How have topics covered in last year’s ISLA conference progressed in the last year?
We started the conference last year with a workshop on the Financial Transaction Tax (FTT). At that time, the idea that all 27 countries in the EU were going to agree on an FTT had broken down, so temporarily it looked like we were off the hook. But John Billige, who gave the speech, said that on the horizon loomed the prospect of some of the member states doing something together, and that we might see some more unilateral action. Both of those things have happened.
The first keynote speaker last year was David Wright, the secretary general for the International Organisation of Securities Commissions. He spoke at a high level as to why we in the markets should expect regulators to be tough and gave us advice as to how to engage with them. It’s fair to say that we’ve seen more regulation, and more talk of further regulation, and policymakers continuing to be tough on financial markets.
At the end of the conference, former MP Michael Portillo gave a closing speech, and he talked about the prospects for Europe at the time. One of the things he talked about was where the UK fits into Europe—at the time, the UK was still enjoying its triple A rating status. He predicted that it wouldn’t last very long, and sure enough, we saw a downgrade happen. Within the conference, we had a good lively discussion with trading desk heads, who talked about the need for conventions in the markets around corporate actions pricing, and how they use data in their businesses. I think lenders and borrowers have been working those conventions out, and data continues to play an increasing role in supporting the role of the securities lending trading desks. We’ve seen announcements in the last year that EquiLend are providing a data service to compliment those already provided by SunGard and Markit Securities Finance.
Clearly, regulation played a big role last year, and our particular focus was on shadow banking. We are still seeing that story unfold. It’s not getting the press it was six months ago, but attention will not fully go away until the Financial Stability Board has published its policy statement in September, and in Europe we know that the European Commission will be publishing a communication on shadow banking regulation shortly. The sooner we get something sensibly agreed the better and the market can move on.
For those who didn’t read ISLA’s response to ESMA regarding short selling and CDS, could you summarise what was in the letter?
There is a lot going on with the short selling regulation, but we’re only focused on a couple of very specific issues. Our initial concern in the original regulation was about the procedures required to cover a short sale. At the highest level, these regulations say short selling is permitted, but that it must be covered. We were worried about what the true definition of “covering” was, because that’s the bit that involves a securities loan.
We ended up with an okay outcome, and certainly better than feared—at one point it was looking like some European regulators wanted the system to be based on a pre-borrow type of arrangement, which would have cause tremendous liquidity issues. We managed to avert that, but nevertheless, ended up with a rather clumsy set of procedures involving differences between liquid and illiquid shares, and while not ideal, the market has found ways to work with the new rules in this particular area.
A recent development was that the European Commission was required to conduct a review of the short selling regulation six months after its implementation. That in itself was challenging, because half a year is not very long to consider how a new regulation is working in practice. It was especially difficult seeing as the definition of market making was still up in the air. We took the opportunity to focus on one issue, which was the regulations’ requirement that a locate of securities that is made to support a short sale has to be done through a third party.
The legal view is that third party must be a separate legal entity. That means if you are a bank and have an internal securities lending and repo desk, you can’t look to that desk to provide the locate to cover your short sale. We’ve been pretty unclear all along of what the policy objective of that requirement is, so have argued that it is unnecessary and doesn’t achieve much in practice. Particularly as it looks like the market making exemption is going to be narrowed, and so some of the activity that should have been exempted from the short selling regulation may in fact now become covered, and that will create more volume of locates in the market.
What is ISLA’s stance on the FTT and again, what recent developments have there been with the tax?
We are continuing to hear unofficially that the 11 member states have differences in opinion about the scope of the tax, among other issues. It’s a little unclear as there’s nothing much that’s official out there, but nonetheless we know that there have been differences of opinion, judging from statements from the German finance minister Wolfgang Schäuble, for example, who said introducing the tax was not an urgent matter, and could take a long time to be finalised.
One thing we can predict is that it’s looking unlikely that the 11 member states will agree on a consistent framework by 1 January next year.
As of now, we are not aware of any official move to change the scope of the original commission proposal. What we have been doing at the International Securities Lending Association is quite a lot of work to analyse the effects of the tax as it is currently proposed on the securities lending market, and we started talking to policymakers to give them some facts. Somewhat like the repo market, we are estimating 65 percent of the European securities lending market would essentially become uneconomic.
It’s the same with the repo market. If you take an absolute 10 basis point charge and apply it to a transaction that generates revenues on a per annum basis in what is essentially a low risk/low return business—it becomes uneconomic extremely quickly.
The design of this tax is just not proportionate for this type of business. The important thing that we are stressing to policymakers is that long-term investors such as insurers and pension funds would immediately lose revenue as a result of that, and based on the last 12 months, it would be in the order of €2 billion.
Given things such as pension fund deficits and the need to encourage long-term savings and returns, that would seem to us to be contrary to those broad policy objectives. The second thing is that we believe, and know that this is broadly accepted by many market observers, that when securities are lent, they support the secondary markets in a fairly substantial way: through providing liquidity to markets; helping transactions to settle on time; ensuring that all trading activity is covered in the market; and that price formation works better.
It is hard to quantify these benefits, but if you accept these reasons, taking away the lending market would result in poorer secondary markets, which is not a good outcome for investors or issuers of securities.
Another interesting issue is that there seems to be conflict between what the FTT will do and what policymakers are generally trying to achieve in their post-crisis regulatory reforms. They are trying to reduce exposures in the markets, and reward collateralised businesses. If a bank has a collateralised exposure, it gets a much better collateral treatment because that business is deemed to be less risky. The market supervisors are pushing more and more transactions onto central counterparty platforms and even in OTC derivatives, regulators are pushing for OTC derivatives transactions that aren’t centrally cleared to be margined using collateral.
This has led to a debate over the last 12 months whether there is enough collateral in the system to support all of these new requirements coming in. There is a bit of an argument about whether there is or there isn’t—on the surface there appears to be, but the issue is, is the collateral in the right place to do the job? And the answer to that is clearly no, because a lot of the securities that would be deemed to be good collateral would be held by long-term investors such as insurers/pension funds, and they’re not necessarily the ones that will need it for regulatory purposes. The only real mechanisms for moving this collateral around are securities lending and repo, so if you tax them out of existence, you’re immobilising the collateral in the system, and that will mean that it will be harder and more expensive for institutions.
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Geffen Advisors
David Geffen
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