The Reserve Bank has called for greater transparency and disclosure in stock lending and is working with the ASX to fix problems in the exchange’s settlement procedures that were exposed by the failure by margin broker, Tricom to settle in late January.
The central bank has strongly suggested that lent stock should be disclosed on all broking buy/sell documentation and at settlement in a major departure from current practice..
The RBA’s report on the problems caused by Tricom’s failure to settle was released yesterday by the bank in Sydney.
The bank said in a short release that:
"On 29 and 30 January 2008, there were significant delays in the settlement of Australian equities.
"As a result of these delays, the Reserve Bank has undertaken an extensive review of settlement practices in the Australian equity market. This review sets out some possible modifications to current arrangements which might improve both the robustness of the settlement process and broader market functioning."
When the RBA becomes involved in examining a problem in the financial markets, especially where there is possible credit risk, counterparty problems and a danger of systemic risk developing (i.e. other parties defaulting) you know its a serious problem.
The bank says the system stood up to the pressures, but deficiencies were exposed and it has recommendation some options to be discussed in its report.
It reckons there’s a case for a possible lifting of fees for non-settlement, wants greater transparency of stock lending and changes made to the share settlement process to lessen the impact that a repetition of the events of late January would have on the system.
"Current settlement practices have served the Australian equities market well over many years," the RBA said in its conclusion.
"The batch settlement process is well established, operationally efficient and minimises liquidity demands (the way the ASX clearing house currently settled share and other dealings each day).
"The events of late January, however, suggest that there is room for some changes to settlement practices that would lessen the effects of any similar disruptions in the future.
"In particular, the Bank sees a strong case for moving to trade-by-trade settlement for equities over the medium term, while taking steps to enhance the robustness of the existing batch settlement process in the interim.
"The Bank will be working with ASX and industry participants over the coming months to assess whether, and how, the changes suggested in this paper might be implemented.
"Improving the transparency of securities lending activity, however, faces a number of practical challenges, both in terms of operational arrangements and enforcement. One possibility might be to tag data at the trade capture stage within CHESS, requiring that the lender (or both the borrower and the lender) populate a field to denote that the trade is related to a securities loan.
"If this were done, it would be useful to separately identify whether the trade was a new loan, a loan return or a loan recall. One possibility is that such arrangements could be enforced by ASX in the context of the participants adherence to operating rules."
The RBA said that during its discussions with securities industry participants " there was a general recognition that transparency needs to be improved. There were, however, a variety of views as to the objectives of increased transparency and the scope of additional information to be disclosed."
It said that "Greater transparency might be expected to have a number of benefits."
In particular, the publication of data on securities lending could:
"Improve general understanding of the potential settlement risk inherent in securities lending positions; help ensure that all participants in the market have access to data on the volume and value of securities lending, rather than just those directly involved in such transactions; assist in ‘ex post’ analysis of market events, and thus help understand the functioning of markets; serve as a proxy for short selling.
"While there are clearly limitations on the usefulness of data on securities lending for this purpose, these data may assist in some cases.
"Some estimates suggest that around 50 per cent of activity in the securities lending market is related to short selling."
The bank said the current settlement system involved a batch process which was run once a day. It takes all transactions and determines a company’s net obligations based on shares bought and sold.
It says a trade-by-trade settlement system would "reduce the potential for market-wide delays in settlement due to problems with a single participant, while preserving links between dependent settlements”
"The possibility of system-wide settlement delays have the potential to undermine confidence in the Australian equity market, which could ultimately have systemic implications beyond any direct financial loss associated with settlement problems,” the report said.
The RBA also suggested a number of possible modifications to the current system to improve the "robustness” of the settlement process.
These include having an explicit set time window for the completion of settlement, allowing more time for participants to ensure securities and funds are in place and increasing the penalties for failed trades.
The report did not look issues of short-selling, margin lending and the supervisory framework for brokers,
