ISLA does not believe it was the intention of the new regulations negatively to impact the securities lending activities of long only investors. However to ensure that there is sufficient clarity on this matter they propose that the definition of short sale within the regulations be clarified to exclude a sale of lent securities.

Many securities lenders are long term, long only investors who may be either restricted from entering into short sales, or who would not want to build the necessary reporting and compliance systems for dealing with short sales. Consequently, in the event that a sale of on-loan securities is classified as a short sale, many such investors will either choose not to lend or will materially reduce the amount of securities that they are willing to lend. Securities lending supports settlement efficiency (by allowing investors to borrow securities to settle transactions in a timely fashion), market efficiency (allowing market makers to borrow securities that they have committed to sell but do not own), and generates important incremental revenues for long term institutional investors such as pension funds and insurance companies.

 

Background

Securities lending programmes are nearly always set up in ways designed not to interfere with the normal investment management process of participating investors. Investors that wish to sell securities simply do so regardless of whether the securities are on loan. Once the sale is executed, the investor makes arrangements to recall any securities from the borrower to settle the sale. Often the securities lending function and the investment management function are performed by separate entities. When a sale is executed, the entity responsible for securities lending will be notified of the sale and will as necessary recall securities, or arrange to “switch” the loan to another investor participating in the programme.

The Proposed Definition of a Short Sale

The European Commission definition of a short sale in the currently-proposed regulation draft is as follows:

"short sale" in relation to a share or debt means any sale of the share or debt which the seller does not own at the time of entering into the agreement to sell including such a sale where at the time of entering into the agreement to sell the seller has borrowed or agreed to borrow the share or debt for delivery at settlement."

 

When securities are lent, the lender passes absolute title to the securities to the borrower. It could therefore be argued that when an investor sells securities that are on loan, they would be deemed to have undertaken a short sale, as legally at the point of sale the investor does not own the securities. They do however have a long economic exposure to the securities being sold.

Consequences

The consequences of treating sales of lent securities as short sales are material. The vast majority of securities lenders are institutional investors, such as pension funds, insurance companies’ collective investment schemes and sovereign wealth funds. Nearly all of these funds would have either restrictions or prohibitions on taking short positions. Being required to comply with the likely provisions of the short selling regulation (such as building systems to disclose positions to regulators and complying with uncovered short sale rules) would be costly. Securities lending is a source of low risk, low returns for long term investors, and increases in the costs of doing business will be prohibitive, severely limiting their securities lending activities. This would have the combined effect of:

• depriving institutional investors of material revenues from lending;

• reducing liquidity in the share and bond markets; and

• contributing to less efficient market settlement as fewer securities would be available to borrow to cover settlement fails.

Conclusion and Proposal

 

An investor who lends securities remains long in economic terms. Under the lending agreement the borrowing counterpart is contractually required to return the securities to the lender, and so the investor remains exposed to the market risk of the lent securities throughout the term of the loan. If the investor sells securities that are on loan, they are not taking a short position. Rather, they are simply selling a long position (which happens to be on loan). Treating sales of lent securities as short sales would have negative consequences for long term investors (who would lose valuable securities lending revenues), market liquidity and settlement efficiency.

 

ISLA therefore proposes that the definition of a short sale is clarified to exclude sales of lent securities. Their proposal is to add the text in bold below to Recital clause 15(a) and the definition of a short sale in Article 2:

 

• Recital clause (15a):

 

 

• Article 2 Definitions:

 

"short sale" in relation to a share or debt instrument means any sale of the share or debt instrument which the seller does not own at the time of entering into the agreement to sell including such a sale where at the time of entering into the agreement to sell the seller has borrowed or agreed to borrow the share or debt instrument for delivery at settlement. This definition does not include:
 

(i) a sale by either party under a repurchase agreement where one party has agreed to sell the other a security at a specified price with a commitment from the other party to sell the security back at a later date at another specified price; or

(ii) a sale of securities that have been lent subject to a securities lending agreement; or
(iii) entering into a futures contract or other derivative contract where it is agreed to sell securities at a specified price at a future date.