[Exclusive] Financial Supervisory Service (FSS) moves to rein in high-rate re-lending of borrowed shares... seeks to separate LP and general-purpose lending

[Financial News] The FSS is considering a plan to separately manage securities lending transactions for providing liquidity to exchange-traded funds (ETFs) and general securities lending. The aim is to correct the practice of brokerages borrowing shares from asset managers at low interest rates and re-lending them to other investors at higher rates. Shares re-lent by brokerages are also used for short selling by private equity funds, hedge funds and others, drawing attention to the potential impact.■ Moves to separate securities lending for LPs from general lendingAccording to financial investment industry sources on the 11th, the FSS recently presented plans at a meeting with securities and asset management firms' staff responsible for securities lending to distinguish lending for liquidity provision from general lending in the Korea Securities Depository (KSD) system, and to manage related accounts separately at brokerages as well. Securities lending is a transaction in which parties agree to lend shares in return for a fee, and has mainly been used by liquidity providers (LPs), market makers (MMs) and in short-selling transactions.
Industry sources say that distinguishing the purpose of each transaction in the system could make it easier to verify why it was made. Rather than having to explain the purpose of each securities lending transaction afterward, the purpose could be recorded when the transaction is made and verified through data.
One reason the FSS is considering separate management of securities lending is the practice of brokerages borrowing shares for LP operations and re-lending them to outside institutions at higher rates to earn a spread. Another issue is whether the low lending rates applied as compensation for LP services serve the interests of ETF investors. Concerns have been raised that while brokerages profit from re-lending, funds may not be receiving all the lending income they could have earned. Whether transaction terms favorable to particular brokerages were provided has also been raised as an issue in previous inspections.
The FSS has been examining the appropriateness of securities lending transactions and the state of internal controls, including by conducting on-site inspections of securities firms' LP operations in April this year.
An FSS official said, “How the system should be improved and revamped is still under discussion. We are continuing to examine in depth internally whether this constitutes a violation of the law or is something that should remain an industry practice.” The official added, “If this practice continues until institutional improvements are made, it could become entrenched,” and said, “We have also urged asset managers to pay close attention to the management of related transactions even before an improvement plan is finalized.”■ “They were encouraging securities lending just yesterday...”—industry frustration, tooThere is also dissatisfaction in the industry over the fact that a long-standing trading practice is now being scrutinized for possible legal violations. An asset management industry source said, “When Korean-style hedge funds were introduced, the authorities also encouraged securities lending, saying the market needed to become active for hedge funds to flourish. It is hard to understand why they are now taking issue with transactions that have continued for so long, even raising the possibility that they violate the law.”
There are also concerns that this could constrain securities firms' LP operations.
An asset management industry source said, “Low-rate securities lending helps reduce LPs' cost burden. If fees at the same level as for general securities lending are applied, costs could exceed revenues, and firms may shy away from LP operations.”
Meanwhile, the FSS held a meeting on the 30th of last month, chaired by the head of its Financial Investment Inspection Bureau 2 and attended by asset managers' ETF division heads, compliance officers and others. On the 6th of this month, its Asset Management Supervision Bureau held a closed-door meeting with securities firms' ETF LP representatives. Securities lending practices were reportedly a key issue at that meeting as well.
[email protected] Lee Jeong-hwa Reporter