Understanding all the New
Regulations
Possible Impact of Dodd-Frank &
Basel III on Securities Lending
Kevin J. Campion, Sidley Austin, LLP
Gregory J. Lyons, Debevoise & Plimpton, LLP
October 11, 2011
Overview – Legal Framework –
Dodd-Frank
• Dodd-Frank – U.S. response to financial crisis
•
– Most significant FS legislation since Great Depression
– Imposes both capital and substantive limitations on securities
lending
Sheer volume of rulemaking placing stress on regulators/industry
– Regulation “due dates” (indicated in slides) slipping
– Industry needs to be sure regulators understand cumulative
impact
– Commenting often difficult given “day job”
– Trades (ABA/FSR/ICI/RMA/SIFMA/TCH) very busy
1
Overview – Legal Framework –
Basel III
• Basel III – International response to financial crisis
•
– Substantially increases capital, procedural requirements on
“banking institutions”
– Particular focus on counterparty activities, like securities
finance and derivatives
Country implementation still in flux
– Basel Committee – Reaffirmed 1%-3.5% surcharges Sept.
28, 2011; FSB confirmed on Oct. 3, 2011.
– CRD IV (Europe) (proposals published July 20, 2011)
– US Section 165 prudential rules due out soon (really)
– Asia generally at least as strict as Basel III
– “Gold plating?” → UK – Vickers Report (published Sept. 12,
2011) – 3% add-on
• Collectively, Dodd-Frank and Basel III directly or indirectly affect
•
•
lenders, securities lending agents and borrowers
Much is known, much to be written
Sum may be worse than the parts
2
Overview – Current State of Securities
Lending
• Global Securities Lending Market Large (But Smaller)
•
•
– $3.5T on loan early 2008 (1.4x FTSE 100)
– $2T currently
Revenues Significant (But Smaller)
– $14.3B in 2008
– $6.5B in 2010
Collateral
– Still significant difference in jurisdictions
– US-Cash somewhat lower but still 90%
– Europe-Cash approximately 20%
– Cash Reinvestment
– Significant migration toward shorter/safer investments
Maturity
ABS
*Source BOE 2011 Q3 Bulletin; RMA; Data Explorers
2007 Q2
2011 Q2
220 days
100 days
26%
6%
3
Orderly Liquidation Authority –
Purpose and Coverage
•
•
Purpose – Response to Lehman; administrative (principally
FDIC) alternative to bankruptcy
Coverage
FI Corp*
(BHC, Nonbank
SIFI, 85% FI)
Bank
(FDIA)
Insurance
(state)
* = Covered by OLA
QFC = Qualified Financial Contract (e.g., Securities Finance)
4
Broker
(SIPA) except
QFCs*
Orderly Liquidation Authority –
Securities Lending Impact
• QFC Timing – One business day stay of QFCs for insolvency
•
•
•
(not stayed if other reasons)
– Generally ends 5 p.m. Monday
– Bigger concern if payments due also suspended
– “Counterparty” = client lender or indemnifying agent?
Process – Need to plan for 2 counterparties
– The “Carcass” 
– Counterparty risks
– The “Bridge” 
– Contract continues
– FDIC – Virtually all QFCs in Bridge – RMA seeking clarity
Contract Terms
– Tighten to address stay?
FSB overlay – July 19, 2011 SIFI Resolution Document
5
Capital – Dodd-Frank
• Timing – Due January 2012, proposals part of “165 rules”
• Coverage – Banking Institutions / Nonbank SIFIs
BHC/SIFI*
Bank *
Broker **
Funds **
* Applies directly
** Applies indirectly via consolidation
•
Requirements (D/F 165, 171)
– Raise capital generally
– Complementary to OLA
– Specifically increase burdens on securities finance?
– Surcharge for > $50B assets (Progressive)
– How interrelate with Basel III surcharges?
6
Capital – Basel III – Capital Ratios
•
Base
– Timing Effective 2013 (See App. A for transition)
– Final Ratios
– Common – 4.5%
– Tier 1 – 6%
– Total – 8%
– Capital Conservation Buffer – Add 2.5% to each
– Leverage (Perhaps better defined) – 3%?
•
Surcharge
– (Released July, 2011)
– Timing – 2016 – 2018
– Add-ons
– 1% - 3.5% (via common)
– Metric (App. B) includes Securities Finance
– Applicability
– BIS projects 28 G–SIBs initially subject to surcharge
7
Capital Basel III – Impact (Not Good)
• QIS Study (BIS)
–
–
Largest International Banks have aggregate € 577 B shortfall
Note – QIS Before surcharge
• Institute of Institutional Finance (Sept. 2011)
–
–
–
–
Banks have added capital, But
● Still need further to meet ratios, AND
● Some tier 1 recharacterized
→ 9.3% Tier 1 as of 2010 adjusted to 7.2%
Capital needs ↑ by $1.3T by 2015
Long-term debt issuance ↑ $0.3T by 2015
Ability to raise capital limited
• The Clearing House (9/22/11)
–
–
–
–
Study of 10 large U.S. Banks
Basel III (base) requires add’l 100% ($525B) of CS over pre-crisis levels
G-SIB surcharges require add’l $200B CS over 4Q 2010 levels
Reduce bank ROE 430-490 bps
8
Capital – Basel III – Denominator
Focus
•
Particular focus on counterparty activities (e.g., securities finance)
– Stressed effective EPE (Wrong Way Risk) (B-98)
– 3 years, must include period of stressed default spreads
– Increased minimum margin (B-103)
– 5-10 → 20 days
– Applies if trades exceed 5K/quarter, or bespoke collateral
– FRB discussions suggest key is that there are less than 5,000
open trades with a particular counterparty during a quarter
– 1.25x correlation multiplier (B-102)
– Regulated FIs with > $100B assets
– Unregulated FIs
−
Includes pension plans?
– FRB discussions suggest focus on borrower
– Applied to Asset Value Correlation Charge
9
Capital - Focus on Leverage Ratio
• Relevant when:
1.
2.
3.
Bank provides indemnification
Conduit Lending
Use of CCP?
• Indemnified
–
–
Current economic exposure (not PFE)
Netting on per contract or broader basis possible
• Conduit
–
–
–
Regulators leaning towards economic exposure position
“Emerging Concern” of impact among some regulators
Note: Applies more generally to repos
• CCPs
–
–
Regulators desire, but
A bit of a mess in the securities finance context
10
Exposure Limits – Dodd-Frank
• Additional requirements beyond capital
•
– Limits bank indemnification/conduit activity
25% Concentration Limit (D/F 165)
– Credit exposure to any unaffiliated company not >25% of
capital and surplus
– “Credit Exposure” includes securities finance/ derivatives
Economic exposure valuation?
– Treatment of affiliated companies
– Due July 21, 2013
11
Exposure Limits – Dodd-Frank (Cont.)
• Lending Limits (National Banks) (D/F 610)
•
•
– Securities loans, repos, derivatives, treated as “loan or
extension of credit”
– Deadline - July 21, 2012
Lending Limits (State Banks) (D/F 611)
– Only requires states to take derivative transactions “into
consideration”
– Deadline – January 2013
Secured Lending Haircut (Study) (D/F 215(a))
– House bill suggested 10% haircut
– Hopefully study = where politically expedient ideas go to die
12
Beyond Dodd-Frank – Guidance on
CCR Management
• U.S. Banking Agencies published June 29, 2011
• Governance
•
•
- Comprehensive framework with Board risk tolerance
- Report counterparty exposures regularly
Risk Measurement
- Employ a range of risk measurement metrics
- Measure @ various levels of aggregation
- Measure on entity and consolidated entity basis
- Measure both specific and wrong way risk
Risk Management
- Counterparty limits formalized into policies
- Regular model validation
13
Volcker Rule – D/F 619
•
•
Focus on bank PE fees and hedge funds, but
Can limit certain collateral pools
Bank
Mutual
Fund Pool
Collective
Fund Pool
Separate
Account
* Potential problem under Volcker Rule
– Possible fiduciary exemption, but
– Credit, services limited
14
Private
Pool *
Dodd-Frank Provisions Regarding Securities
Lending
•
•
Section 929X of the Dodd-Frank Act requires broker-dealers to supply customers
with certain notice regarding short sales and the borrowing of securities.
Specifically, broker-dealers are required to notify customers that they may elect
not to allow their fully paid securities to be used in connection with short sales.
–
•
If such securities are used, the broker or dealer must provide the customer with notice
that it may receive compensation in connection with lending the customer’s securities.
While the provision grants the authority to the SEC to adopt rules on point, they
are not required to do so, and at this point have not done so.
• SIFMA, with the assistance of Sidley Austin LLP, provided sample disclosures for firms to
•
consider in providing notice to:
– customers with whom a firm has an agreement under Rule 15c3-3(b)(3) allowing for
use of fully-paid securities, and
– margin customers generally.
In addition, SIFMA, with the assistance of Sidley, published “best practices”
concerning the required disclosures on its web site, which incorporated the views
of SIFMA firms and the SEC’s staff in the Division of Trading and Markets.
•
http://old.sifma.org/legislative/Dodd-Frank-Act-Compliance-Guidance.html
15
Dodd-Frank Provisions Regarding Securities
Lending
• Section 984(b) of the Dodd-Frank Act requires the SEC to promulgate
rules designed to increase the transparency of information available
to brokers, dealers and investors, with respect to the loan or
borrowing of securities.
– The SEC has until July 21, 2012 (two years after the date
of enactment) to promulgate these rules.
• The SEC is currently accepting public comments on Section 984.
– Comments can be submitted, and comments received can
be viewed, on the SEC website at:
http://www.sec.gov/spotlight/regreformcomments.shtml
16
Dodd-Frank Provisions Regarding Short Sale
Disclosure
• Section 929X of Dodd-Frank requires the SEC to prescribe rules
providing for the public disclosure of the name of the issuer and the
title, class, CUSIP number, aggregate amount of the number of short
sales of each security and any additional information determined by
the SEC following the end of the reporting period.
• At a minimum, this public disclosure must be made on a monthly
basis. The expectation is that institutional investors will submit the
required information to the SEC, who will then release the information
publicly on an aggregate basis.
• No definitive timeframe for this to be completed, so is likely not
imminent, pending completion of other more pressing Dodd-Frank
matters.
17
Dodd-Frank Provisions Regarding Study on
Short Sales
• Section 417 of the Act, entitled “Commission Study and Report on
Short Selling,” requires the SEC to conduct a study on the state of
short selling on national securities exchanges and in the over-thecounter markets, with a particular focus on the impact of recent rule
changes and the incidence of:
• the failure to deliver shares sold short, or
• delivery of shares on the fourth day following the short sale
transaction.
The SEC is required to submit the results of this study to the Committee
on Banking, Housing, and Urban Affairs of the Senate and the
Committee on Financial Services of the House no later than 2 years
after the date the Act is enacted.
18
Dodd-Frank Provision Regarding Study on
Short Sales
Section 417 also requires the SEC to conduct a study of:
•
the feasibility, benefits, and costs of requiring public reporting, in real time, of
short sale positions of publicly listed securities or, in the alternative, reporting
such short positions in real time only to the SEC and FINRA;
•
the feasibility, benefits, and costs of conducting a voluntary pilot program in
which public companies will agree to have all trades of their shares marked
“short,” “market maker short,” “buy,” “buy-to-cover,” or “long” and reported in
real time through the Consolidated Tape.
The SEC is required to submit the results of this portion of the study to the
Committee on Banking, Housing, and Urban Affairs of the Senate and the
Committee on Financial Services of the House no later than 1 year after the
date the Act is enacted. Of course, that one year timeframe has now come
and gone.
19
Dodd-Frank Provisions Regarding Study on
Short Sales (cont’d)
• The SIFMA comment letter on this study, which Sidley
helped prepare, identified significant operational
issues with such disclosure regime, and also potential
harmful unintended consequences associated with
disclosure, including impacting investors’ trading
strategies and presenting potentially misleading and
confusing information to the markets.
• Moreover, the letter noted the significant amount of
information that is already available in the
marketplace, including daily aggregate short sale
information published by the exchanges and FINRA,
and twice-monthly short interest figures.
20
Short Sale Alternative Uptick Rule
• Full compliance with Rule 201 of Regulation SHO was required
by February 28, 2011.
– The Rule 201 circuit breaker is triggered when the stock
price drops 10% from the prior day’s closing price.
– Subject to certain limited exceptions, short sales in securities
that triggered the circuit breaker cannot be executed or
displayed at or below the national best bid (“NBB”).
– The “Alternative Uptick Rule” applies at all times when the
NBB is collected, processed and disseminated pursuant to a
national market system.
21
Short Sale Alternative Uptick Rule (cont’d)
•
Not unexpectedly, with all of the market volatility over the last several
months, there are more stocks tripping the short sale circuit breaker.
•
For example, data provided by SEC Staff members in March 2011
showed that an average of approximately 100 total stocks each day
were tripping the Rule 201 circuit breaker.
•
During August 2011 this figure was much higher, with calculations
showing that approximately 104 NYSE and 30 NYSE AMEX stocks, and
approximately 360 Nasdaq stocks, were tripping the short sale circuit
breaker each day.
•
These figures were impacted by a couple of significantly volatile days in
August – for example, there was a high of 1214 NYSE and 181 NYSE
AMEX stocks, and a high of 1515 Nasdaq stocks, on one day.
22
Other Steps – Another Short Sale Ban?
• Many foreign jurisdictions have implemented bans on short
•
selling.
Unlikely that the SEC will do the same due to, among other
things:
• Certain unintended consequences associated with the
SEC’s 2008 short sale ban (e.g., impact on convert
offerings);
• Other protections in place now that were not present back in
September 2008 (e.g., Rule 204 close-out requirements,
Rule 10b-21, and the Alternative Uptick Rule;
• Reg SHO has a locate requirement while many foreign
jurisdictions do not have similar restrictions.
23
Other Steps – Changes to Locate
Requirement?
• Over time, various discussions on whether the current “locate”
requirement of Reg SHO should be amended.
• Commenters have suggested imposing a pre-borrow, or
arrangement to borrow requirement.
• GAO Study 09-483 – cited questions/concerns:
– Cited some commenters’ concerns that current locate
–
requirement allows broker-dealers to provide more locates
than have shares available.
Certain commenters advocated requiring short sellers to
first borrow before effecting short sales.
24
Other Steps – Changes to Locate
Requirement? (cont.)
• GAO Study 09-483:
– Noted SEC Staff and industry estimates that 5-10% of
locates result in actual borrowing and delivery of shares.
– Noted Rule 204 close-out requirements had also
strengthened locate processes.
– Based on review of OCIE exams, noted differing practices
regarding decrementing ETB lists to reflect locates given.
– Trading and Markets Staff informed GAO that costs of
marketwide pre-borrow requirement might outweigh
benefits, but would continue to evaluate.
• SEC has not, as of current date, taken steps to adjust the
current locate requirement.
25
FINRA Disciplinary Actions Regarding
Fully Paid Lending
•
Firm #1:
– Firm enabled customers to lend their fully paid securities to the firms (Fully Paid
Lending) on a solicited and unsolicited basis to facilitate, among other things,
short selling by firms’ other customers.
– FINRA found the firm failed to disclose or to adequately disclose that:
–
the security was hard to borrow, and was frequently being borrowed to facilitate short
selling;
–
the firms could reduce interest rates;
–
while securities were on loan, dividends were paid as “cash-in-lieu” payment and were
therefore subject to higher taxes; and
–
shares on loan could be sold at any time.
– FINRA also found the firms failed to establish, maintain and enforce written
procedures reasonably designed to supervise Fully Paid Lending, and had no
system or procedures to notify branch managers that customers were
participating in Fully Paid Lending.
– Censured, fined $175,000 each, and required to establish and maintain a
system related to fully paid lending prior to soliciting or facilitating any new fully
paid loans from customers.
26
FINRA Disciplinary Actions Regarding Fully Paid
Lending (cont’d)
•
Firm #2:
– Firm’s Direct Borrow Program (DBP) borrowed fully paid hard-to-borrow
securities owned by firm customers (mostly retail customers) to facilitate
clients’ short-selling strategies.
– FINRA found firm failed to disclose or to adequately disclose that:
–
–
–
–
–
the security was hard to borrow;
the firm could reduce interest rates;
brokers received commissions for duration of the loan;
while securities were on loan, dividends were paid as “cash-in-lieu” payment
and were therefore subject to higher taxes; and
shares on loan could be sold at any time.
– FINRA also found firm operated without a system or procedures to
supervise or monitor its DBP and did not notify branch managers that
customers were participating in the DBP.
– FINRA also found firm distributed 3 versions of marketing materials
regarding its DBP that were not fair or balanced and were misleading.
– Fined $650,000.
27
Proposed FINRA Rules Regarding Fully Paid
Lending Arrangements
•
FINRA published Regulatory Notice 10-03 in January 2010, requesting comments
on Proposed Rules 4330, 4314, and 4340
–
–
•
Rule proposals have not yet been filed with the SEC or published in the Federal
Register
SIFMA, with assistance of Sidley Austin, submitted comment letter.
Proposed Rule 4330: Customer Protection – Permissible Use of
Customers’ Securities
–
–
–
Require members, before entering into securities borrow transactions with customers,
to provide information on risks.
SIFMA comment letter stated preference for an industry-standard form of risk
disclosure, with standards mutually-agreeable among regulators and industry.
SIFMA also requested clarification on the frequency, disclosures, and suitability
requirements.
28
Proposed FINRA Rules Regarding Fully Paid
Lending Arrangements (cont’d)
•
Proposed Rule 4314: Securities Loans and Borrowing
– Require disclosure of parties’ capacities, establish right of liquidation, and
require written agreement with non-members.
– SIFMA requested confirmation that the transfer of data between the agent
lender and broker-dealer under the ALD regime will be sufficient to meet the
capacity disclosure requirement.
•
Proposed Rule 4340: Callable Securities
– Eliminate impartial lottery system and allow members to establish
procedures that require the allocation to be conducted on fair and impartial
basis. Also require members to post allocation procedures on website and
provide notice to customers explaining how procedures may be accessed.
– SIFMA commented that only a general description of procedures needed be
posted, since procedures may contain third-party proprietary information.
29
Appendix A: Basel III – Phase-In
2011
Leverage Ratio
Minimum Common Equity
Capital Ratio
2012
Supervisory
monitoring
2013
2014
2015
2017
Parallel run
1 Jan 2013 – 1 Jan 2017
Disclosure starts 1 Jan 2015
3.5%
4.0%
4.5%
Capital Conservation Buffer
Minimum Common Equity
Plus Capital Conservation
Buffer
2016
3.5%
Phase-in of Deductions
from CET1 (Including
Amounts Exceeding the
Limit for DTAs, MSRs and
Financials)
4.0%
20%
4.5%
40%
2018
As of 1
January
2019
Migration
to Pillar 1
4.5%
4.5%
4.5%
4.5%
0.625%
1.25%
1.875%
2.50%
5.125%
5.75%
6.375%
7.0%
60%
80%
100%
100%
Minimum Tier 1 Capital
4.5%
5.5%
6.0%
6.0%
6.0%
6.0%
6.0%
Minimum Total Capital
8.0%
8.0%
8.0%
8.0%
8.0%
8.0%
8.0%
Minimum Total Capital Plus
Conservation Buffer
8.0%
8.0%
8.0%
8.625%
9.25%
9.875%
Capital Instruments That no
Longer Qualify as Non-core
Tier 1 capital or Tier 2
capital
Phased out over 10 year horizon beginning 2013
30
10.5%
Appendix B – Capital Surcharge
Category (and weighting)
Cross-jurisdictional activity (20%)
Individual Indicator
Indicator Weighting
Cross-jurisdictional claims
10%
Cross-jurisdictional liabilities
10%
Size (20%)
Total exposures as defined for use in the Basel III leverage ratio
20%
Interconnectedness (20%)[1]
Intra-financial system assets
6.67%
Intra-financial system liabilities
6.67%
Wholesale funding ratio
6.67%
Assets under custody
6.67%
Payments cleared and settled through payment systems
6.67%
Values of underwritten transactions in debt and equity markets
6.67%
OTC derivatives notional value
6.67%
Level 3 assets
6.67%
Trading book value and Available for Sale value
6.67%
Substitutability (20%)
Complexity (20%)
For each bank, the score for a particular indicator is calculated by dividing the individual bank amount by the aggregate amount summed across all banks in the sample
for a given indicator. The score is then weighted by the indicator weighting within each category. Then, all the weighted scores are added. For example, the size
indicator for a bank that accounts for 10% of the sample aggregate size variable will contribute 0.10 to the total score for the bank (as each of the five categories is
normalized to a score of one). Similarly, a bank that accounts for 10% of the aggregate cross-jurisdictional claims would receive a score of 0.05. Summing the scores for
the 12 indicators gives the total score for the bank. The maximum possible total score (i.e., if there were only one bank in the world) is five.
[1]
Securities finance transactions with other institutions are expressly included.
31