Consultation on Variation of the Financial Stability Standard for Securities Settlement Facilities: Disclosure of Equities Securities Lending 2. Securities-lending Disclosure

In late January 2008, there were significant delays to settlement in the cash equities market. These delays arose, in part, from a participant's inability to meet obligations arising from a series of securities-lending transactions. These types of transactions are currently settled in a batch process operated by the ASX Settlement and Transfer Corporation (ASTC) alongside equity trades novated to the central counterparty, Australian Clearing House (ACH). However, in contrast to transactions undertaken on the exchange, about which there is considerable transparency, securities-lending activity is much more opaque. Reflecting this lack of transparency, the Reserve Bank's Review of Settlement Practices for Australian Equities conducted earlier in the year concluded that further steps needed to be taken to improve the disclosure of information about equities securities-lending activity.^[1] In particular, the Reserve Bank concluded that there was a strong case for the publication of data on the aggregate accumulated outstanding on-loan position, by stock.

The Reserve Bank's main objective in seeking greater transparency is to improve participants’ understanding of the potential settlement risks arising from securities-lending activities, thereby improving the overall functioning and stability of the market. Greater transparency would:

• assist the system operator in managing the settlement process. Separate identification of securities-lending transactions would improve the system operator's understanding of the composition of the daily settlement schedule, facilitating analysis of dependencies within the settlement process, and providing important input to back-out and batch-recalculation processes in the event of problems;
• assist both the system operator and participants in identifying potential settlement risks arising from securities-lending positions. Observation of a large outstanding on-loan position in a stock relative to its market capitalisation, or average daily turnover, might give some indication of the potential difficulty in covering that position to return the loan, particularly in the event that the loan was recalled unexpectedly. Separate identification of loans directly from custodians’ established loan programmes and those on-lent via an intermediary might also be useful in understanding risks and dependencies arising from ‘chains’ of loans;
• improve the quality of analysis of settlement fails. Recourse to a deep and liquid securities-lending market can help to prevent settlement fails when a participant is otherwise unable to deliver, perhaps due to an operational problem at a client or a custodian. On the other hand, vulnerability to the large-scale recall of loaned securities or to ‘chains’ of loans could, in some circumstances, lead to a higher incidence of fails. Bringing comprehensive data on securities lending together with settlement fails data could therefore assist in analysing the role of securities lending in the incidence and management of settlement fails;
• lead to a better understanding of the way the market functions. More generally, these data could be applied in broader analysis of the functioning of markets, assisting in ex-post analysis of market events and in the empirical study of the role played by securities lending in improving market functioning. In particular, the data could be applied in: analysing the relationship between price moves and changes in securities-lending activity; explaining seasonal patterns; and understanding the role of intermediaries in this market. Over time, such analysis could, by improving knowledge and understanding of the role of this market, help to improve overall market efficiency; and
• ensure a balance in the availability of information to market participants. Public dissemination of these data could help to ensure that all participants in the market had access to data on the volume and value of securities lending, rather than just those directly involved in such transactions or subscribers to proprietary services.

A high proportion of securities-lending transactions are motivated by the need to cover short-sold positions, whether these are directional trades, hedging transactions, or trades executed as part of an arbitrage strategy involving an offsetting derivatives position. Unless a trader is expecting an offsetting incoming delivery of a security, any short-sold position must ultimately be covered by securities borrowing if the trade is to settle as scheduled at T+3. Disclosure of securities lending is therefore complementary to short-selling disclosure, in respect of which ASIC has been working on improvements with ASX, and on which the Government is developing legislative reforms. In addition to covering short sales, other motivations for securities borrowing and lending exist, including borrowing to cover potential failed trades, dividend-driven activity, and some financing trades.

While the Reserve Bank's Review of Settlement Practices for Australian Equities concluded that transparency of securities-lending activity should be improved, it also concluded that securities lending and short selling support the efficient functioning of the equity market in normal market circumstances. Both practices add to market liquidity and to the efficiency of pricing, contributing to lower bid-offer spreads and helping to ensure that prices reflect the views of both bullish and bearish investors. Securities lending also plays an important role in ensuring that trades settle on time, even when market participants experience operational problems. However, as illustrated by recent experience, a lack of transparency over short selling and securities-lending activity can undermine confidence in the functioning of the market during periods of turbulence.

Since the publication of its review, the Reserve Bank has been in discussion with ASX and industry participants about how best to improve disclosure of securities lending. Following these discussions, the Reserve Bank is of the view that the most effective way of proceeding is to amend the Financial Stability Standard for Securities Settlement Facilities to make it clear that it expects ASX to collect and publish the relevant data. ASX indicated support for this proposal in a recent position paper.^[2]

Footnotes

The report is available at: <https://www.rba.gov.au/payments-system/clearing-settlement/pdf/practices-au-equities-may08.pdf> [1]

This paper, released on 2 October 2008, is available at: <http://www.asx.com.au/documents/public-consultations/transparency_of_short_selling_and_securities_lending.pdf> [2]