Part 2 of 2: Customer securities loans and Regulation SHO
Part 1 explained how customer cash and securities are protected at a US self-clearing broker-dealer. Part 2 focuses on two activities that are often discussed together but operate under different rules: securities lending and short selling.
A securities loan is a financing transaction in which securities are delivered to a borrower against collateral. A short sale is a market transaction that creates an obligation to deliver securities at settlement. These activities can be connected because borrowed securities are often used to satisfy the delivery obligation created by a short sale.
This article explains how those transactions fit together, how Regulation SHO governs short-sale activity, and how lending, borrowing, settlement, and market-making controls operate around them.
Two Separate Transactions
A securities loan occurs when a lender delivers securities to a borrower in exchange for collateral. Collateral in securities lending is commonly cash, but may also consist of other eligible collateral, such as US Treasury securities, depending on the lending arrangement. The borrower is contractually required to return equivalent securities.
A short sale is generally a sale of a security the seller does not own or that is completed using borrowed securities. Short sales are principally governed by SEC Regulation SHO.
Borrowed securities may be used to settle a short sale, but the loan and the sale involve different parties, contracts, records, and regulatory requirements. Both long and short sales create an obligation to deliver securities on settlement date.
In a long sale, the seller already owns the shares being sold, and those securities are generally already held in custody through Alpaca Clearing and The Depository Trust Company (DTC).
In a short sale, the seller does not own the shares being sold. The shares therefore need to be borrowed or otherwise available for delivery so the settlement obligation can be completed. A securities loan can provide the shares needed to satisfy that delivery obligation.
The securities loan provides the shares for settlement; the short sale is the market transaction.
Securities loan: Exchange securities for collateral.
- Lender → securities → borrower
- Lender ← collateral ← borrower
Short sale:
- Short seller → sale → purchaser
- Borrowed securities → delivery → purchaser
Fully Paid Securities Lending (FPSL)
Under our Stock Lending Program for Trading API, an eligible customer may agree to lend fully paid or excess margin securities.
When securities are loaned, Alpaca administers the transaction under the applicable customer and counterparty agreements. Those agreements govern the collateral supporting the loan, lending compensation, how the loan may be terminated, and the borrower’s obligation to return equivalent securities.
We operate the program under SEC Rule 15c3-3, Exchange Act Section 15(e), and FINRA Rule 4330. These requirements address customer agreements, collateral arrangements, customer disclosures, appropriateness determination under Rule 4330, compliance records, regulatory notifications, and related supervisory processes.
Our customer disclosures explain:
- The collateral supporting the loan
- The customer’s voting rights while securities are on loan
- The customer’s right to sell and any applicable limitations
- How lending compensation is determined
- The potential tax treatment of substitute payments
- How the loan may be terminated
- What may happen if the borrower fails to return the securities
While securities are on loan, the customer has a contractual right to receive equivalent securities back under the lending agreement. Collateral is maintained to support that obligation.
Consistent with FINRA Rule 4330, our disclosures explain that SIPA protections may not apply to the securities-loan transaction and that collateral may be the customer’s primary source of recovery if the borrower does not return the securities.
Alpaca also provides FPSL infrastructure to broker partners through the Broker API. Partners that offer FPSL through Alpaca are also subject to the applicable securities-lending requirements and customer disclosure obligations.
Read Important Risk Disclosures With Respect To Participating In Fully Paid Securities Lending Transactions and FAQs carefully before deciding whether to participate in lending Fully Paid Securities or agreeing to enter into a Master Securities Lending Agreement with Alpaca Clearing.
The Lifecycle of a Security Loan
A customer securities loan generally follows these steps:
- The loan is initiated under the applicable customer and counterparty agreements.
- The securities are delivered to the borrower, and the borrower provides collateral under the agreed terms.
- The value of the loaned securities and collateral is checked daily. Additional collateral may be required if the value of the securities increases, commonly referred to as marked-to-market. This ensures enough collateral is maintained for the loan to cover daily market fluctuations.
- Lending compensation and any substitute payments, such as payments made in place of dividends, are recorded.
- A customer un-enrollment from the program, sale, recall, or other termination event begins the return process.
- Equivalent securities are returned and the collateral is released.
Throughout the loan, we separately record the securities on loan, the collateral supporting the loan, and the customer’s right to receive equivalent securities back. We also process collateral movements, lending payments, recalls, and returns under the applicable agreements.
Collateral reduces exposure to the borrower but does not eliminate operational, market, liquidity, legal, counterparty, or insolvency risk. The current program agreement and disclosures govern each customer’s participation.
Regulation SHO
Regulation SHO, also known as Reg SHO, governs several stages of a short sale, including order marking, pre-sale locate requirements, price restrictions, delivery, and the close-out of failures to deliver.
Rule 200: Order Marking
Every sell order for an equity security must be marked long, short, or short exempt.
- Long means the seller is deemed to own the security and the applicable delivery conditions are satisfied.
- Short generally means the seller does not own the security or delivery will be made using borrowed securities.
- Short exempt means the short sale qualifies for an exception under Rule 201.
Order marking identifies the nature of the sale. It is separate from determining whether securities are available to borrow.
Rule 203: Locate Requirement
Before effecting most short sales, a broker-dealer must have borrowed the security, arranged to borrow it, or have reasonable grounds to believe it can be borrowed and delivered by settlement.
Compliance with this requirement must be documented before the short sale is effected. This pre-sale assessment is called a locate, which indicates that securities are reasonably available to borrow. It is not the same as a completed borrow.
Rule 203 contains limited exceptions. For example, a registered market maker may qualify for the locate exception when the sale is connected to bona fide, or actual, market-making activity. The exception is transaction-specific and does not remove other Regulation SHO obligations. Alpaca Clearing is not a market maker, and does not qualify for the market maker exemption.
Rule 201: Price Restriction
Rule 201 is triggered when a covered security declines by 10% or more from its prior day’s closing price. Once triggered, the restriction generally remains in effect for the rest of that trading day and the following trading day.
While the restriction is active, trading centers generally cannot execute or display short-sale orders at or below the current national best bid, subject to specified exceptions. A qualifying order may be marked short exempt.
The Rule 201 price restriction is separate from Rule 203’s locate requirement. An order may qualify for an exception under one rule without qualifying for an exception under the other.
Rule 204: Delivery and Close-Out
After a trade is executed, the securities must be delivered through the clearance and settlement process. A fail to deliver (FTD) occurs when the required securities are not delivered by settlement.
As a participant in a registered clearing agency, National Securities Clearing Corporation (NSCC), we monitor our delivery obligations and fail positions. Rule 204 requires an applicable fail to be closed out within the prescribed period by purchasing or borrowing securities of like kind and quantity.
If a fail is not closed out on time, we and broker-dealers for which we clear may become subject to a pre-borrow requirement for additional short sales in that security. That restriction generally remains until the fail has been closed out and the closing purchase has settled.
A FTD does not, by itself, establish that an improper short sale occurred. Fails may arise from long or short sales, processing delays, lending recalls, or other settlement events. Rule 204 governs how the outstanding fail must be addressed.
Market Makers and ETFs
A market maker provides bids and offers and may move between long and short inventory while supplying liquidity. The Rule 203 locate exception applies only to short sales connected to bona fide market-making activity. Order-marking, price-restriction, delivery, and close-out requirements continue to apply as specified.
An exchange-traded fund (ETF) is a fund that holds a basket of securities or other assets. New ETF shares are created when an Authorized Participant delivers the required basket of underlying securities to the fund in exchange for newly issued ETF shares. The reverse happens in a redemption: ETF shares are returned to the fund in exchange for the underlying basket. An Authorized Participant (AP) is a financial institution that has an agreement with an ETF manager, allowing it to create or redeem large blocks of ETF shares called Creation Units.
An ETF manager may also lend securities from its portfolio under applicable law, its governing documents, and its securities-lending program. This securities-lending activity is separate from the ETF creation and redemption process described above. The AP may purchase or borrow the underlying securities needed to assemble the creation basket.
An investor’s ownership of ETF shares does not change because the fund lends an underlying portfolio security. The fund records and administers that loan within its own framework. The ETF manager, Authorized Participant, market maker, securities lender, borrower, and short seller may all be different entities, even when one institution performs more than one role.
Market-Access Controls
When we provide market access within the scope of SEC Rule 15c3-5, we apply automated financial and regulatory controls before an order reaches an exchange or alternative trading system.
These include credit and capital thresholds, erroneous-order controls, pre-order regulatory checks, restricted system access, and information for post-trade surveillance.
Market-access controls are separate from customer custody requirements under Rule 15c3-3, securities-lending requirements under Rule 4330, and short-sale requirements under Regulation SHO.
How the Rules Fit Together
In the firm’s systems and operational processes, the loan, order, execution, clearing obligation, delivery, fail, and close-out are treated as distinct events. The applicable control depends on the function being performed and the rule that applies at that stage.
Additional Resources
We will be publishing additional resources, including technical articles examining loan accounting, collateral, locate sources, Rule 204 time frames, threshold securities, and ETF mechanics in greater depth.
References
- SEC: Key Points About Regulation SHO
- FINRA Rule 4330
- FINRA: Rule 15c3-3 interpretations
- Our disclosures
Alpaca Securities LLC offers the Fully Paid Securities Lending program pursuant to a Master Securities Lending Agreement between Alpaca and its FPSL customers. Participation in FPSL involves risk, including the risk of loss. Cash collateral posted by borrowers is held at one or more custodian banks and is not FDIC-insured or SIPC-protected. Please see alpaca.markets/disclosures for important additional disclosures regarding the FPSL program.
Please read Important Risk Disclosures With Respect To Participating In Fully Paid Securities Lending Transactions carefully before deciding whether to participate in lending Fully Paid Securities or agreeing to enter into a Master Securities Lending Agreement with Alpaca Securities LLC.
These disclosures describe important characteristics of, and risks associated with engaging in, securities-lending transactions.
This material is for general informational purposes only and does not constitute legal, tax, investment, financial, or compliance advice. It describes selected requirements at a high level and is not a complete statement of applicable law. Rules, interpretations, account terms, programs, and insurance coverage may change. Eligibility for a particular protection depends on the facts and governing terms. All investments involve risk, including possible loss of principal.
Securities brokerage services are provided by Alpaca Securities LLC (dba "Alpaca Clearing"), member FINRA/SIPC, a wholly-owned subsidiary of AlpacaDB, Inc. Technology and services are offered by AlpacaDB, Inc.
