Outreach Blog

Monday, June 7, 2021


Creating ESG Models to Change Negative Views of Financial Markets

Author: Ed Blount

Good morning, this is Ed Blount and I am speaking to you from the Center for the Study of Financial Market Evolution here in Washington, D.C. I've been asked by my good friends at the Risk Management Association, RMA, just up the road in Philadelphia, to offer some thoughts on "how data-based models can be used to change the negative views of financial markets that are held by some bank customers and regulators, especially in the wake of the pandemic."  So, that is an interesting question.

I'm going to approach the answer in two parts: 

First, I'll talk about the nature of models that are increasing regulatory and litigation risk following the pandemic; and then,
Second, I'll talk about how to deal with those increased regulatory and litigation risks, based on modeling precedents using newer technologies.

As a preamble, and as the reason I've been asked for comment, I have been engaged as a testifying expert [1] over the last 10 years in more than a dozen class-action lawsuits or civil litigation matters; as well as regulatory enforcement actions for the Department of Labor and the Securities and Exchange Commission.  In fact, I've testified before all three branches of the US federal government. So, that's the credentials part. Now, let's talk about models.

Deconstructing Negative "Views" to Create Rebuttal Models

Negative views are formed because someone has a belief that is based upon a structured proposition and a set of facts that are assumed to correspond with reality. Philosophers call this the "Correspondence Theory of Truth." There's a very good description available for free on the Stanford University website, in their "Encyclopedia of Philosophy." 

I think it should be no surprise that, in our modern world, we call these theories of truth "models." And, if all financial modeling relies on pattern recognition, as we were reminded in a recent RMA podcast,  then to change a negative view, we have to employ a model that corresponds to a truth that is derived from a positive pattern of propositions.  In the world of financial litigation, we call that a "rebuttal." 



So, what is the greatest risk following the pandemic? I would say that it is the relative (a) ambiguity and (b) paucity of information available to defend banks against charges of "Breach of the Public Trust," as implied within the policy sphere that is popularly called ESG (environmental, social, and governmental policies). 

We'll look at two proposed models that, in my opinion, will cause difficulty for banks and their customers over the next several years. 

Negative ESG-derived Views of Securities Finance

I have had to deal with flawed academic papers in my role as a defense expert for banks or asset managers. Often enough, these papers are cited by the plaintiffs' attorneys who are filing charges of malfeasance [4] or, in some cases, market manipulation

  1. 1.    In the case of the negative academic paper [5] we're using as an example, charges were made that (a) banks were aiding index fund managers in neglecting their fiduciary duty to exercise their governance obligations and privileges as portfolio owners of many securities, by (b) lending those securities out in order to gain additional income and improve their tracking errors.  

Now, the typical response to that charge is based on articulated voting policies included either in the documents creating the fund or in the trust that underlies it. Unfortunately, a lot of the available data that's being used for rebuttal is so limited that it lends itself to challenge by plaintiffs' attorneys. 

  1. 2.    The second critical model represents a significant regulatory risk, and is being used by ESMA to energize the European Parliament's call for a review of cross-border securities loans, that are being used (allegedly) to cheat the German and Danish governments out of an estimated 50 billion Euros in otherwise-entitled tax revenues. 


These are serious charges. Each represents a potential "Betrayal of the Public Trust," which goes to the S within ESG, as well as to the G.   

There are strong challenges that can be brought against the structural propositions that are used in the (a) academic paper, as well as in the (b) basic model for ESMA's support of the intrusion into the investment process that would be represented by audits of cross-border securities loans

Both of these negative models attack the field of Securities Finance, which is essential to the liquidity and price discovery functions of the global fixed income and equity markets, mostly through their support for short sales, as well as hedging by institutions. 

So, how would a bank or an asset manager who's being challenged respond to those charges? Well, actually, we have a precedent to consider. 

Spiking the Negative ESG Views

Several years ago, I was tasked with the response to a series of academic papers that alleged, in great detail and with great quantitative support, that (a) hedge funds were borrowing shares in the securities finance and lending markets in order to (b) gain control of the vote in an Annual General Meeting, determining (c) whether a proposed tender, merger or other corporate action, would be (d) approved by the shareholders. [8]

The argument was made by the academics that, based on the data they had collected from one custodian and one prime broker, that spikes across the proxy record date presented evidence of a theory that the hedge funds were moving before the record date in order to build up their positions. [9]

We at CSFME worked with RMA and the broker-dealer trade group, SIFMA, to collect and analyze more than 800 million loan records, and then to produce a white paper. In turn, the data was anonymized, encrypted and turned over to a team of academics that studied the data and concluded that, in fact, this was not evidence of vote manipulation, but rather it was further evidence that lender-customers of banks were recalling their loans. [10] So, it was a positive outcome from the spike. And that is the way that we responded. [11]

I believe that's the best way to respond to arguments that challenge the compliance of managers or banks with their stated policy goals or investment strategies. 

Building DLT Models to Change Negative Views

Let's deal with the ESMA proposal to establish audits of cross-border loans by the European Union. The rebuttal opportunity there is to use the new technology that's already been developed -- distributed ledger technology -- to respond to charges of complicity in avoiding withholding taxes on cross-border dividend payments. 

Unfortunately, the structure of the increased post-crisis regulatory disclosures that are available for rebuttal in securities finance is such that only positions are really being disclosed. It is true that loan data is being mined for those disclosures, but the objective of that data collection process is to identify excess leverage. 

As a result, it is not easy to reconstruct that loan data into the end-to-end mapping that would be required to demonstrate that the lending spikes are indeed evidence of benign trading activity, not manipulation of the markets. In fact, it would be necessary to recreate what CSFME did before, that is, create a loan-level industry model to demonstrate that lenders, asset managers, agents, and borrowers (as represented by the prime brokers) are, in fact, complying with their disclosed policies about proxy voting. 

That is potentially a big project. But the technology exists to get it done. [12]

In my opinion, that loan level model would not only be available for response to regulatory charges such as those being proposed by ESMA, but would also be available to courts in support of summary dismissal motions for any complaint brought that would be based, even partly, on the arguments embodied within the critical academic paper described above. 

Hoisted on their own Petards (Spikes)

This is a different way to approach a model. It's not a credit or market risk model. It's a litigation or regulatory risk model. There are similarities in that their structures are both based on propositions and data. But the way to approach the rebuttal is not to try forecasting an outcome -- or to absolutely destroy an opponent's argument -- but rather to recast their own evidence in a positive view.  

That's the way you change someone's opinion. You're not going to be able to argue methodology with them. You're not going to argue the facts because they're going to have a different interpretation of those same facts. 

What you have to do is identify the common areas that you agree on and structure the rebuttal to reinterpret that set of facts. 

In the cases that I mentioned before, we all agreed that there were spikes in the activity patterns being recognized by the models. But what we did at the time, and which should be done in the future, was to recast those spikes as evidence of a positive process: compliance with stated policies

Thank you for listening and I hope everyone has a very good outcome from the end (hopefully) of the pandemic.

Originally posted here, as, "The Impact of Data-based Models on Financial Markets," by the Risk Management Association, June 7, 2021.


1. Edmon W. Blount, Eric B. Poer, Tiko V. Shah, "Securities Finance Disputes," Chapter 30, The Litigation Services Handbook: The Role of the Financial Expert, 6th Edition, Wiley, 2017, pp 30.1 - 30.20, at https://www.amazon.com/Litigation-Services-Handbook-Financial-Expert/dp/1119166322

2. Stanford University Encyclopedia of Philosophy, https://plato.stanford.edu/entries/truth/#ReaTru

3. RMA Podcasts, “The Impact of Covid-19 on Modeling,” November 19, 2020, https://soundcloud.com/user-524270410/the-impact-of-covid-19-on-modeling.

4. Malfeasance, defined as "Evil-doing; the doing of that which ought not to be done; wrongful conduct, especially official misconduct; violation of a public trust or obligation; specifically, the doing of an act which is positively unlawful or wrongful, in contradistinction to misfeasance, or the doing of a lawful act in a wrongful manner." American Heritage Dictionary, at https://www.wordnik.com/words/malfeasance.

5. Hu, Edwin and Mitts, Joshua and Sylvester, Haley, The Index-Fund Dilemma: An Empirical Study of the Lending-Voting Tradeoff (December 22, 2020). NYU Law and Economics Research Paper No. 20-52 , Columbia Law and Economics Working Paper No. 647, Available at SSRN: https://ssrn.com/abstract=3673531  or http://dx.doi.org/10.2139/ssrn.3673531 

6. ESMA, Final Report on Cum Ex and Other Multiple Withholding Tax Reclaim Schemes, Sept. 23, 2020. https://www.esma.europa.eu/document/final-report-cum-ex-and-other-multiple-withholding-tax-reclaim-schemes   

7. Ibid.

8. Hu, Henry T. C. and Black, Bernard S., The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership. As published in Southern California Law Review, Vol. 79, pp. 811-908, 2006, University of Texas Law, Law and Econ Research Paper No. 53, Available at SSRN: https://ssrn.com/abstract=904004 

9. Christoffersen, Susan E. and Geczy, Christopher Charles and Reed, Adam V. and Musto, David K., Vote Trading and Information Aggregation (January 2007). AFA 2006 Boston Meetings Paper, Sixteenth Annual Utah Winter Finance Conference, ECGI - Finance Working Paper No. 141/2007, Available at SSRN: https://ssrn.com/abstract=686026 or http://dx.doi.org/10.2139/ssrn.686026

10. Moser, Shane and Van Ness, Bonnie F. and Van Ness, Robert A., Securities Lending Around Proxies: Is the Increase in Lending Due to Proxy Abuse, or a Result of Dividends? (December 6, 2011). Available at SSRN: https://ssrn.com/abstract=1969051 or http://dx.doi.org/10.2139/ssrn.1969051

11. CSFME, Borrowed Proxy Abuse: Real or Not, October 2010. https://www.sec.gov/comments/s7-14-10/s71410-202.pdf 

12. CSFME, “Systems Experts Set the Bar for Blockchain in Securities Finance,” Feb. 19, 2019. https://csfme.org/Full_Article/category/all/systems-experts-set-the-bar-for-blockchain-in-securities-finance 

13. See, note 4, supra.



The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting