Protecting the retail investor
08 August 2023
The European Securities and Markets Authority highlights the risks facing retail investors that enter into securities financing transactions, a trading constituency that is creating a “significant source” of revenue to firms providing investment services. Carmella Haswell explores these risks with insight from market participants
Image: stock.adobe.com/LAYHONG
The European Securities and Markets Authority (ESMA) has released a public statement highlighting the risks of securities lending in regards to retail client financial instruments, and how MiFID II rules apply in this area to protect investors.
While securities finance transactions (SFTs) may bring extra returns on financial instruments, ESMA says, SFTs are also a “risky and complex practice” that can present counterparty and collateral shortfall risk, proving difficult to understand for the average retail client.
Given its concerns around these perceived risks for retail customers, the Authority has released a public statement highlighting the dangers of securities lending in regards to retail client financial instruments and how the second Markets in Financial Instruments Directive (MiFID II) rules apply in this area to protect investors.
In its statement, ESMA highlights that the investor lending out financial instruments will incur a loss if the external borrower is unable to return the borrowed financial instrument, the value of the collateral is insufficient to cover the loss of the financial instrument lent out, or if the investment firm is unable to compensate for the loss.
MiFID II is an EU regulatory framework designed to regulate financial markets and improve protections for investors. MiFID II therefore imposes strict requirements regulating the use of client financial instruments. The regulation enforces rules on securities lending in the areas of client consent, provision of collateral and information disclosure.
Speaking to SFT, an ESMA spokesperson says: “Securities lending is a risky practice for retail clients and it affects their ownership rights on the securities lent out. The objective of the statement was not to ‘democratise’ the use of securities lending with retail assets but to flag relevant risks and identify some practices to ensure compliance with legislation and fair treatment of clients.”
Preventing risk via MiFID II
The securities lending industry is moving into the spotlight as appetite from private investors continue to grow, according to Alex Panaite Fornari, general counsel at Sharegain. Panaite Fornari notes an increased regulatory focus in key areas including customer protection, client asset segregation and revenue share. These are world-wide trends, she adds.
“The growth of this sector and, in particular, the role of the retail client aggregators or brokers, raises some important questions for our markets,” explains Farrah Mahmood, director of regulatory affairs at the International Securities Lending Association (ISLA). She adds it is imperative to ensure that the underlying retail investor fully understands the risks involved in any such arrangement.
ISLA supports ESMA’s statement regarding the risks arising from securities lending activity for retail clients, and encourages ESMA’s focus to strengthen investor protection in tandem with the “increasingly more complex investment options” becoming available to this segment of the market.
While London-based consulting firm Aon agrees that securities lending and other SFTs are a — as ESMA puts it — “risky and complex” practice, Tom Daniels, practice lead for Aon’s securities lending oversight service, says that SFTs do not have to be ‘risky’ transactions, despite complex transaction nuances.
He continues: “Many agents accommodate beneficial owner customisation in their direct lending programmes, some down to the transaction level, thereby allowing for fine tuning of the risk-reward ratio that is in line with the lender’s risk tolerance and revenue objectives.”
Based on the lendable assets’ demand value, Daniels indicates that a certain base level of collateral and parameter flexibility may be required and can be optimised with expert guidance. He adds that there are operational safeguards and legal risk of loss provisions that can further mitigate client risk exposures.
To help protect retail investors, Daniels suggests that since retail lending programmes “do not typically provide the investor the level of customisation, disclosure or oversight that may be available in direct lending programmes”, firms could benefit most by engaging in lower risk transactions that focus on the intrinsic demand of the lendable assets. Daniels explains that this has less reliance on collateral risk, whether that be cash collateral reinvestment return or potentially less liquid non-cash collateral.
In light of these perceived risks, ESMA indicates that the bar for investor protection is higher when a firm engages in lending activity using retail client financial instruments.
In its technical advice to the European Commission on aspects relating to retail investor protection (ESMA35-42-1227 – April 2022), ESMA identified securities lending, in relation to client financial instruments, “as a practice increasing the risks incurred by retail clients and deserving further analysis in order to ensure the rigorous application of MiFID II investor protection requirements in this area”, according to the regulator’s spokesperson.
To safeguard client assets, MiFID II presents a requirement for firms to make adequate arrangements to safeguard the ownership rights of clients and to “prevent the use of a client’s financial instruments on own account except with the client’s express consent”, as dictated in Article 16(8).
To prevent loss occurring to the investor who is lending out the financial instruments, firms involved in these transactions should adopt specific arrangements to ensure that the borrower of client financial instruments provides appropriate collateral, as stated by Article 5 of the MiFID II Delegated Directive. The firm must also monitor the “continued appropriateness” of such collateral and take steps to maintain the balance with the value of the client financial instruments.
Allocation of additional revenue
ESMA indicates that firms should always act honestly, fairly and professionally in accordance with their clients’ best interests, as pinpointed by Article 24 (1) of MiFID II.
Written consent is a large component of the MiFID II Delegated Directive on investor protection. Article 5 of the regulation states that firms entering into SFTs which involve use of client financial instruments should obtain written consent from clients regarding how these client assets will be used on specified terms.
For written agreements and provision of information, firms are required to provide adequate information to the client on an ex-ante and ex-post basis, also providing transparency through “clear, full and accurate information” in terms of the obligations and responsibilities held by the firm with respect to the use of those financial instruments — this includes the risks involved.
Where SFTs involving client financial instruments will generate a return for the client, the terms must be included within the written client agreement. When a firm is securing a client’s consent, ESMA explicitly states that this written agreement should not be sought as part of agreeing to the firm’s general terms and conditions, a practice that the Authority has identified at some firms.
Developing this point, ESMA has questioned whether retail investors are receiving the full benefit of revenues generated from securities lending of retail client financial instruments in all cases.
The Authority found that some firms are retaining a share of revenues arising from this activity — sometimes justifying this activity by stating that retail clients are benefiting because it enables lower trading commissions to be charged to clients, ESMA reports.
In ESMA’s view, however, a firm using retail client financial instruments to generate additional revenues for the firm “may not be acting fairly and professionally in accordance with the best interests of its retail clients”, as required under MiFID II.
The Authority states that additional revenues from securities lending should directly accrue net of a normal compensation for the firm’s services to the retail client whose financial instruments are being lent out — for example, direct and indirect operational costs and a fair and proportionate fee.
The prospect of any indirect ‘benefit’, such as lower trading commissions, may not justify exposing a retail client to the risks of securities lending, according to ESMA. Furthermore, such an indirect ‘benefit’, if any, would not necessarily and proportionately accrue to all retail clients exposed to the risks arising from the lending of their securities, but to retail clients exhibiting more active trading behaviour, the Association adds.
On this point, Daniels says: “Firms engaging in retail client SFTs argue the practice benefits their clients by lowering other fees. While this may be true, those accommodations may not necessarily accrue to clients in accordance with the demand value of their securities. In other words, one client may reap larger revenue benefits or cost savings due to the value of their larger AuM but low demand securities relative to another client that has less AuM but higher demand securities.”
He argues: “It may be controversial whether the revenues should directly accrue to the applicable retail client versus proportionally to clients overall. Regardless, we think there needs to be more disclosure and standardisation of fees and the nature of charges for quicker take up.”
ISLA supports the broad premise that the bulk of all lending revenues should accrue to the underlying consumer in all areas of the market. ESMA acknowledges in its statement that intermediaries in the value chain should be duly compensated for their services. In this regard, ISLA’s Mahmood notes that the cost of a firm's services may differ for a number of reasons including the service level offering, return generation and risk management.
Mahmood endorses transparency in the disclosure of costs arising from securities lending intermediaries, adding that regular reviews of these securities lending arrangements is a must. She adds: “To provide maximum protection to end investors, there must be choice; this will help to support a commercially viable securities lending market for retail aggregators and allow them to maintain their ability to earn revenue for the benefit of their end investors.”
A good starting point
In May 2023, the European Commission adopted a Retail Investment Strategy to empower retail investors to engage and invest for their long-term interests since, according to Mahmood, retail participation in the EU had been traditionally low when compared to other jurisdictions. This strategy also forms part of the 2020 Capital Markets Union Action plan.
The Retail Investment package includes amending rules for MiFID II, the Undertaking for Collective Investment in Transferable Securities (UCITS) Directive and the Alternative Investment Fund Managers Directive (AIFMD). The package also amends the Insurance Distribution Directive (IDD) and Insurance and Reinsurance Directive (Solvency II).
Discussing how well MiFID II regulation protects the retail investor in the case of securities lending, Mahmood comments: “Securities lending requirements for retail investors will likely be adapted as part of this package of measures, to ensure the safety of consumers.”
ISLA says it will be working closely with regulators in Europe and the UK to ensure “sufficient levels of investor protection” through legislation and market guidance. The Association views similarities in the existing rules around UCITS and see this as a good starting point as ISLA begins to address similar issues.
The international association is also considering creating a securities lending guide for retail investors to educate and inform them of the practicalities and benefits to the wider capital markets of engaging in stock lending, as well as providing an additional return on their investment and to boost long-term savings.
In an effort to protect the retail investor, Sharegain provides a Securities Lending as a Service solution that aims to democratise the practice of securities lending. This is designed to give lenders the flexibility to meet different regulatory and structural requirements globally, and the varied needs of their own underlying clients.
For Sharegain’s Panaite Fornari, adaptability to ongoing regulatory change is important in protecting the retail investor, while having an agile partner can reduce the legwork significantly. “We believe that ESMA’s statement, and the proactive approach taken by other regulators across the world, will have a positive impact on our industry and will lead to even wider adoption by private investors,” she says.
“While MiFID II certainly contemplates many beneficial, base-line requirements, barring independent oversight, it does leave open the opportunity for potential abuses to retail investors like above market fees and application of expenses,” Daniels adds. “Without the client seeking consultative guidance, there may be no transparency for the client to understand if they are reaping adequate return for a given level of risk.”
The Aon representative says that there needs to be more disclosure and standardisation of programme parameters, as well as the nature and application of fees to further the democratisation of securities lending. A form of independent review or oversight would help alleviate avenues for firm self-dealing and retail investor abuses. He adds: “A review of retail investor programmes would help provide further confidence to safely grow this space.”
Panaite Fornari suggests that education is key to allowing securities lending to grow safely within this space. “While the industry has made positive steps toward educating the wider market, there are still several misconceptions among private investors about what securities lending entails, how lending programmes work and what rights they have,” she explains.
“We’re working with our clients to demystify securities lending for private investors,” Panaite Fornari adds. “Even simple changes in terminology, such as distinguishing securities lending from securitised lending, can have a significant impact. Further collaboration between all industry stakeholders is required to continue these efforts, establish best practices and deliver solutions that are transparent and absolutely trustworthy.”
In conclusion, ESMA’s spokesperson says: “Securities lending appears to be used as a significant source of revenue by some firms engaging in this practice when providing investment services to their clients. ESMA is therefore issuing the statement to clarify its expectations arising from the application of MiFID II requirements to treat clients fairly and professionally in accordance with their best interest.
“This includes the expectation that revenues directly accrue to the retail clients, who ultimately bear the risk of this practice, net of a normal compensation for the firm’s services; furthermore any such compensation should be clearly included in information on costs and charges provided to the client.”
ESMA and National Competent Authorities will continue to monitor whether firms’ behaviours are in line with these expectations.
While securities finance transactions (SFTs) may bring extra returns on financial instruments, ESMA says, SFTs are also a “risky and complex practice” that can present counterparty and collateral shortfall risk, proving difficult to understand for the average retail client.
Given its concerns around these perceived risks for retail customers, the Authority has released a public statement highlighting the dangers of securities lending in regards to retail client financial instruments and how the second Markets in Financial Instruments Directive (MiFID II) rules apply in this area to protect investors.
In its statement, ESMA highlights that the investor lending out financial instruments will incur a loss if the external borrower is unable to return the borrowed financial instrument, the value of the collateral is insufficient to cover the loss of the financial instrument lent out, or if the investment firm is unable to compensate for the loss.
MiFID II is an EU regulatory framework designed to regulate financial markets and improve protections for investors. MiFID II therefore imposes strict requirements regulating the use of client financial instruments. The regulation enforces rules on securities lending in the areas of client consent, provision of collateral and information disclosure.
Speaking to SFT, an ESMA spokesperson says: “Securities lending is a risky practice for retail clients and it affects their ownership rights on the securities lent out. The objective of the statement was not to ‘democratise’ the use of securities lending with retail assets but to flag relevant risks and identify some practices to ensure compliance with legislation and fair treatment of clients.”
Preventing risk via MiFID II
The securities lending industry is moving into the spotlight as appetite from private investors continue to grow, according to Alex Panaite Fornari, general counsel at Sharegain. Panaite Fornari notes an increased regulatory focus in key areas including customer protection, client asset segregation and revenue share. These are world-wide trends, she adds.
“The growth of this sector and, in particular, the role of the retail client aggregators or brokers, raises some important questions for our markets,” explains Farrah Mahmood, director of regulatory affairs at the International Securities Lending Association (ISLA). She adds it is imperative to ensure that the underlying retail investor fully understands the risks involved in any such arrangement.
ISLA supports ESMA’s statement regarding the risks arising from securities lending activity for retail clients, and encourages ESMA’s focus to strengthen investor protection in tandem with the “increasingly more complex investment options” becoming available to this segment of the market.
While London-based consulting firm Aon agrees that securities lending and other SFTs are a — as ESMA puts it — “risky and complex” practice, Tom Daniels, practice lead for Aon’s securities lending oversight service, says that SFTs do not have to be ‘risky’ transactions, despite complex transaction nuances.
He continues: “Many agents accommodate beneficial owner customisation in their direct lending programmes, some down to the transaction level, thereby allowing for fine tuning of the risk-reward ratio that is in line with the lender’s risk tolerance and revenue objectives.”
Based on the lendable assets’ demand value, Daniels indicates that a certain base level of collateral and parameter flexibility may be required and can be optimised with expert guidance. He adds that there are operational safeguards and legal risk of loss provisions that can further mitigate client risk exposures.
To help protect retail investors, Daniels suggests that since retail lending programmes “do not typically provide the investor the level of customisation, disclosure or oversight that may be available in direct lending programmes”, firms could benefit most by engaging in lower risk transactions that focus on the intrinsic demand of the lendable assets. Daniels explains that this has less reliance on collateral risk, whether that be cash collateral reinvestment return or potentially less liquid non-cash collateral.
In light of these perceived risks, ESMA indicates that the bar for investor protection is higher when a firm engages in lending activity using retail client financial instruments.
In its technical advice to the European Commission on aspects relating to retail investor protection (ESMA35-42-1227 – April 2022), ESMA identified securities lending, in relation to client financial instruments, “as a practice increasing the risks incurred by retail clients and deserving further analysis in order to ensure the rigorous application of MiFID II investor protection requirements in this area”, according to the regulator’s spokesperson.
To safeguard client assets, MiFID II presents a requirement for firms to make adequate arrangements to safeguard the ownership rights of clients and to “prevent the use of a client’s financial instruments on own account except with the client’s express consent”, as dictated in Article 16(8).
To prevent loss occurring to the investor who is lending out the financial instruments, firms involved in these transactions should adopt specific arrangements to ensure that the borrower of client financial instruments provides appropriate collateral, as stated by Article 5 of the MiFID II Delegated Directive. The firm must also monitor the “continued appropriateness” of such collateral and take steps to maintain the balance with the value of the client financial instruments.
Allocation of additional revenue
ESMA indicates that firms should always act honestly, fairly and professionally in accordance with their clients’ best interests, as pinpointed by Article 24 (1) of MiFID II.
Written consent is a large component of the MiFID II Delegated Directive on investor protection. Article 5 of the regulation states that firms entering into SFTs which involve use of client financial instruments should obtain written consent from clients regarding how these client assets will be used on specified terms.
For written agreements and provision of information, firms are required to provide adequate information to the client on an ex-ante and ex-post basis, also providing transparency through “clear, full and accurate information” in terms of the obligations and responsibilities held by the firm with respect to the use of those financial instruments — this includes the risks involved.
Where SFTs involving client financial instruments will generate a return for the client, the terms must be included within the written client agreement. When a firm is securing a client’s consent, ESMA explicitly states that this written agreement should not be sought as part of agreeing to the firm’s general terms and conditions, a practice that the Authority has identified at some firms.
Developing this point, ESMA has questioned whether retail investors are receiving the full benefit of revenues generated from securities lending of retail client financial instruments in all cases.
The Authority found that some firms are retaining a share of revenues arising from this activity — sometimes justifying this activity by stating that retail clients are benefiting because it enables lower trading commissions to be charged to clients, ESMA reports.
In ESMA’s view, however, a firm using retail client financial instruments to generate additional revenues for the firm “may not be acting fairly and professionally in accordance with the best interests of its retail clients”, as required under MiFID II.
The Authority states that additional revenues from securities lending should directly accrue net of a normal compensation for the firm’s services to the retail client whose financial instruments are being lent out — for example, direct and indirect operational costs and a fair and proportionate fee.
The prospect of any indirect ‘benefit’, such as lower trading commissions, may not justify exposing a retail client to the risks of securities lending, according to ESMA. Furthermore, such an indirect ‘benefit’, if any, would not necessarily and proportionately accrue to all retail clients exposed to the risks arising from the lending of their securities, but to retail clients exhibiting more active trading behaviour, the Association adds.
On this point, Daniels says: “Firms engaging in retail client SFTs argue the practice benefits their clients by lowering other fees. While this may be true, those accommodations may not necessarily accrue to clients in accordance with the demand value of their securities. In other words, one client may reap larger revenue benefits or cost savings due to the value of their larger AuM but low demand securities relative to another client that has less AuM but higher demand securities.”
He argues: “It may be controversial whether the revenues should directly accrue to the applicable retail client versus proportionally to clients overall. Regardless, we think there needs to be more disclosure and standardisation of fees and the nature of charges for quicker take up.”
ISLA supports the broad premise that the bulk of all lending revenues should accrue to the underlying consumer in all areas of the market. ESMA acknowledges in its statement that intermediaries in the value chain should be duly compensated for their services. In this regard, ISLA’s Mahmood notes that the cost of a firm's services may differ for a number of reasons including the service level offering, return generation and risk management.
Mahmood endorses transparency in the disclosure of costs arising from securities lending intermediaries, adding that regular reviews of these securities lending arrangements is a must. She adds: “To provide maximum protection to end investors, there must be choice; this will help to support a commercially viable securities lending market for retail aggregators and allow them to maintain their ability to earn revenue for the benefit of their end investors.”
A good starting point
In May 2023, the European Commission adopted a Retail Investment Strategy to empower retail investors to engage and invest for their long-term interests since, according to Mahmood, retail participation in the EU had been traditionally low when compared to other jurisdictions. This strategy also forms part of the 2020 Capital Markets Union Action plan.
The Retail Investment package includes amending rules for MiFID II, the Undertaking for Collective Investment in Transferable Securities (UCITS) Directive and the Alternative Investment Fund Managers Directive (AIFMD). The package also amends the Insurance Distribution Directive (IDD) and Insurance and Reinsurance Directive (Solvency II).
Discussing how well MiFID II regulation protects the retail investor in the case of securities lending, Mahmood comments: “Securities lending requirements for retail investors will likely be adapted as part of this package of measures, to ensure the safety of consumers.”
ISLA says it will be working closely with regulators in Europe and the UK to ensure “sufficient levels of investor protection” through legislation and market guidance. The Association views similarities in the existing rules around UCITS and see this as a good starting point as ISLA begins to address similar issues.
The international association is also considering creating a securities lending guide for retail investors to educate and inform them of the practicalities and benefits to the wider capital markets of engaging in stock lending, as well as providing an additional return on their investment and to boost long-term savings.
In an effort to protect the retail investor, Sharegain provides a Securities Lending as a Service solution that aims to democratise the practice of securities lending. This is designed to give lenders the flexibility to meet different regulatory and structural requirements globally, and the varied needs of their own underlying clients.
For Sharegain’s Panaite Fornari, adaptability to ongoing regulatory change is important in protecting the retail investor, while having an agile partner can reduce the legwork significantly. “We believe that ESMA’s statement, and the proactive approach taken by other regulators across the world, will have a positive impact on our industry and will lead to even wider adoption by private investors,” she says.
“While MiFID II certainly contemplates many beneficial, base-line requirements, barring independent oversight, it does leave open the opportunity for potential abuses to retail investors like above market fees and application of expenses,” Daniels adds. “Without the client seeking consultative guidance, there may be no transparency for the client to understand if they are reaping adequate return for a given level of risk.”
The Aon representative says that there needs to be more disclosure and standardisation of programme parameters, as well as the nature and application of fees to further the democratisation of securities lending. A form of independent review or oversight would help alleviate avenues for firm self-dealing and retail investor abuses. He adds: “A review of retail investor programmes would help provide further confidence to safely grow this space.”
Panaite Fornari suggests that education is key to allowing securities lending to grow safely within this space. “While the industry has made positive steps toward educating the wider market, there are still several misconceptions among private investors about what securities lending entails, how lending programmes work and what rights they have,” she explains.
“We’re working with our clients to demystify securities lending for private investors,” Panaite Fornari adds. “Even simple changes in terminology, such as distinguishing securities lending from securitised lending, can have a significant impact. Further collaboration between all industry stakeholders is required to continue these efforts, establish best practices and deliver solutions that are transparent and absolutely trustworthy.”
In conclusion, ESMA’s spokesperson says: “Securities lending appears to be used as a significant source of revenue by some firms engaging in this practice when providing investment services to their clients. ESMA is therefore issuing the statement to clarify its expectations arising from the application of MiFID II requirements to treat clients fairly and professionally in accordance with their best interest.
“This includes the expectation that revenues directly accrue to the retail clients, who ultimately bear the risk of this practice, net of a normal compensation for the firm’s services; furthermore any such compensation should be clearly included in information on costs and charges provided to the client.”
ESMA and National Competent Authorities will continue to monitor whether firms’ behaviours are in line with these expectations.
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