Pension Funds Claim Collusive Behavior in Securities Lending Markets

Steven Lofchie Commentary by Steven Lofchie

Three pension funds (the "plaintiffs") sued numerous major broker-dealers for allegedly inhibiting competition in the stock lending market.

In the Complaint filed in the U.S. District Court for the Southern District of New York, the plaintiffs claimed that the defendants have actively engaged in a conspiracy to maintain their control over the stock lending market. The plaintiffs characterized the alleged cooperation as a "working cartel," and argued that the broker-dealers formed a "dealer consortium" to protect their mutual interests.

Specifically, the plaintiffs allege that the defendants are working together to prevent the rise of companies that facilitate electronic trading and allow for lenders and borrowers to interact without the presence of a "middleman." They explained that the defendants have repeatedly taken steps to preserve their own "supracompetitive" profits, and in turn have prevented technological advances that would contribute to transparency and benefit other market participants:

"[T]he Defendants colluded to keep the securities lending market opaque by making the Prime Broker Defendants masters of the exclusive "gateway" that forces the buy side to rely on them, and them exclusively, for stock loan trading. Defendants have relegated both lenders and borrowers to an inefficient OTC market to protect their own supracompetitive profits. This market structure is wholly artificial and has directly imposed significant financial harm on other market participants."

Commentary

Much of the complaint is predicated on the assertion that, were it not for industry collusion, it is inevitable that the securities lending markets would be centrally cleared. In reality, central clearing is far less attractive than the plaintiffs assume. One need only look at the swaps market where, despite all of the initial regulatory enthusiasm, central clearing has not advanced beyond the most plain-vanilla products. Similarly, the notion that central clearing eliminates credit risk is simply wrong, as all of the regulators have now conceded: it simply transfers credit risk, and it may not do so in an economically efficient manner (which may be why the central clearing of swaps has stalled).

The plaintiffs' comparison of securities lending to securities trading is off-base. When one buys stock, the identity of the seller is irrelevant. When one borrows stock, the identity of the lender matters; e.g., it impacts the tax treatment of dividends and whether the stock loan is likely to be terminated.

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