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This Notice provides guidance to Dealer Members (Dealers) on IIROC’s expectations for implementing a fully-paid securities lending program (FPL program).
IIROC initially published this guidance in 20191 with the expectation that we would have rules in place for FPL programs by the end of 2022. IIROC has been monitoring the evolution of the FPL programs and has determined more data is needed to develop appropriate rules. Currently, five Dealers have been granted approval to introduce FPL programs. For most of these Dealers, their programs are in the development or infancy stages where the number of clients enrolled in the program is minimal.
IIROC will continue to monitor how the FPL programs operate and evolve. We expect to have rules in place for FPL Programs in 2024 before the expiry of the exemptive relief orders provided to Dealers in the program. In the meantime, IIROC is re-publishing the guidance on its expectations for implementing a FPL program.
Dealers with self-clearing operations generally have securities lending desks that, among other things, earn revenue by lending securities (that they own and/or hold for clients on margin) to institutions such as hedge funds, financial institutions and other broker-dealers (street borrowers) as a means to
FPL programs permit Dealers to borrow the fully-paid securities they hold on behalf of their clients and generally operate as follows:
In FPL programs, the Dealer borrows from their clients as principal (i.e. the Dealer transacts directly with their client as borrower, and then with the street borrower as lender, in two separate transactions). The client and street borrower are unknown to each other and do not have any legal rights or responsibilities to each other with respect to the loan transaction.
Fully-paid securities lending generates income for the client. Street borrowers pay a fee to the lender based on the supply and demand of the securities in the lending market (borrow fees). In particular, securities that have limited supply but substantial demand are considered “hard to borrow” and command higher borrow fees. The Dealer shares the borrow fee with the client.
Dealers will also have greater access to supply to meet their delivery obligations on trades, thereby increasing settlement efficiency.
For purposes of this Notice, FPL programs do not include arrangements where the Dealer acts as custodian for an institutional client’s1 securities, and as lending agent between the institutional client and street borrowers. The street borrower and institutional client are disclosed to each other and are each responsible for the associated counterparty credit risk. The Dealer, as lending agent, acts as administrator for the securities loan transaction and, in most cases, as custodian of the collateral. These arrangements are considered part of traditional securities lending arrangements that fall within the scope of IIROC Rule 4600 Financing Arrangements – Cash and securities loan, repurchase agreement, and reverse repurchase agreement transactions.2
The Dealer holds fully-paid securities in custody for their own clients, clients of other Dealers (Introducing brokers), and/or clients of portfolio managers. If a client wants to be part of the FPL program, they must sign a securities loan agreement with the Dealer and acknowledge that they understand and accept the risks associated with lending out their fully-paid securities.
Once the client is enrolled in the FPL program, the Dealer may borrow securities from the client at any time. When the Dealer borrows fully-paid securities from the client’s securities trading account, they send a confirmation to the client and set collateral aside for them. The client continues to see the lent fully-paid securities in their account but the positions will not be shown as segregated and cannot be used in any hedging strategy.
The term of the loan may be for a specified period of time (fixed term loan), overnight or, most commonly, open-ended, that is, it can be terminated at any time by either the client or the Dealer. Each day that the securities are out on loan, the Dealer marks to market the collateral for the client. The collateral is excluded from the calculation of loan value in the client’s account.
The Dealer makes the following payments to the client in their securities account:
The client or the Dealer can terminate a loan at any time. The client may want to terminate a loan for a variety of reasons including:
The client can sell their securities that are out on loan at any time and follow normal-course processes at the Dealer to place their sell order. If the client wants to terminate the loan for any other reason, they must contact the Dealer. The Dealer may restrict the client’s participation and eligibility in the FPL program if the client frequently terminates fully-paid securities loan transactions.
When a loan is terminated, the Dealer will attempt to recall, borrow or buy-in the securities within stipulated timeframes.
Securities lending is an area that is currently dominated by institutions. The FPL program will extend securities lending to retail investors who typically do not have the same level of sophistication, trading knowledge or tools as institutional lenders. There are certain risks associated with being a securities lender that the average retail client may not fully understand. Some of these risks are discussed below.
Loaned securities are often in demand by street borrowers to support short sales. Short selling could potentially put downward pressure on the long-term value of the client’s long security position. The likelihood of downward market impact increases for securities that are not widely held nor actively traded.
In securities loan transactions, the lender remains the beneficial owner but the title and ownership of the securities transfers to the borrower. Voting rights on the client’s fully-paid securities that are out on loan pass to the Dealer and, if lent on to street borrowers, pass on to the ultimate borrower. If the client wishes to vote on the securities, they need to request a recall of the securities (i.e. terminate the loan). There is a risk that
The client may have tax implications associated with:
Since the client remains the beneficial owner of the fully-paid securities that are out on loan, in order to reflect the client’s entitlement to the economic benefit of their lent securities, the Dealer makes a “manufactured payment” to the client that mirrors all dividends and distributions on the securities. The client may experience unintended and undesired tax consequences because the manufactured payment may not have the same tax treatment as the dividends and distributions normally received from the issuer of the security.
The client may exercise their right to the cash collateral under certain circumstances such as, in the event of insolvency of the Dealer or when the Dealer is unable to recall lent securities within stipulated timeframes. If the client exercises this right, they may have a deemed disposition of the loaned security which could result in tax implications.
The client may not get their securities back from the Dealer on termination of the securities loan transaction if there is limited availability for the Dealer to recall, borrow or buy-in the securities. The client will be impacted in the following circumstances:
This risk does not impact the client if they sell the fully-paid securities on loan.
In securities loan transactions, the borrower provides collateral to the lender equivalent to the market value of the securities that have been borrowed. The lender generally collects an overcollateralization amount to protect themselves from the credit risks associated with default by the borrower.
Dealers with large-scale FPL programs may have increased leverage risk from reinvesting or re-hypothecating the additional liquidity.
In FPL programs, the credit risk to the client arises from a Dealer insolvency. If a Dealer were to go insolvent, the client may not receive their lent securities back and may have limited recourse to the collateral because:
The FPL program has the potential to raise compensation-related conflicts of interest. Some examples are discussed below.
The potential for market manipulation may increase if the types of securities being introduced into the FPL program are not actively traded or not widely held. Such securities may be more vulnerable to practices like “short and distort”4 schemes and short squeezes5 . Similarly, increased short-selling in these securities may make them hard-to-borrow and therefore, result in delays in obtaining securities if a loan is terminated, and increased issues with settlements.
Dealers must contact IIROC with a change in business model notification before implementing FPL programs at their firms. IIROC has established terms and conditions to address the above investor protection and market integrity concerns which would effectively:
In 2019, IIROC’s Board of Directors approved the introduction of FPL programs at five Dealers and, subject to the terms and conditions0, provided exemptive relief from the following Dealer Member Rules (DMR):
The exemptions continue to apply for the equivalent IIROC Rules (clause 4603(3)(ii)) that became effective on December 31, 2021. If no new rules related to fully-paid lending are implemented prior to 2024, the existing exemptions will be void by 2024.
The Dealer must record the client’s fully-paid securities lending transactions and the cash collateral in the same account as, or a sub-account(s) of, the securities trading account (FPL combined account)6 .
The Dealer must ensure that the FPL program is restricted to equity securities that are
The Dealer must also ensure that for Canadian listed equity securities the FPL program includes only those securities that meet at least one of the following criteria8 :
The Dealer is required to maintain a list of securities eligible under the FPL program based on the above criteria. They must review their FPL program transactions against this criteria at least monthly and terminate loans that don’t meet the criteria as soon as possible.
The Dealer cannot borrow fully-paid securities from their clients under the FPL program to settle or cover their own inventory trading strategies unless the Dealer can demonstrate, to the satisfaction of IIROC, that they can effectively manage the conflicts of interest.
The Dealer must provide cash collateral to the FPL program client and keep it in a separate bank account held in trust for clients9 . The collateral cannot be withdrawn by the client or used to settle the purchase of securities in the account. A mark-to-market calculation must be done daily by the Dealer to value the lent securities which may result in changes to the collateral amount.
The Dealer must also provide to clients cash collateral of the same dollar amount as that received from lending the securities to street borrowers, but not less than 100% of the value of the securities.
The total amount of cash collateral to be set aside and calculated daily is the sum of:
The Dealer must obtain instructions from the client on:
The Dealer must ensure that each introducing broker has received a non-objection letter from IIROC before fully-paid securities of clients of introducing brokers are borrowed by the Dealer.
The Dealer must also ensure that each portfolio manager has notified the applicable Canadian Securities Administrators (CSA) regulator before fully-paid securities of clients of portfolio managers are borrowed by the Dealer.
The Dealer must sign a securities loan agreement directly with the client. Clients of an introducing broker or portfolio manager must enter into a tri-party securities loan agreement with the Dealer where:
The securities loan agreement must be in a form acceptable to IIROC and must clearly identify the:
The Dealer must provide a clear description to clients of the FPL program including the type of accounts or sub-accounts to be opened and the purpose of borrowing the fully-paid securities.
The Dealer must also obtain signed risk disclosure acknowledgements from, and provide documentation in plain language11 to, the client that explains all applicable risks including:
The Dealer must provide a confirmation to the client with all required details related to the securities loan transaction when the following has occurred:
The Dealer must send the client a monthly statement of the FPL combined account which:
The Dealer must incorporate fully-paid lending in the performance report and fee/charge report provided to retail clients for the FPL combined account in the following manner:
The Dealer is required to have policies and procedures addressing the FPL program to ensure compliance with IIROC requirements and applicable laws including:
The Dealer will need to ensure accurate reporting of fully-paid securities lending balances in the Monthly Financial Report (MFR) and Form 1, and calculation of the segregation, concentration and margin requirements as follows:
The Dealer must obtain an annual special purpose audit report to certify that the policies and procedures, systems and supervisory controls implemented for the FPL program comply with the following:
Any Dealer that would like to implement a FPL program must formally notify IIROC of a change in business model and apply to IIROC to facilitate the implementation of a FPL program and for appropriate exemptions from clause 4603(3)(ii) of the IIROC Rules and the capital requirements in the Notes and Instructions to Schedule 1 of Form 1. The IIROC Board of Directors will consider the Dealer’s proposed FPL program provided that it meets the terms and conditions discussed in section 3.
IIROC will continue to monitor how the FPL programs operate and evolve. This will provide valuable information when developing Rules relating to FPL programs. We expect to have IIROC Rules in place for FPL Programs in 2024 before the expiry of the exemptive relief orders provided to Dealers in 2019.
This Guidance Note discusses the following IIROC Rules:
This Guidance Note replaces Notice 19-0109 – Fully-paid Securities Lending.