NEW YORK -- Investors tend to stay quiet about financial products they don't understand as long as the profits keep coming in, but when the tide goes out and profits fall, they want answers.
After several profitable decades of operating largely in the shadows, securities lending is undergoing some major changes -- along with virtually every other financial market in the world -- that will drastically increase price transparency, and those markets and instruments that can adapt to these changes will survive and prosper, lending experts say.
Securities lending was able to operate discretely for so long because of the high level of trust among beneficial owners in tightly knit social and business groups, but this trust has been shaken in the past 18 months, said speakers at the North American Securities Lending Forum held in Manhattan last week.
"People don't want to be surprised. There have been enough surprises," said Mark Faulkner, founder of Data Explorers, which hosted the forum. "That's what people mean when they talk about transparency."
Investors and regulators still desire securities lending, but they have been demanding much better transparency after Lehman Brothers declared bankruptcy last September.
"Beneficial owners' trust has been shaken," said Christine Donovan, managing director of global securities lending for Brown Brothers Harriman. "These problems have been around for years. Clients were experiencing the same issues in 1994 as they are today."
In addition to increasing transparency, Donovan said clients need to take on more responsibility for understanding how revenue is derived. While the national media made a big deal about the exodus from securities lending late last year, she said that the majority of people who pulled out have already returned.
"We've had a high success rate in bringing back clients," said Reeve Serman, global head of securities lending trading and market execution for RBC Dexia Investor Services.
In order for risk to be managed properly, it needs to be as transparent as possible, he said.
"The onus is on beneficial owners to understand what risks are in securities lending," Serman said. "There is an equal onus on us as lenders to educate clients. I don't think risk is something to be afraid of."
"All of these problems could have been solved by better documentation," said Andre Stern, founder of Oxford Asset Management. "It's easy to blame regulators, but it's insane to believe that any regulator could have prevented this crisis."
Transparency is still a tricky issue for firms not used to it. Like players in a poker game, everyone wants to know what cards the other players have, but no one wants to reveal his own hand.
"We are very supportive of the idea of having confidential disclosure to regulators, but we are very concerned about that information getting to the public and to short sellers," said Jennifer Han, assistant general counsel for the Managed Funds Association. "From a public company standpoint, this is very harmful. This is your Coca-Cola formula. You don't want that information to be out there in the public."
Han said if new regulation has to come about, she would rather have it come from the Securities and Exchange Commission, whom she calls "trained experts."
"Congress is not the expert on trading," she said. "It makes much more sense for the SEC to do it."
For years, many firms have had one prime broker. To diversify the risk of a broker failing, some firms took on additional brokers. But prime brokers don't know what clients are doing with other prime brokers, and this lack of information can increase risk to the lender.
No mutual fund is required to lend its securities, but if a fund decides to lend to a pool, it needs to know what else is in there, said Gene Gohlke, associate director of the SEC. Without transparency, it is extremely difficult to know what other investments are in the pool. Such a decision could lead to a lot of headaches for the fund and could result in a fund having an inaccurate net asset value, he said.
The securities lending industry had its reputation hurt late last year when the public went looking for a scapegoat and decided to blame short sellers, despite the lack of supporting evidence and understanding of the role of short selling plays in markets.
"Securities lending always gets thrown into discussions about naked short selling, but it has nothing to do with naked short selling," said Michael McAuley, chairman of the securities lending committee for the Risk Management Association.
In 1938, the SEC adopted Rule 10a-1, widely known as the uptick rule, which says that short selling may only be done when the last trade of the preceding day was at an uptick, a higher price than the preceding transaction. The rule was removed in 2007 after several studies found no difference in price declines between stocks with or without an uptick rule.
Short selling was blamed when the stock markets began to drop following the removal of the rule, but rather than reinstate the rule, the SEC put a temporary ban on all short selling. "All our studies have shown that the ban on short selling had a terrible impact on markets, liquidity and pricing efficiency," Han said.
There has been a lot of political pressure to reinstate the uptick rule exactly like it was or in a slightly revised version, though there is no evidence the rule could prevent future pricing drops.
"We don't think an uptick rule would be helpful," Han said.
Despite the short sale controversy, increased transparency for the securities lending market seems inevitable.
"I think securities lending will look very different in a few years," said Ed Oliver, director of Data Explorers. "A lot of things are going to change in the next year or two. We're still winning back the confidence of the beneficial community."
"In the end, securities lending firms will have to be more transparent," said one executive lender. "Even if some firms have to be dragged kicking and screaming, they will come around eventually."
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