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Understanding all the New Regulations

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.

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Understanding all the New Regulations

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  1. Understanding all the New Regulations Possible Impact of Dodd-Frank &Basel III on Securities Lending Kevin J. Campion, Sidley Austin, LLPGregory J. Lyons, Debevoise & Plimpton, LLP October 11, 2011

  2. 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

  3. 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

  4. 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 3 *Source BOE 2011 Q3 Bulletin; RMA; Data Explorers

  5. Orderly Liquidation Authority – Purpose and Coverage • Purpose – Response to Lehman; administrative (principally FDIC) alternative to bankruptcy • Coverage FI Corp*(BHC, NonbankSIFI, 85% FI) Bank(FDIA) Insurance(state) Broker(SIPA) exceptQFCs* * = Covered by OLAQFC = Qualified Financial Contract (e.g., Securities Finance)

  6. 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

  7. BHC/SIFI* Bank * Broker ** Funds ** * Applies directly** Applies indirectly via consolidation Capital – Dodd-Frank • Timing – Due January 2012, proposals part of “165 rules” • Coverage – Banking Institutions / Nonbank SIFIs • 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?

  8. 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

  9. 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

  10. 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 opentrades with a particularcounterparty 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

  11. Capital - Focus on Leverage Ratio • Relevant when:1. Bank provides indemnification2. Conduit Lending3. 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

  12. 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

  13. 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 derivativetransactions “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

  14. 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

  15. Volcker Rule – D/F 619 • Focus on bank PE fees and hedge funds, but • Can limit certain collateral pools Bank CollectiveFund Pool SeparateAccount Private Pool * MutualFund Pool * Potential problem under Volcker Rule – Possible fiduciary exemption, but – Credit, services limited

  16. 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

  17. 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

  18. 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.

  19. 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-the-counter 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.

  20. 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.

  21. 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.

  22. 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.

  23. 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.

  24. 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.

  25. 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.

  26. 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.

  27. 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.

  28. 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.

  29. 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.

  30. 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.

  31. Appendix A: Basel III – Phase-In

  32. Appendix B – Capital Surcharge 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.

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