Securities and Exchange Commission (SEC) | Capital Markets Union (CMU) | SFTR
The past two weeks have seen the release of two quite different publications, both having the potential to significantly influence the future direction of our markets.
Mid November, the Securities and Exchange Commission (SEC) published proposed Exchange Act Rule 10c-1 to increase transparency and efficiency in the securities lending market, whilst earlier this week the European Commission (EC) published an update on their Capital Markets Union (CMU) initiative. Whilst I will look at both in more detail in due course, I wanted to pause for a moment and think about how the back-story for both is in part driven by a common theme, namely retail investors.
The publication of the proposed Exchange Act Rule 10c-1 from the SEC is seen by many as a direct response to the events surrounding GameStop earlier in the year, where the concept of swarm trading was first seen. Retail investors using mobile applications were essentially able to influence specific outcomes in what many would regard as the most open capital markets eco- system in the world. In stark contrast, the update from the EC on the CMU talked about the lack of engagement of many retail investors across the European capital markets.
Those looking at the emergence of swarm trading in North America from Europe, may need to be careful about what they wish for, as they aspire to making Europe a more attractive environment for individuals. Empowering individuals through the application of increasingly powerful technology brings with it very real questions about control and how the regulatory community responds to these shifts in market behaviour. As these new and agile investors take more control of their destiny, I am not convinced ‘more of the same’ in terms of regulation and oversight will be sufficient. The SEC and the EC are at different points in their development life cycles but have in many ways similar challenges, especially around the role of data which is at the heart of these recent proposals. In my view, simply rolling out a familiar sounding reporting regime or enhancing existing reporting protocols feel like using old technology to solve today’s problems. Instead, I believe that we as a financial services community should be more aspirational and look towards the digital world to help address these challenges; more of the same is not sustainable.
Anyone looking at the proposed Exchange Act Rule 10c-1 to increase transparency in the North American securities lending markets, will immediately see parallels with the SFTR regime here in Europe. Whilst the SEC has opted for single-sided reporting, thereby removing one of the most problematic aspects of SFTR, it does look very familiar both its terms of reference and the questions it asks. In some ways this is not surprising, as the SEC’s proposals can probably trace their origins back to the original recommendations of the FSB Workstream on Securities Lending and Repos (WS5) under the FSB Shadow Banking Task Force, which also led to SFTR.
As I reflect on what SFTR taught us about ourselves and the market that we represent, there is no doubt in my mind that coming together and solving for common problems has not only provided a cohesive and single voice to the regulatory community, but it has allowed the Association to deliver clear and concise guidance to our members. This guidance in the form of best practice has helped firms to implement SFTR in a consistent way, thereby creating fewer breaks and better connectivity across our markets.
To an extent SFTR opened the door to the wider digital world, where we are already seeing the regulatory community looking to pull data from standardised market data models, rather than demand endless reports. This approach, that is gaining significant momentum in some markets, leads me to believe that SFTR may have been the last of its kind; the traditional reporting world is having one last hurrah in the form of the SEC’s latest proposals.
The CMU update published by the EC earlier in the week again underlines the desire of the EU to build a broadly-based capital markets ecosystem, where the reliance on bank financing is reduced, and the focus is on integrating previously separate national markets into a genuine single market as well as incentivising retail investors. The CMU is also seen as an integral part of the developing green agenda, where it is generally accepted that governments alone cannot finance the cost of the green transition, and that the role of the private sector is key to the success of this shift.
I have already mentioned the significant role that individuals must play in any developing capital markets ecosystem. As Europe grapples with the potential move away from state funded pay as you go pension systems to fully funded individual pensions, it is important that the infrastructure exists to support those investors. Quite rightly the EC highlights the need for better financial fluency at the individual level; one may conclude that street investors around GameStop were trading financial products that they did not fully appreciate, or understand the risks that they were taking.
So, whilst I would applaud much of the aspirational thinking in the update paper, I still feel there is much to do in other areas. What I would have like to have seen is references to how we can collectively make markets run more efficiently, and provide the services that in particular retail investors need in order engender their confidence.
One of the most important factors that will support the CMU on a daily basis, is market liquidity. Without deep and liquid pools of securities, investors will not see effective price discovery and cheap and simple cash market execution. Not unexpectantly as someone who represents a securities lending association, you might argue that I would say that! However, as I look at the markets across Europe today, there is no doubt that the prevarication around CSDR has dented the confidence of many international investors.
Similarly, I have talked endlessly about the lack of market liquidity coming from UCITS constructs, and how the current restrictions make them an unattractive source for market makers and short side participants, etc. to source securities. Our recent analysis of SFTR data suggested that potentially over 90% of all lending liquidity comes from outside of Europe. Basel IV will only compound the situation, as it will penalise any direct exposure to unrated entities including many UCITS funds. Any logical switch to a pledge collateral model that would negate the capital issues associated with Basel IV, is not possible for UCITS due to their inability to receive collateral on any basis other than through a title transfer arrangement. What this tells me is that without some form of intervention, UCITS will increasingly become a source of ‘specials’ only, where the cost of capital associated with the trade will be outweighed by the value of the security to the borrower. Frankly this just feels wrong in my view, and fundamentally relying on non-EU market participants for most if not all of the liquidity underpinning the European markets, presents an increasing level of systemic risk that could undermine the success of the CMU project.
It is now the right time to re-evaluate what we want from these markets, and most importantly how we improve market liquidity being generated from within the EU as part of the desire to create a genuine single capital market.
Andrew Dyson, CEO