The Securities and Exchange Commission this morning issued three new aggressive rules to curb naked short-selling in the securities market. These include penalties on broker-dealers whose short-selling clients fail to deliver shares for settlement, the repeal of the options market-maker exception to the close-out provisions in Reg SHO, and anti-fraud rules targeted at short-sellers. These rules go into effect tomorrow.
What follows is the September cover story of Traders Magazine, which explored what the SEC might do on the short-selling front against the backdrop of the changing securities lending industry. The article was written in August, before the SEC’s latest action to curb naked short-selling.
The SEC noted in its announcement of these rules that its actions “go beyond its previously issued emergency order” of the summer, which put restrictions around short sales in 19 financial stocks, including Fannie Mae, Freddie Mac, Lehman Brothers and Merrill Lynch. These new rules are expected to be controversial.
In its biggest attack on naked short-selling, the SEC is imposing stiff penalties on broker-dealers whose clients fail to deliver shares for short sales by the settlement date, which is three days after the trade date. Those brokers will be prohibited from facilitating new short sales in those securities for all clients unless they “pre-borrow” the shares in question.
The SEC noted that this rule is effective starting tomorrow on an “interim final basis.” However, the regulator said it “is seeking comment during a period of 30 days on all aspects of the rule.”
In its second new rule aimed at curtailing abusive short-selling activity, the SEC repealed the exception for options market makers to the close-out provisions in Reg SHO. The SEC’s Reg SHO, a set of rules governing short sales, went into effect in January 2006. As a result of the exception, options market makers, unlike other market participants, did not have to locate shares for short sales if those sales were part of hedging strategies for bona fide market making.
Finally, the SEC adopted a new anti-fraud rule aimed at short sellers. Rule 10b-21, the anti-fraud rule proposed by the SEC in March, outlaws deception by short-sellers “about their intention or ability to deliver securities in time for settlement.”
What follows below is the September cover story from Traders Magazine.
In the Crosshairs
The stock loan market braces for change
By Nina Mehta
Traders Magazine, September Issue
Is a screen-based market in the securities lending industry’s future? That sounds like crazy talk to some, but it is one of the ideas floating around the stock loan industry these days as broker-dealers nervously await new rule proposals coming out of the Securities and Exchange Commission. The regulator has promised to introduce regulations in the coming months to reduce certain short-selling behavior it considers harmful.
The Commission is under considerable pressure from Congress and the editorial pages of newspapers to do something about what many are calling abusive and manipulative short-selling. A proposal would follow the SEC’s unprecedented Emergency Order this past summer. For 23 days starting on July 21, the SEC banned naked short-selling in 19 stocks, requiring traders to have in place bona fide agreements to borrow shares from their brokers before they could sell the stocks short. The SEC did this, it told the world, to prevent rumor-mongerers from trashing the stocks of Fannie Mae, Freddie Mac and another 17 financial companies.
What this means for large swaths of the $8 trillion stock loan industry, most likely, is a fistful of tighter requirements around parts of the trading and settlement process for short sales. That could transform the industry, temporarily at least, by crimping the revenues of prime brokers, the market’s major intermediaries. It could also push the industry toward greater automation.
“The foundation of prime brokerage is lending money and lending securities to hedge fund clients,” says Paul Busby, Americas head of securities lending at Deutsche Bank. “Any new rules could affect prime brokers.” However, he adds, securities lending, a traditionally opaque bilateral market, should become more transparent to customers. The dissemination and availability of more pricing information, he says, is good for the market and should increase overall volume by injecting more efficiency into the industry.
Specifically, the SEC might do a number of things. In a move that would be considered drastic, the SEC could extend the Emergency “pre-borrow” to all stocks or impose it under certain market conditions. It could install tighter rules around the settlement process, or shrink the close-out provisions for broker-dealers whose customers fail to deliver securities for stocks they’ve sold short.
Bilateral Market
The securities lending industry is dominated by a tight, relationship-based network of lenders and borrowers. That “wholesale” market includes pension funds, mutual funds and other large buyside institutions that loan portions of their portfolios to prime brokers and broker-dealers. Brokers then lend securities needed for short sales to hedge funds and other clients.
The buyside institutions with the loan supply do their lending through behemoth custodian banks or third-party agent lenders. The brokers borrowing stock have bilateral relationships with the lending firms, buttressed by counterparty credit arrangements. All securities lending transactions are collateralized by cash or other securities, with the lending firm investing the collateral and paying a market-based rebate to the borrower. Loans are made on an overnight basis, with the rebate rate (which could be negative for hard-to-borrow names) reflecting the market price of the loan.
At the end of June, the global market of securities available for loan was $14 trillion, with $8 trillion in equities, according to Data Explorers, a London-based global data aggregation company focused on securities lending. This past June, there were $1.4 trillion of global equities on loan, with $586 billion of that in U.S. equities.
In a typical short sale, a hedge fund or other customer borrows shares and sells them in the open market, expecting to profit by replacing the borrowed shares once the stock price declines. Since 2005, customers could also “locate” the shares for short sales from a broker-dealer. The locate requirement, enshrined in the SEC’s Reg SHO rule, which provides the regulatory framework for short-selling, allows customers to execute shorts if there are reasonable grounds to believe that the shares can be borrowed by the settlement date, which is three days after the trade date. Naked short-selling refers to trades in which the seller doesn’t borrow or locate the securities in time for settlement. Abusive naked short sales are transactions in which the trader intentionally fails to deliver the shares for settlement.
By requiring traders executing short sales to arrange firm pre-borrows of stock before executing, the SEC’s Emergency Order underscored, in the starkest terms, the Commission’s concern that the locate requirement wasn’t a high-enough barrier to prevent potentially abusive activity during a period of extreme crisis. The SEC, therefore, is now considering additional ways to reduce abusive naked short-selling and lax or deceptive practices around short sales that result in failures to deliver securities for settlement. “Fails” include both inadvertent and operational delays in settling transactions, and manipulative naked short sales.
Data about the current level of fails in the market are not public. However, the National Securities Clearing Corp. has said that daily outstanding fails represent one percent of the total value of trades it processes daily. Market practitioners point out that the NSCC’s statistic is based on all securities it settles rather than just equities, decreasing the share of the market that the fails represent.
More Manual
The SEC has floated several ideas about its prospective rulemaking around short-selling, some publicly in speeches and Congressional testimony. One of the first things SEC Chairman Christopher Cox suggested after imposing the Emergency Order was that the Commission might require a pre-borrow for all short sales in equities. However, objections from the Securities Industry and Financial Markets Association and other organizations, including hedge fund groups, came swiftly, and within days Cox appeared to back down.
“It’s irrefutable that a short sale has met the requirement when there is a stock borrow that is executed, cleared and settled,” says Shawn Sullivan, global head of flow finance at Credit Suisse. “But a pre-borrow may not be the best solution for the broader market.” Broker-dealers and prime brokers don’t think such a rigid rule should be applied to short-selling activity more generally. Such a requirement, they argue, could hamper price discovery, reduce statistical arbitrage that adds liquidity to the market, and push some short-selling into the options industry. These reactions were fleshed out in numerous comment letters to the SEC in response to the Emergency Order.
For prime brokers, the SEC’s emergency action made the pre-trade process for the 19 targeted names more manual and time-consuming. A lingering concern is that any type of non-emergency pre-borrow requirement could put speed bumps around the trading process by requiring new technology. “Some prime brokers would need to update and reconfigure platforms to accommodate a significant technology build-out,” says James Martin, head of funding for Citi’s U.S. prime finance business.
Right now, the locate process is largely automated at most prime brokers. Hedge funds electronically send their primes lists of securities they may want to short and get back locate replies automatically, based on the broker’s ability to source the stock. Citi, for instance, processes 140,000 to 160,000 requests per day. Credit Suisse says its system processes more than 100,000 locate requests daily.
Prior to the SEC’s announcement of the Emergency Order, only seven of the 19 targeted financial stocks were “specials,” according to SunGard Astec Analytics, a data aggregation service in the lending industry. Specials usually have borrowing costs that start at 30 basis points, but, say practitioners, can rise to 2 or 10 or even 30 percent of a stock’s value on an annualized basis for extremely difficult-to-borrow names. What makes stocks expensive are supply and demand and factors related to the strategy around the short. “General collateral” stocks, or easy-to-borrow names, typically cost 10-20 basis points.
When the SEC’s temporary order expired, Astec found, the volume of shares on loan in the 19 names was one-third higher than it was pre-emergency, and the borrow cost was 28 basis points higher, on average. In Astec’s view, the increase in borrow volume and costs reflected the need of broker-dealers to ensure they had sufficient supply to accommodate short-sellers’ borrow requirements in those stocks, rather than pure market demand.
Brokers say a broader pre-borrow mandate applied to the market could increase costs and therefore cramp some trading strategies. “If we’re borrowing stock externally on trade date for a short-seller, that customer must take on that financial burden for those extra three days till settlement,” says one executive at a big prime broker. The person adds that there is also a “funding implication” with pre-borrows since prime brokers must pledge collateral before they receive client’s short-sale proceeds.
Other prime brokers agree that those additional costs would be shouldered by clients. Credit Suisse’s Sullivan adds that if a pre-borrow is required, his firm would scrutinize the locates it gives customers more carefully. “If a customer locates a large percentage of the average daily trading volume, we could borrow the size but, realistically speaking, only a small lot will actually be traded short,” Sullivan says. “In that case, I would have borrowed too much for the day. The over-borrow, along with the carry cost for the actual short sale, leads to an additional cost that would be passed on to the hedge fund customer.”
More Action
The SEC’s recent Emergency Order and focus on pre-trade obligations during a high-risk market suggest that some more action on this front may be likely even if there’s no pre-borrow. The issue, according to a range of market participants, is that brokers’ easy-to-borrow lists of stocks may not be adequate, or may not represent the availability of shares on the settlement date in some names. Traders may therefore not borrow hard-to-borrow shares because they’re costly. Alternately, brokers may be unable to deliver shares for settlement because locates in the same name were given out to too many customers who subsequently needed to tap that supply. A hedge fund manager says that some bulge shops, at times, decide to deliver shares for settlement late, making their locate lists more pliable.
An ongoing concern about locates relates directly to loan supply. “The key is not giving locates [for stock sales] in excess of what’s available to be borrowed,” says an executive at a large prime broker. “That’s the concern with naked short-selling, that people are allowed to sell stock short that physically can’t be borrowed or settled down.”
James Angel, a finance professor at Georgetown University and expert on short-selling, believes the SEC has focused too much on settlement in recent years. In his view, it’s a sign that the Commission “has never grasped the economics of fails.” Some traders, he says, fail to deliver securities because it’s expensive to borrow those securities, and failing to deliver them on time has little downside for them. Angel suggests that a stiff penalty for fails could be a disincentive. In an academic paper published in 2006, Leslie Boni, a managing director at agency broker UNX Inc. and a former finance professor at the University of New Mexico, presented evidence that cash and options market makers sometimes choose “strategic delivery failures” in lieu of delivering expensive-to-borrow securities to the NSCC.
The SEC has other options in its bag of tricks to prevent fails by forestalling potentially abusive short-selling. It has broached the idea of imposing disclosure requirements on short-sellers holding large borrow positions, akin to disclosure mandates for long positions. Former SEC chairman Arthur Levitt has also publicly recommended requiring “timely publication of the cost to borrow stock and stock-lending transaction volume.” That could shed light on borrow practices and add to price discovery. In addition, the SEC could reinstate the uptick rule that Reg SHO did away with, or a variation that imposes some type of price test designed to curb naked short-selling when the market in that security is declining.
Georgetown’s Angel suggests a way for the SEC to crack down on the prospect of naked shorting before it actually happens, while not trampling on the legitimate role of short-selling in the price-discovery process. The Commission, he says, could impose a “hard borrow requirement” for short sales that kicks in when a stock drops 5 percent from the previous day’s close. That solution would address the problem of “nefarious short-sellers” who pile into a security in a deteriorating market, but would not interfere with short-selling during normal market conditions.
How the SEC may eventually act to put some restraints around abusive short-selling isn’t clear. However, many industry observers expect SEC action to spur more disclosure and pricing information. Andy Dyson, a senior business consultant at Spitalfields Advisors, a London-based global securities lending consultancy, observes that if a regulatory change in the U.S. requires hard borrows or “hard availability” to cover naked shorts, that would likely make access to the borrow supply more critical to hedge funds, and that could ultimately benefit the biggest prime brokers. “What’s important is the depth of supply,” he says. “These types of things play into hands of the larger players, who have more resources to respond quickly and a broader depth of securities.”
Hedge funds, naturally, welcome better pricing, especially for hard-to-borrow securities. They also view access to prime brokers’ war chest of specials as critical. “As hedge fund managers are mainly interested in receiving specials, they will do as much business as possible with their primes in order to achieve a higher client status profile,” said a recent report from research firm TABB Group. At the same time, the report said, hedge fund managers would like the process of searching for borrows to be more streamlined across their primes and better integrated into their front-end trading tools.
Spitalfields’ Dyson agrees that hedge fund managers want better pricing, but notes that prime brokers traditionally provide bundled services. “It may mean that the price a manager pays to borrow a security may look expensive, but in the context of the overall relationship, it may be the right price,” he says. “The prime broker is providing its credit between the hedge fund and the lender, since the lender isn’t comfortable lending directly to the hedge fund. There’s a cost to pay for that.” Spitalfields is owned by the company that owns Data Explorers.
Short Skirts
In recent years, the SEC has emphasized the importance of rules involving settlement failures for short sales. For the regulator, focusing on settlement has been a way to try to constrain abusive naked short-selling, which by definition results in a failure to deliver securities, since the securities aren’t borrowed. Over the last 12 or so months, the Commission has tightened some of these rules. But according to some securities lending professionals, that post-trade focus doesn’t address the problem fully. Traders can sell stocks short and, if the stock price falls, buy stock in the open market to cover those positions, eliminating the need for a borrow to settle the trade. That lets some traders skirt Reg SHO’s borrow requirement and avoid the cost of borrowing stock.
Still, several possible changes relating to settlement failures are now in the SEC’s sights. One is a drastic reduction in the 13-day grace period before fails in “threshold” securities must be closed out. After 13 days, if a broker-dealer doesn’t close out the fails by buying securities, the broker-dealer and any firms whose transactions it clears cannot effect new short sales in that security without pre-borrowing shares. According to Reg SHO, “threshold” securities are those with fails for at least five settlement days exceeding 10,000 shares and half of one percent of the stock’s outstanding shares.
Each listing market publishes a list of its threshold securities daily. In mid-August, Nasdaq had 170 names on its list, while the New York Stock Exchange had over 100. An executive at a large prime broker who asked not to be named points out that requiring earlier closeouts would compel prime brokers to be more conservative in giving clients the ability to get short in certain names.
To reduce persistent fails, the SEC may also eliminate the options market-maker exception to Reg SHO’s close-out requirement, which it has contemplated doing for some time. In July, the SEC reopened the comment period for its proposed amendment from August 2007 to scrap the exception. SIFMA, the options exchanges and options market-making firms had already weighed in with their disapproval of the amendment. By mid-August, the SEC had received more than 1,300 comments from the public, most of them advising the SEC to cut the market makers loose.
Supply Side
Short-selling, in recent years, has become a more mainstream activity. Hedge fund assets have risen to $1.9 trillion, and traditional funds have increasingly ventured over to the short side. That growing demand has fueled the need for more automation. Indeed, the OTC world of securities lending couldn’t have grown to support the demand without automation.
“Automation is transforming securities lending, but right now it’s not about screen-based trading,” says Citi’s Martin. “It’s about supply and how you locate stock.” He notes that Citi, which has a 28-person securities lending desk in New York, processes about 95 percent of locates from customers automatically, while about 75 percent of the broker’s interactions with custodian banks and other prime brokers is automated. Citi is a net lender to other prime brokers, Martin says, with probably the largest supply of internal inventory for stock loans on the Street.
Deutsche’s Busby agrees that securities lending is about locating inventory. “Any prime broker in the industry that can facilitate more access to liquidity over another has a recipe for success,” he says. At Deutsche Bank, 80 percent to 85 percent of the broker’s sourcing and borrowing is automated. Busby adds that the large majority of sales traders on his New York securities lending desk spend their time sourcing hard-to-borrow names at competitive rates. They also provide customers, he says, with a “high level” of market color and analytics that enable them to make better-informed short-side execution and trading decisions.
Even as the SEC mulls over its plans, some brokers and industry players are chomping at the bit at the prospect that new regulations, combined with a growing demand for stock loans to support short-selling and arbitrage strategies, could urge the industry toward more disclosure and pricing transparency. There are now a half-dozen firms, from SecFinex in London to New York-based companies Quadriserv and LendEx, hoping to carve out a niche for themselves. The goal of many of these firms is to try to centralize borrowing and trading activity and make the market more competitive for more players.
Bruce Turner, chief operating officer of Quadriserv, a New York-based provider of data and technology services to lenders and borrowers, believes the SEC’s focus on the process around short-selling will benefit the industry. “If traders are better informed, they’ll make better decisions,” he says. “Components of stock loan, such as the locates for hedge funds, could be improved.”
However, creating a centralized market is easier said than done. Securities lending remains a global, complex OTC market based on bilateral relationships. Prices from multiple sources aren’t displayed on screens, and there is no centralized market for custodians, brokers and the end-users to turn to for their loan and borrowing needs. Securities lending is a business run by intermediaries. And forging direct relationships between those supplying the industry with shares to borrow and those who need to borrow shares for their short-selling activity is difficult, if not currently impossible.
In late 2006, research firm Celent predicted that 20 percent of the securities lending business between custodians and brokers would be conducted on electronic platforms by 2009, up from 10 percent at that time. That electronic business includes trades on EquiLend and small, screen-based, competitive markets such as SecFinex and interdealer-broker ICAP’s i-Sec in Europe. EquiLend is an industry “utility” formed by 10 big securities lending players in 2001 to streamline administrative, order-matching and post-trade tasks around the lending and borrow process.
Many of the largest broker-dealers, investment banks and custodians also maintain direct pipes with one another to facilitate their sourcing and trading needs. However, a significant portion of the market remains manual, with the locate-and-borrow process taking place through phone-calls, Bloomberg messaging and faxes. The biggest prime brokers typically have dozens of traders on their securities lending desks in New York and London. The industry’s largest primes are Goldman Sachs and Morgan Stanley, and both have a dominant presence in the stock loan market, according to practitioners.
Citi’s Martin points out that credit is the currency in securities lending, as it is in other OTC markets. And credit, in his view, is likely to be a limiting factor that will constrain the growth of some of the screen-based platforms vying for a place at the table. “With more information on a screen, potentially the spreads could narrow,” he says. “But hedge funds must also get over a credit hurdle. Public pensions do not want to extend credit directly to hedge funds.”
Credit Suisse’s Sullivan takes a longer view. “Every product goes through a life cycle where it starts out with little volume and wider spreads,” he says. “As the product matures, the volume picks up and spreads comes in. Could there be a screen-based exchange for securities lending? There could be.” But unlike, for instance, the OTC repo market, there are hundreds of securities “trading special,” he says. That could make a screen-based platform, which typically relies on the commoditization of products to stimulate liquidity, more difficult.
Roy Zimmerhansl, an executive at interdealer broker ICAP and head of i-Sec, a screen-based platform with a toehold in the European securities lending market, says his goal is centralized trading for stock borrows that can yield better real-time pricing information for borrowers and lenders. In his view, that should be available not only to the wholesale market of lenders and broker-dealer borrowers, but eventually to hedge funds as well. However, he acknowledges, centralized trading in securities lending still hinges on bilateral credit relationships. And until the obstacles around credit are surmounted, hedge funds aren’t going to be invited to the party.
Sidebar #1: Automation, Anyone?
Here is a quick primer on third-party trading and order-matching services in the securities lending world. The list below includes established players in the OTC arena and hopefuls that would like to see active screen-based markets. Some of these firms, but not all, compete with one another. Several have functionality that overlaps what’s available on other platforms.–N.M.
>> EquiLend
A platform created as a “utility” by 10 broker-dealers and lending agents in 2001 to standardize and automate their bilateral trading process and post-trade operations. Live since 2002, it was initially designed as an alternative to Loanet, a books-and-records company formed in 1982 and now owned by SunGard. The New York-based platform’s 45 participants can electronically send their borrowing needs or inventory data to approved counterparties, for U.S. and non-U.S. securities. Traders can view and filter lists, negotiate transactions and communicate electronically with counterparties. EquiLend’s AutoBorrow service, which allows users to order-match their low-touch flow bilaterally, executes about 18,000 trades totaling $20 billion daily, up from 8,000 trades per day in 2003. The platform’s Trade2O product, launched in February, enables firms to negotiate rates with other users and accommodates specials. Currently, 68 percent of the EquiLend’s transactions are in U.S. equities, 22 percent in non-U.S. equities, and 10 percent in fixed income. Owners include Goldman Sachs, Morgan Stanley, Barclays Global Investors and State Street.
>> i-Sec
Interdealer broker ICAP’s electronic trading market for European stock loan transactions. The screen-based platform, displaying anonymous bids and offers from broker-dealers, investment banks and agent lenders, launched in April 2007 with four pilot clients trading in six markets. It now has 15 clients trading 11 markets, although the firm declined to say how much it transacts daily. Users can execute automatically or negotiate trades. The platform, for the wholesale securities lending market, controls which counterparties users execute with, based on their counterparty credit arrangements and exposure limits. I-Sec plans to add U.S. ETFs to the platform this fall, following European ETFs, which were rolled out last spring.
>> LendEx
An electronic, auction-based securities matching platform for borrowers and lenders that rolled out in May. LendEx says loan inventory comes from large retail broker-dealers and small corporate pension funds. LendEx is a joint venture by Kalorama Partners, a consulting firm run by former SEC chairman Harvey Pitt, and John Tabacco, the founder of LocateStock.com, a platform to locate hard-to-borrow stocks. The LocateStock company includes a female-dominated online TV show highlighting the day’s most shorted stocks, with occasional digressions about Paris Hilton and other topics. The Alaska USA Trust Co. provides central credit counterparty services to LendEx. Borrowers using LendEx must ascertain that their clearing firm can accept borrowed shares from a broker-dealer on the platform.
>> Quadriserv
A stock loan market data and technology company that says it “hopes” the industry will move toward supporting a marketplace with competitive pricing for hedge funds. The firm, founded in 2001, has a data portal called Aquas, with historical rates and volume data from 15 brokers and current borrow rates from medium-size banks and broker-dealers. The firm’s hedge fund clients can upload their portfolios for order-matching against inventory data from brokers’ automated feeds. Quadriserv says it facilitates matching between hedge funds and counterparties, with trades occurring manually. The firm shut down its broker-dealer subsidiary several months ago. The company’s investors include private equity firm Bessemer Venture Partners and Renaissance Technologies, a hedge fund management company.
>> SecFinex
An electronic trading platform based in London with over 40 participants, down from more than 50 two years ago. The platform, launched in 2001 to try to centralize trading in the European wholesale lending market, has two main services: a Private Market, which enables bilateral trading by borrowers and lenders who can see each other’s identity and negotiate prices electronically, and an Order Market, which offers live screen-based trading with pre-trade anonymity. The latter displays bids, offers and depth of book. SecFinex allows broker-dealers to white-label its offering and give clients access to the platform. The firm has gone through several owners. In March 2007, Euronext (now NYSE Euronext) bought 51 percent of the company. The other 49 percent is owned by Fortis and Societe Generale.
Sidebar 2: Thou Shalt Not Lie!
Traders, it turns out, sometimes stretch the truth. They may, for instance, tell their executing broker they received a locate from another broker for a stock they’re selling short. To address this problem, which has been on the SEC’s radar for a while, the regulator in March proposed a naked short-selling anti-fraud rule aimed at manipulative pre-trade behavior.
The proposed Rule 10b-21 targets hedge funds and prop traders who deceive broker-dealers about their ability to deliver securities for settlement. Abusive naked short-selling that’s part of a manipulative scheme is already illegal under the anti-fraud provisions of the federal securities laws, the SEC stressed in its proposal. But, it said, this rule “would highlight the specific liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares.”
The proposal struck a nerve with a vocal segment of the public. By mid-August, the SEC had received over 700 comment letters in support of its plan. Most were from individual investors, many of whom had raked the Commission over the coals in earlier comment letters about not taking what they considered sufficiently aggressive action against alleged naked short-sellers.
Hedge funds groups and other industry organizations objected to the proposal. They said it was unnecessary and that broker-dealers, worried about their own liability if they took the word of hedge fund traders about locates, might require their clients to pre-borrow shares for short sales. –N.M.
