Subject: S7-08-22: WebForm Comments from David Hoelscher
From: David Hoelscher
Affiliation:

Oct. 25, 2022

October 25, 2022

 While I appreciate that this rule aims to increase the transparency of securities lending, and is thus a step in the right direction, I would like to make the case that existing securities lending itself is entirely unnecessary for \"fair, orderly, and efficient markets.\" Rather, securities lending as it currently stands distorts the markets, obscuring true price discovery.

Ownership of a security confers distinct benefits to the owner:
-the right to vote those securities
-the right to receive dividends
-the right to sell the security

No one would argue that the housing market is unfair or inefficient. If I want to buy a house, I have to find one to buy from a willing seller. And if I rent a house, I have no right as a tenant to sell that rental house to someone else. As long as I rent it, I can receive benefits from the house by living in it. If I want to sell a house, I must first own a house. If I want to buy a house but I cannot afford it, I must secure a loan of money to buy that house (i.e. a mortgage).

Why should the securities market be any different? If I want to buy a security, I have to find one to buy from a willing seller. And if I rent a security (through securities lending), I should have no right to sell that security to someone else. As long as I rent that security, I can benefit from that security by voting it and collecting dividends. If I want to sell a security, I must first own a security. If I want to buy a security but I cannot afford it, I should secure a loan of money to buy that security (i.e. a cash loan).


The current method of securities lending erroneously conveys to the holder all benefits of ownership, whereas it would be more correct to convey through lending all of the benefits of owenership except for the right to sell the securities.

If an entity wishes obtain the right to sell the securities, this can be achieved without creating a moral hazard (that is, creating a situation with unlimited risk) by:
(1) locating a lender to provide the funds required to purchase the security,
(2) purchasing the security, and
(3) selling the security

In this way, ownership of the security is treated as a first-class citizen in the securities market. If the price of the security goes up after selling the security, there is no \"infinite risk\" that comes with short selling, because there is no absolute requirement to re-purchase the security. Instead, worst case there would simply be a default on the original cash loan, which results in a reasonable limitation of loss.

Some key difference to note with this method:
-Securities lending may still have utility with regards to voting securities and receiving dividends. If I want to have a greater say in the direction of a company, or if I think dividends will pay substantially more, I can borrow securities for that purpose, and do so more affordably than buying securities outright.
-Securities lending for the purposes of short selling would be replaced with cash lending to fund the purchase of securities to sell.

The current lack of an ownership requirement for selling (a.k.a. short selling) creates perverse incentives by way of excessive up-front capital generation (that is, proceeds from the short sale) and creation of excessive risks (potential for unlimited losses). If an entity wished to profit from \"securities lending\" in its current form, it would be far less risk to structure it as a repurchase agreement: the \"lender\" legitimately sells the securities to the counterparty, and agrees to repurchase them from the counterparty at a future date at either market prices or an agreed upon price. If either party fails in their obligation (the \"lender\" is unwilling/unable to buy them back due to increase in price, or the counterparty is unwilling unable to sell them back), then there are indeed losses, but those losses are now limited. Thus, if a security owner enters such an agreement, while they may benefit by receiving periodic payments, they are also subject to the potential loss of t
 he securities themselves in the event of counterparty failure. Taking on such potential liability may reduce the lender's willingness to enter such agreements, which is of course their business decision to make independently.

The existing structure also happens to expose a fatal flaw in the current system: securities lending is constructed in such a way that it generates virtually risk-free returns. If I hold a security and choose to lend it in the current system, the DTCC and its subsidiaries replace the individual counterparty risk with DTCC counterparty risk. Thus, I will generate returns from the stock lending, and I am still guaranteed by the DTCC to get the security back later, so long as the DTCC continues to exist. Given such an opportunity for reward without apparent risk, this removes any requirement for risk analysis with regards to securities lending decisions, and essentially drives brokers and institutions to lend their securities without limit (aside from consideration for the temporary loss of voting rights and dividend payments).

While I'm just an individual investor, and I'm statistically certain the contents of my letter will not make a measurable difference, I am optimistic and hopeful that it might strike a chord somehow, or inspire others to realize that securities lending in its current form is entirely unnecessary for fair, orderly, and efficient markets.

Securities lending for the purposes of obtaining voting rights and dividend payments is reasonable. Securities lending for the purpose of short selling is unreasonable, unconscionable, and unnecessary. Securities lending in any form should be more closely measured and reported--but admittedly if the ability to sell loaned securities is eliminated, then the reporting requirement becomes less important because the ability to distort securities markets through short selling becomes greatly reduced.

Thank you,
David Hoelscher