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November 11, 2008

A New No-Fail Zone

The market for stock loan readies for change

By Nina Mehta

Sept. 18, 2008, is a day that may live in infamy among short sellers and stock-loan professionals. That's the day the Securities and Exchange Commission took out its big stick and instituted a penalty on broker-dealers that fail to deliver shares to settle short sales. That was done primarily to curb naked short selling, in which the short-seller doesn't attempt to borrow the shares for settlement, potentially skewing the market on the short side. The SEC imposed its penalty to remove some of the leniency that enabled short sellers to try to drive down the price of stocks.

That regulatory change, according to industry participants, will push up the cost of borrowing securities for hedge funds and others. It will also, they say, impact the way the securities lending business operates. Many predict more automation and efficiency in an industry that's often seen as having protected its own at the expense of greater transparency for market participants.

"Securities lending is in the spotlight in a way it's never been," says Tim D'Arcy, head of business development at SunGard Astec Analytics, a securities lending research and data unit at SunGard. "The days of an opaque market are going away. Change is coming."

In particular, the penalty behind the mandate requiring brokers to deliver shares for settlement will affect the way prime brokers deal with their hedge fund clients. Prime brokers will become stricter about facilitating short sales, many industry participants say.

The new penalty will also affect how brokers handle their own borrowing needs to support the activities of their customers. And it's likely to alter some of the arrangements between prime brokers and the agent lenders or custodians that represent the portfolios of loanable stocks for the pension funds, mutual funds and other beneficial owners of the securities.

On Thursday, Sept. 18, a day before the SEC imposed a temporary ban on short-selling financial stocks, the regulator announced, by fiat, that broker-dealers would face severe consequences if they didn't deliver shares to settle short sales on the settlement date. The settlement date is three days after the trade date. The penalty is simple: If a firm doesn't settle the trade before the start of trading the morning after the settlement date, by 9:30 a.m. on T+4, it can't execute additional short sales for itself or other customers without first pre-borrowing the shares, until the failed position clears. The T+3 delivery requirement previously existed, but the SEC's penalty was new. Punishment replaced tolerance on delivery fails.

Pre-Borrow Costs

The SEC's penalty, introduced through an emergency order, was drastic because pre-borrowing is costly and slows down the trading process for hedge funds. The SEC loosened some of the rules on Sept. 22, but the core of the penalty remained intact: a failure to deliver results in pre-borrow requirements. The Commission subsequently announced that its emergency penalty would continue "without interruption in the form of an interim final rule" once the order lapsed in mid-October. Firms could comment on the rule, but the rule was already in place. Referring to the new penalty, Erik Sirri, director of the SEC's Division of Trading and Markets, said in early October he expected that "the Commission will continue on this path."