A putative class action suit filed in August 2017 alleges that U.S. investment banks and broker-dealer units of global banks conspired to restrain competition in the domestic stock lending markets. (Read our review here.) The fact that a Connecticut hedge fund and Los Angeles County’s pension system have joined the suit is the development that has captured the media headlines. However, the risk to banks’ profits is the real story here.

As is usual in cases like these, plaintiffs made no initial estimate of monetary damages. So readers would have had to pick up a pencil to appreciate that the defendants’ exposure had risen from $35 billion to $50 billion or more, based on their (alleged) restraint on profits to damaged parties over five years – and possibly more if the court agrees to set the peg farther back in time.

The amended complaint, filed November 17, grew from 87 to 144 pages and gives clear evidence of advice and counsel from (allegedly) injured (and undoubtedly angry) market systems vendors. As is often the case in headline litigation, the original complaint’s filing (very likely) attracted (eager) collaborators to the plaintiffs. The new filing has gained more descriptive details and defendants’ (alleged) quotes for its background narrative. Given the hearsay allusions to conspiratorial dinners etc, it is likely that plaintiffs expect to find a treasure trove of damaging intelligence in the traders’ macho emails that might be produced in response to a successful discovery motion by plaintiffs.

The $50 billion financial exposure is breathtaking, but it is very unlikely that plaintiffs’ arguments will prevail in their entirety. Much of the evidence of culpability is hearsay and the charges are based largely on unproven assumptions, so the case will (likely) be won in discovery and depositions if it survives an inevitable defense motion for summary judgment.

At this point, plaintiffs have offered no evidence that dealers either rigged prices or colluded to keep rates artificially low. The complaint is all about an (alleged) lack of transparency that prevented market participants from evaluating the degree to which dealers profited from their “matchmaking” services. There is no reference to the financing services that dealers provide to hedge funds, nor to their research, administrative or clearing services.

The plaintiffs’ main premise is, “Bringing lenders and borrowers together in a regulated, centralized trading platform would lower the cost of borrowing and increase the returns on lending.” 

Plaintiffs’ assumption is that central clearing always reduces costs. Their hope is that the court only looks at the transaction processing aspect of the securities financing business. And, somewhat uneasily for that argument, plaintiffs offer no proof in support of the critical assertion that, “Prime Broker Defendants take approximately 65% of the gross revenues generated each year in the stock loan market, amounting to more than $9 billion annually — far more than the returns paid to any other market participant, including the beneficial owners of the stock being lent.”

The plaintiffs’ key allegation is that dealers colluded to prevent vendors from automating the stock lending market, to the disadvantage of the pension funds which lend the securities.

This suit is not about securities finance, although reference is made to a $1 or $2 trillion market. (Plaintiffs lowered the figure in the amended complaint.) Stock lending is the target of this suit. The amended complaint makes no reference to the fixed-income markets. (If there is a whistleblower at the banks or dealers, he or she is -- no doubt -- on the equity side of the business.)

Plaintiffs have also not included the value-added services provided by dealers to the equity financing markets, such as convertible equity-bond arbitrage, dividend and scrip arbitrage, or market-neutral, long-short, and other stock/hedge-based trading strategies that lenders and dealers enable for their sophisticated borrowers. All of those services are provided as part of the prime brokerage relationship. Securities finance is not just transaction processing. Nevertheless, the suit is doggedly focused on the cost of the trade, citing vendor research to support claims:

Quadriserv’s analysis found that the modernization promised by AQS was predicted to reduce by more than 30% the total fees paid by borrowers and to redistribute total revenues more fairly as between the lenders/beneficial owners, the agent lenders, and the broker-dealers. In other words, the AQS platform could simultaneously make more money for stock lenders and save money for stock borrowers (while improving systemic financial system risks) by reducing and redistributing the 65% cut skimmed off the top by the Prime Broker Defendants. (Page 57)

Some of the revisions to plaintiffs’ complaint appear to have come from former executives at systems vendors who are vying to serve as expert witnesses for the plaintiffs. If so, they may also have cautioned counsel that progress has indeed been made in securities lending. That may explain why the assertions on trade restraint in the amended complaint have been softened a bit. Instead of alleging that “Defendants conspire to block competition,” the new claim is “to inhibit competition.” (p 41) Yet, the consultants may also have given the court a lot more (alleged) evidence of collusion, in that 30 pages of conspiracy allegations have grown to 69 pages in the amendment. Six cartel references in key arguments have grown to ten.