Richard Levin, chair of Nelson Mullins’s FinTech and Regulation Practice, was recently quoted in an article in FinOps report – “U.S. SEC Loan Reporting: Ops Cost of Transparency." The article discussed the operational and legal challenges of complying with the Securities and Exchange Commission (SEC) and its requirement to report information on securities loan transactions to the Financial Industry Regulatory Authority.

The SEC requests that lenders of securities or their lending agents report the economics and other detailed terms of securities lending transactions to a regulated national securities agency (RNSA) 15 minutes after they are completed. Some argue that such disclosure would indicate to all other market participants that a short position is being established, establishing a market impact that will increase the costs associated with continuing to build a short position over time. "The SEC’s analysis of the costs of implementing its proposal may be challenged as flawed," Levin said.

An electronic trading and Wall Street veteran, Levin was one of the first lawyers to focus on the regulation of blockchain and digital assets. He is considered a thought leader in the FinTech space. Chambers and Partners has recognized him as one of a select group of attorneys in the FinTech, blockchain, and cryptocurrency space. He is a frequent speaker at conferences on FinTech and regulatory issues and is the co-author of several chapters of books on U.S. regulation of digital assets and blockchain technology.

The operational and legal challenges of complying with the US Securities and Exchange Commission’s potential requirement to report information on securities loan transactions to the Financial Industry Regulatory Authority could outweigh the benefits of transparency to investors, say operations and legal experts.

Instead of offering any feedback to the SEC’s proposal, some industry players asked the regulatory agency to extend its deadline for comments from thirty days to ninety days because the January 7, 2022 deadline was too short to evaluate the SEC’s complex over 100-page long proposal. Even those who approved of the SEC’s plan in principle pointed out there were some provisions which needed clarification and others which would be challenging to meet.

In a nutshell, the SEC wants lenders of securities or their lending agents to report the economics and other specified terms of securities lending transactions to a regulated national securities agency (RNSA) fifteen minutes after they are completed. As the RNSA, FINRA would assign each transaction a unique transaction identifier (UTI). If the lending agents are not members of FINRA they must either report info about the securities loans on their own behalf or rely on broker dealers to do the reporting for them. Data and other third-party vendors cannot be used. At the end of the day, the amount of securities lent and the amount of securities which are available to be lent must also be reported to FINRA. The broker-dealer watchdog will present all the information to the public the next day aggregated by security.

The driving force for the transparency is two-fold– the Dodd-Frank Act of 2010 required the SEC to mandate it, and recent scandals involving short selling made the SEC believe that the securities lending market is opaque. Securities lending is a way for institutional investors to earn incremental revenues on their portfolios, but SEC says it is uncertain whether borrowers and lenders are paying or earning the right fees. Disclosure would presumably reduce the cost of short-selling. Whether there is a need for further disclosure is debatable, but what is clear is that securities finance operations managers will have plenty of extra administrative work.

The SEC’s proposal bears some similarities to the predecessor Europe’s Securities Financing Transactions Regulation (SFTR) which also requires reporting of securities loan transactions. However, there are some key differences. “SFTR requires reporting by both the lender and borrower and to a data repository rather than a regulatory agency,” says Martin Walker, head of product management for securities finance at Broadridge Financial in London. “There are also more types of transactions included under SFTR, such as repurchase agreements and margin loans. The timing of reporting also differs: in the US there is a 15 minute requirement, while Europe allows for next-day reporting.” The SEC’s plan calls for information to be made available to the public aggregated by security the next day in the US, while SFTR calls for monthly disclosure. SFTR. implemented in a phased approach beginning in July 2020, applies to counterparties established in the European Union (including their branches), and non-EU counterparties acting within an EU-based branch.

A common request among respondents to the SEC’s request for comment was for the regulatory agency to limit the types of transactions included for reporting and to phase in compliance starting with US exchange-traded equities. Topping the list of desired exclusions was short-selling transactions. “The proposed rule would reduce the cost of short-selling and facilitate more short-selling activity due to the ramifications of disclosing individual borrows between prime brokers and their customers effected to facilitate short transactions,” writes Lindsey Weber Keijo, acting head of the Securities and Financial Market Association’s Asset Management Group. “However, such disclosure would signal to all other market participants that a short position is being established, creating a market impact that will increase the costs associated with continuing to build a short position over time (particularly in hard-to-borrow securities) and potentially leading to copycat short selling activity, thereby disincentivizing fundamental research and short selling activity.”

Richard Karoly, managing director of the legal department for broker-dealer Charles Schwab & Co., cites duplicative reporting as the reason for eliminating short-selling transactions from the SEC’s plan. “The trading activity is already being reported [under FINRA’s Short-Interest Reporting Rule and the Consolidated Audit Trail] and asking firms to report this activity again under the proposed rule is redundant, would result in the double counting of those transactions, and may lead to confusion,” he writes in his letter to the SEC.

At first glance, the fifteen minutes required to report the details of a securities loan doesn’t seem to be a problem if an automated system were used to complete the transaction. However, that may not always be he case. “Most lenders would not be able to meet the fifteen-minute requirement without substantial technology development and cost,” writes Edward Marhefka, global head of equities data and analytics at IHS Markit in his letter to the SEC . “This would disadvantage smaller lenders and more without an existing relationship with FINRA.”

Other respondents to the SEC’s request for comment also caution that the fifteen-minute timeframe isn’t sufficient to collect all the necessary information because securities loans differ from equity or fixed-income transactions. “As collateral type, fees, and even loan size are typically worked out between the parties before ultimately being settled, typically at the end of the business day, the required reporting of securities lending data as well as modifications to such data within fifteen minutes would result in the publication of a large number of data that is incomplete, inaccurate and subsequently unhelpful,” writes SIFMA’s Keijo. She recommends the SEC require reporting by the end of the day after all the terms of the loan are agreed to produce more accurate and useful results. The mutual fund trade group Investment Company Institute agrees that the data on securities loans should ideally be reported the next business day. However, if the SEC insists on the same business day the regulatory agency should specify the time to ensure it is feasible.

Other market players cite different reasons for disapproving of the fifteen-minute reporting timetable. Jiri Krol, deputy chief executive and global head of government affairs at the Alternative Investment Management Association (AIMA) points to the possible risk of data leakage. “The 15-minute reporting requirement will provide market participants the ability to evaluate terms and potential signals of recently effected loans,” he writes in his letter to the SEC. “Such an outcome, however, will provide too much proprietary information to the market regarding closely guarded trading strategies, potentially leading to a situation in which it is possible to infer information about a particular market participant’s trading position.” The result: potential short-squeezes and front-running which could cause market participants to adjust their trading strategies and exit the borrowing market. Reduced liquidity and increased volatility would follow. Krol’s solution: next-day reporting. “The T+1 reporting would still achieve the transparency the Commission seeks to achieve without the potential harmful effects,” he writes.

Just as problematic as the fifteen-minute reporting timetable, say respondents to the SEC’s request for comment and others. is the accuracy of end-of-day data on the amount of securities lent and amount available to be lent. “The information on the amount of securities lent could rapidly change throughout the day and the SEC has provided no timeframe as to when during the end of day the calculation should be made which makes it difficult to know whether the information would be based on before or after the US national securities depository, Depository Trust Company, closes its books,” Martin Walker, head of product management for securities finance at operations outsourcing giant Broadridge Financial tells FinOps Report.

In her letter to the SEC, SIFMA AMG’s Keijo says the group does not object to the SEC requiring end-of-day information on securities lent, but she warns that end-of-day information on securities available to be lent could be grossly overcalculated. “The SEC should modify the proposed requirement to avoid providing such misleading information to the public until the SEC has the chance to review the quality of the data published.” recommends Keijo. “One idea which may merit consideration is to reference publicly available information on a securities total share float– which could be both accurate and readily available.”

James Angel, associate professor of finance at Georgetown University’s McDonough School of Business in Washington, D.C. cites the lack of clarity in the SEC’s definition of total supply available shares and available inventory as the reason why the end-of-day information on the amount of securities available to be lent isn’t such a good idea. Mutual funds are prohibited from lending more than one-third of their assets. Therefore, it is unclear whether the lender should report 100 percent of a particular stock as available or only 33 percent, explains Angel. He also questions whether the definition of available inventory should include securities owned by the broker-dealer as part of proprietary trading or only shares owned by customers.

The ICI agrees that based on regulatory restrictions relying on end-of-day securities available to be lent would be inaccurate. “Reporting this information would be misleading to market participants and could discourage beneficial owners from lending due to an inaccurate perception of the supply of securities available to lend,” write Susan Olson, general counsel, and Sarah Bessin, associate general counsel, of the ICI in their letter to the SEC.

Regardless of when the information on securities loan transactions must be transmitted to FINRA, the goal is for the data to be presented in a way which could be understood by the end users — the investors. The FIX Trading Community, the industry group advocating the FIX protocol for trade and post-trade functions, recommends the information sent to FINRA be in a standardized format while the lending agents and reporting agents could rely on proprietary methods. In his letter to the SEC, the FIX Trading Community’s regional director for the Americas Jim Kaye writes: “Users of proprietary standards, especially if defined differently by each RNSA. will be expected to increase implementation costs both for reporting firms and anybody working to consolidate data. A common standard will reduce costs and make it easier for firms to switch between reporting agents or use multiple RNSAs.” Likewise, because there are many lending agents and reporting agents, the use of reporting standards would also help reduce implementation costs, he argues.

Another respondent to the SEC’s request for comment, Pirum Systems, warns that the SEC’s requirement that FINRA create a UTI for each securities loan transaction will cause potential operational glitches for industry players. “Redesigning the firms’ existing mechanisms (designed to capture UTIs earlier in the process and include them in the transaction report) to support a model whereby the initial report is to omit the UTI would reduce the reusability of the existing mechanisms, and as a result increase the overall cost and time required to implement the proposed reporting for in-scope firms,” writes Robert Zekraus, chief operating officer and head of Americas for the securities finance technology firm. In addition,

if a transaction were to be reportable under the US and UK/EU SFTR regimes then it could end up having two distinct UTIs– one from FINRA and another from the reporting party for SFTR. Zekraus’ solution: have the reporting party issue the UTI in the US. “We can see no technical challenge in allowing firms to assign and report their transactions using UTIs they have created/received, which would allow them to observe the relevant global guidance and enable duplication between jurisdictions, as required for global data aggregation.” he writes in his letter to the SEC.

An even bigger problem with the SEC’s proposal than timing of data transmittal and other technicalities, say respondents to the SEC’s request for comment and others, is the requirement that only broker-dealers can be reporting agents. Not all lending agents are broker-dealers. “The limited scope of reporting agents is troublesome,” Howard Meyerson, managing director of the Financial Industry Forum tells FinOps Report. The New York-based industry group specializing in financial service operations, technology implementation, and regulatory compliance has established a committee to evaluate the SEC’s proposal.

Establishing new technological links is the tip of the iceberg in what lending and reporting agents must do to deal with data transmittal. Determining legal liability could be even more challenging. “The SEC’s proposal raises the issue of who will be held responsible for a data breach,” Matthew Comstock, a partner in the law firm of Murphy & McGonigle in Washington, DC. tells FinOps Report. “Ultimately lending agents and reporting agents could end up debating that point if the asset owner sues the lending agent.” In the hotseat for potential litigation, lending agents could find themselves in contractual battles with reporting agents to reduce their potential liability.

Naturally, FINRA won’t want to assume any responsibility for data breaches. If the FINRA-operated Consolidated Audit Trail provides any point of comparison, securities lending agents and broker-dealers could find themselves at odds with FINRA in deciding how liability will be handled for data breaches on securities loans. Broker-dealers were recently successful in fighting against taking responsibility for any cybersecurity breaches for CAT-related data held by FINRA. The SEC’s proposal on reporting of securities lending transactions even more expansive than CAT in that it incorporates fixed-income securities. The CAT is limited to executed trades in equities and options.

Contractual quagmires are just one of the reasons broker-dealers might not want to become reporting agents. Others are whether they could earn sufficient revenues to offset the costs of change and potential conflicts of interest. “The lender would have to provide an inventory of data to an entity with whom it may be trading the underlying securities, or the underlying client might not want to divulge its positions to the broker-dealer entity,” writes IHS Markit’s Marhefka who argues that such concerns about confidentiality could be alleviated using data vendors, such as IHS Markit, as reporting agents. He also says that a competitive landscape of different types of reporting agents could be more cost-effective than just relying on broker-dealers.

Michele Hilary, general manager of clearing and settlement at US market infrastructure Depository Trust & Clearing Corp., wants the SEC to clarify that DTCC’s role as a registered clearing agency does not make it a lending agent, but will allow it to act as a reporting agent for securities loans. “Clearing agencies are also subject to comprehensive regulation and examination by the Commission as well as a number of other regulators,” she writes in her letter to the SEC. “Moreover, clearing agencies have experience acting as financial market infrastructures and performing functions as such.”

Georgetown University’s Angel believes that FINRA can enforce the rules of reporting through its legal agreements with any reporting entities, so there is no need to rely solely on broker-dealers as reporting agents. “The submitters would agree in the contract to have documented and enforced policies and procedures in order to submit accurate information in a timely manner and to cooperate with FINRA in auditing the submitted data,” writes Angel in his letter to the SEC. “FINRA would then submit evidence of violations to the SEC.”

Given all the work fund managers, broker-dealers, custodian banks, and FINRA will need to do to comply with the SEC’s mandate on reporting of securities loans, if adopted, the question of just how much benefit investors would receive arises. The answer: a slew of retail investors responding to the SEC’s request for comment appear to be pleased with the added transparency. Others, not so much. The consensus of two dozen securities finance operations managers at broker-dealers contacted by FinOps Report over the past month was best expressed by Jim Toes, president of the Security Traders Association, the New York-based trade group representing traders at asset management firms and broker-dealers.”I don’t know how retail investors will find this information useful,” he tells FinOps Report.”

Likewise, the ICI in its letter to the SEC says that the potential benefit of reporting the SEC identifies in its proposal appears to be speculative at best. “It is fundamentally unclear from the Commission’s analysis, who other than FINRA and the SEC, would benefit from reporting of securities loans,” write Olson and Besin. However, the compliance cost could be helty. “The SEC’s analysis of the costs of implementing its proposal may be challenged as flawed, according to Richard Levin, chair of the fintech and regulation practice at the law firm of Nelson Mullins. “Critics may argue that the figures of US$375 million in initial costs and US$30 million to US$40 million in ongoing costs underestimate the cost of setting up policies, procedures, technological infrastructure and testing,” he tells FinOps Report.

The ICI argues that the SEC’s figures also overlook the potential cost to investors for fees passed along by lending and reporting agents. “Such costs may result in higher costs to administer a securities lending program or the potential decision by a fund that it is no longer economically worthwhile to operate a securities lending program, in either case lowering fund returns for shareholders,” write Olson and Bessin. “The Commission should explicitly account for these costs in its economic analysis.” The STA’s Toes warns that the fees charged by reporting agents to lending agents might outweigh the benefits of transparency. “The issue of what broker-dealers, as reporting agents, will charge lending agents becomes critical, because those expenses will ultimately be paid by investors. Smaller to mid-sized lending agents and their clients could be harmed,” he tells FinOps Report.

Respondents to the SEC’s request for comment and others can now only hope that the SEC will give them more time to analyze its proposal and will devise more practical steps for implementation. The jury is still out on whether the benefits of reporting on securities loans outweigh the costs.