SEC Weighs New Rules for Lending of Securities

The Wall Street Journal / BUSINESS
SEPTEMBER 29, 2009
By KARA SCANNELL and CRAIG KARMIN
Securities regulators are exploring new regulations for the multitrillion-dollar securities-lending market, the first major step regulators have taken in the area in decades.
Securities and Exchange Commission Chairman Mary Schapiro said she wants to shine a light on the "opaque market." After many large investors lost millions in last year's credit crunch, she said, "we need to consider ways to enhance investor-oriented oversight."
The SEC is holding a public round table Tuesday to explore several issues around securities lending, which has expanded into a big moneymaker for Wall Street firms and pension funds. Regulation hasn't kept pace, some industry participants contend.
Securities lending is central to the practice of short selling, in which investors borrow shares and sell them in a bet that the price will decline. Short sellers later hope to buy back the shares at a lower price and return them to the securities lender, booking a profit. Lending and borrowing also help market makers keep stock trading functioning smoothly.
The opacity of the securities-lending market worries regulators on several counts. The lack of transparency in the market has some people concerned that certain market participants could take on big risks that could threaten the financial system.
Another issue is how securities lenders invest the cash collateral put up by borrowers. The lenders are typically large institutional investors such as pension plans and mutual funds. They work through agents that act as middlemen between lender and borrower.
Last year's credit crunch exposed cases in which investors' agents placed collateral into risky pools of securities that had big losses. That spurred lawsuits by investors against agents. In some cases, the declines have been so severe that they undermined years of profits. The California Public Employees' Retirement System reported last month a loss of $634 million for its securities-lending program in the year ended in March.
Wilshire Consulting said that figure could end up as high as $1 billion, wiping away much of the $1.4 billion that Calpers has earned from this since its inception more than 20 years ago.
"We are in the process of developing new policies to reduce risk and losses in the program's reinvestment of collateral cash," said Calpers spokesman Brad Pacheco.
Fearing further losses, many investors tried to terminate securities-lending programs last year. That led banks with some of the biggest securities-lending programs, including Northern Trust Corp., State Street Corp. and Bank of New York Mellon Corp., to impose restrictions on the ability of investors to withdraw assets from these programs.
The SEC is looking into whether agents gave lenders complete information about the terms of the collateral investment. State Street disclosed in a recent SEC filing that the SEC is investigating its cash-collateral pools, among other areas.
Even in more-normal cases, when the collateral does earn a decent return, the SEC wants to make sure that the agents are being candid with the lenders about how the profits are being shared. Market participants said typical "splits" between lender and agent can be 80-20 or 60-40.
"We all know there are issues we need to work on," said Curtis Knight, director of securities lending and market risk at the Risk Management Association, a trade group that represents lending agents and custodian banks.
He said the group will work with the SEC and warned against rules that could stifle the market.
Tuesday's round table is a preliminary step and doesn't mean any rules are in the offing.
Lending also plays a role in the SEC's separate effort to limit, in particular, "naked" short selling, in which investors sell stock they don't own. The SEC has said it is exploring a "preborrow" requirement, which would require a short seller to have an agreement to borrow specific stock from a specific broker before placing the order.
Some firms are recommending regulators take strong steps. Quadriserv, an automated marketplace that displays quotes for stock loans, said stock lending should pass through a central clearinghouse.
—Jennifer Levitz contributed to this article.