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DerivSource: 3 Risks to Firms and the Markets

The following was first published by DerivSource on September 25, 2023.

Three capital markets trade associations – including the Securities Industry and Financial Markets Association (SIFMA), have shared their concerns on the Securities and Exchange Commission’s (SEC’s) proposed position reporting requirements for security-based swaps (SBS) or Rule 10B-1, under the Securities Exchange Act of 1934. In the second comment letter filed with the SEC on the matter, the trade associations collectively warn the regulator of the various risks, operational burden and costs the introduction of the currently proposed reporting requirements would create. In a Q&A with Kyle Brandon, managing director, head of derivatives policy at SIFMA, we offer DerivSource readers insight into the concerns regarding Rule 10-B and the potential downside to derivatives market participants and the global capital markets industry.

Q: What is Rule 10B-1? And why has the SEC re-opened the comment period?

A: Rule 10B-1 is a requirement that all market participants report large positions of SBS and related products within one day of that position crossing a certain threshold, and that this is made public simultaneously with being reported to the SEC.

The SEC has stated it wants to increase the transparency of large positions. There was a provision in the Dodd-Frank Act for the SEC to establish position limits and position reporting to inform those limits. That provision was the catalyst for this rule, but it did not foresee the identification of the position holders, which this rule does. In most other contexts, large position reporting is done on an aggregated basis and does not identify the holders of those positions. The comment period was reopened after comment letters from various industry participants questioned the lack of cost benefit analysis of how the rule would impact regulated entities and the markets.

“The SEC is capturing a huge amount of data essentially to find a needle in a haystack. Only a tiny sliver of the data is actually useful, while other things may be mistaken for important information.”

Q: What are the top risks that SIFMA has identified regarding the proposed Rule 10B-1?

A: There are significant risks associated with publishing this data in the way the rule is proposed. The rule requires exceedingly detailed information about SBS and related positions, including identifying the market participants that hold the positions. The SEC is capturing a huge amount of data essentially to find a needle in a haystack. Only a tiny sliver of the data is actually useful, that is it identifies large directional positions, while other things may be mistaken for important information.

Data capture is misleading for the public

SBS are used for all sorts of reasons besides amassing a directional exposure to a security. They are also used for hedging or portfolio adjusting, which tells the observer nothing about a directional view. However, making such a position public could give other participants or indeed the SEC a false impression of what the holder is trying to do.

For example, a bank that lends to corporates may want to make a loan to a client but discovers it has reached its risk limit exposure for that client. One way to finance the company’s activity and hedge their exposure as a credit matter would be to buy credit protection through a single name credit default swap (CDS). All the public would see is that bank X needs credit protection from client Y. Outsiders could interpret that to mean the bank is worried about the health of its client, which would be incorrect.

Or a dealer might want to help a commercial client hedge its risks to a commodity, an FX or interest rate, and enter into a swap with that counterparty and in turn hedges the credit exposure on that swap by buying CDS protection on the client. It does not think that the client is at risk, it is simply facilitating the hedging of its client. That is another type of large position that could be misleading and does not tell the SEC or the public anything about large directional positions. There are many such examples, several of which we detail in our comment letter jointly filed with the International Swaps and Derivatives Association (ISDA) and the Institute of International Bankers (IIB).

The public disclosure included in this proposed rule would have serious unintended consequences and introduce additional risks for firms and the broader markets.

Opportunistic traders could reverse engineer strategies

Another risk is that opportunistic traders attempt to replicate the strategies of their competitors. If an investor puts on a position, as part of a complex strategy that they have developed, their ability to execute that strategy could be harmed if it can be copied or reverse engineered before it is completely in place.

The irony is that opportunistic trading is one of the reasons the SEC uses to justify the need for public reporting, whereas in fact it could end up being exacerbated.

Single name CDS or other SBS are typically not very liquid and sometimes positions take weeks to put in place. Forcing investors to tip their hands before they have finished executing their strategy will have a real impact on institutional investors of all kinds, and their ability to put their strategies into action. It could make it impossible for institutional investors to execute this kind of investment strategy because they will not be able to complete it before it is made public. It could inhibit firms from using these strategies at all and affect the health of the market.

“The irony is that opportunistic trading is one of the reasons the SEC uses to justify the need for public reporting, whereas in fact it could end up being exacerbated.”

The operational burden of additional reporting systems

There are a number of other positions reporting proposals outstanding, including short position reporting and securities lending, as well as proposed amendments to beneficial ownership reporting. This is in addition to the migration to T+1 securities settlement and other rules that require substantial technology and operational builds. The same teams must build all these systems. All these reporting regimes differ in terms of what firms are required to capture, how they will capture it, and how they will report it, whether public, public aggregated or not individually identified.

And so, in addition to the individual expense of any one of these rules, the SEC needs to consider the interaction of the rules when developing cost estimates, which it has not done.  For Rule 10B-1 alone the SEC estimates firms will need to find over $100,000 to build a new system. SIFMA believes this to be a vast undercounting and the true costs could run into multiple millions. Depending on the complexity, breadth and geographic reach of the business, firms are also supposed to aggregate so-called related positions, not just the SBS. It is daunting just to contemplate, and likely will cost firms well above the SEC’s estimates.

Q: What are the next steps for SIFMA and for market participants?

A: The bottom line of our comment letter is that we do not believe the rule should be adopted as proposed, especially the public reporting aspects. The operational and technological costs will be high regardless of whether the reporting is made public so that will also have to be addressed. There are questions around what data the SEC is capturing and how much it costs to do so versus what the SEC could do with the data it already has access to. So, as a first step we believe the SEC should leverage the data it already collects and identify what more it needs and why. . And should it demonstrate the need for SBS large position reporting, identifiable date should be reported to the SEC only, in line with other regimes that publish limited, aggregated data only.

We have real doubts about the ability of the market to function in the event of public reporting requirements. SIFMA, and many others, have written comment letters, and will continue to press for industry engagement on this topic through media interviews like this. Market participants across the industry also need to engage with regulators on the real-world implications of this rule.

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Kyle Brandon is Managing Director, Head of Derivatives Policy at SIFMA

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