Securities lending regulation

I managed to catch up with the CEO of ISLA, Kevin McNulty, to hear how his conference went and also get an update on the status of short selling related regulation in Europe. Ahead of the lengthy summer vacation being taken by European politicians it is as well to know where the industry stands. Do watch the video alongside today’s piece.

A new feature at this year’s ISLA conference was a “regulatory workshop” and this was what Kevin was keen to bring up. He had invited along a firm with lots of experience of lobbying EU politicians – Fleishman Hillard. The takeaway message was for securities finance to adapt to dealing with a new type of overseer. I think it is a good point that before the crisis, the SEC, the FSA and the Bank of England were the only large bodies the industry needed to address, and over time relationships had been established with these firms. Post 2008 and billions of tax payer money later, regulating finance has since become a much more complex and mainstream activity whereby ISLA has a new audience to appease of elected politicians.

Perhaps the best encapsulation of this is the type of politician who is leading the efforts to alter the way short selling and CDS is traded. Pascal Canfin is a French Green Party MEP and who has been quoted saying he "finds it very weird that you can buy a CDS on an asset you don’t have, or to cover a risk you are not exposed to” . It is not surprising he finds this strange given he has never worked in finance, having been a journalist with an MA in European Studies. For too long, finance has acted as if the rest of society need not know what it really does. Justifying complex financing practices to people who come to the topic with nothing but a sense that bankers need restraining is the tough challenge we are facing up to.

There are 3 areas currently being negotiated in the European corridors of power. At present there is not much agreement between the European Parliament’s position and the opinion of the Council of Ministers. It does not look like anything will be agreed before the summer recess. These two bodies need to find agreement before anything can pass into Europe wide law.

Short selling disclosure

The European Council of Ministers is keen to introduce public disclosure above 0.5% of a company’s total shares alongside private disclosure to regulators when over 0.2% but under 0.5%. Interestingly, this private disclosure was what the Italian regulator, CONSOB, instituted last week and it worked rather well in that they discovered no herd behavior by short sellers. Market participants have been supportive of private disclosure to regulators but are concerned that named public disclosure will have adverse effects such as encouraging “copy cat” trading by less sophisticated investors. The European Parliament appears to have accepted that public disclosure may be damaging and has removed this requirement from its draft. What ends up in the final regulation will be down to negotiation.

Reserve and locate requirement

There is still a chance that the EU will propose some damaging new rules forcing borrowers to, in effect, already be in possession of securities or have reserved them in the lending market before they can affect a short sale. This would change the dynamic of the industry and go further than the US rules in this area. If such a rule came to pass, Agent Lenders would require enormous buffers to prevent people reserving securities they didn’t end up using and throws up the question of whether the borrower is prepared to pay to have taken securities that they may or may not need. I think we know the answer to that – no!

Recall and implied short sale

With all the focus on how far to regulate short selling and whether naked sovereign CDS contracts should be banned, an important matter that is getting little attention is that a lender who sells a share that has been lent out could be deemed to have made a short sale. Economically this is clearly not the case and the unintended consequence of this would be to make it impossible for certain funds to lend in the first place.

Finally, as a footnote, I note an announcement this week from the Financial Stability Board (aka the new organ of regulation to address “vulnerabilities affecting the global financial system”) that securities lending and repo is a one of the areas of the shadow banking system and that this area needs greater ‘oversight and regulation’. . It’s early days and we will keep you appraised about developments.