- or post-trade lifecycle of the trade will be managed.

This article is part of the Securities Finance Americas Guide 2021, and if you want to find more click here to download the guide.