Tuesday, October 20, 2020

Squaring ESG with Securities Lending

Compliance without Knowing the Borrower's Purpose - Is it Possible?

Author: David Schwartz J.D. CPA

Sustainable investing is becoming more important to investors when creating portfolios. As a result, institutions often follow policies with formal environmental, social, and governance (ESG) factors to guide their investments. They commit substantial resources to ESG research and produce comprehensive reports about their compliance.[1] But then the same institutions give away their proxy votes when they lend securities for fees to cover their bank charges. And the loans of those securities – and their proxies – go to borrowers with unknown intentions, and often with unknown identities.


One market veteran asked if there is any other space in capitalist finance where the lender knows neither the specifics of the borrower nor the purpose of the loan?  Given this opacity, can ESG factors really be squared with securities lending strategies?


A recently published Risk Management Association (RMA) whitepaper took on that very question after surveying 44 of the world’s top asset managers. The vast majority felt that securities lending and ESG investing could coexist. [2] It would not be easy, but necessary. According to Fran Garritt, RMA's Director of Securities Lending and Global Markets Risk:


As climate change, Diversity, Equity, and Inclusion, and data privacy become defining issues for our economy and society, ESG will only become more strategic for every institution. We hope that this paper can help investors everywhere integrate their approaches to ESG and securities lending.


Aligning securities lending with ESG principles does present some real challenges, however. Among these are (1) balancing lending income against proxy voting duties and, according to a growing number of lenders, (2) ensuring that their borrowers also complied with ESG principles. [3] Panelists at the RMA’s Securities Finance Virtual Summit in October 2020 pointed out the progress that has been made on #1, but not on #2.


Governance and Loan Recalls

ESG-compliant securities lending means recalling loans of, or not even lending securities with strategic ESG-related issues on the voting agenda. However, that can be problematic: recalling loaned securities to vote proxies can disrupt securities lending strategies and affect a lending program's profitability. A lack of timely information about proxy record dates and voting questions complicates the process of recalling stock that is on loan. Two-fifths of respondents to the RMA survey said that more clarity around proxy record dates and agendas would ease their loan recall decisions easier.


Similarly, understanding the materiality of the issues to be voted in a given proxy and the importance of governance to the ESG goals of the beneficial owner is key to striking a balance against the potential for lost lending revenue. More and better interaction with teams managing ESG issues would foster a better understanding of the ESG weight of the issue versus security lending revenue opportunities. As Roy Clothier, Associate Portfolio Manager at CalSTRS, said on October 13 during the RMAs virtual panel on ESG investing:


Governance might want to vote on an issue, but there's a high revenue opportunity on the securities lending side. We talk to them, we work with them, and say what's more important, the [lending revenue] or the vote on the proxy? We're in constant contact with our lending agents and with our corporate governance group to have kind of this win-win as best as we can balance.


The kind of cooperation Clothier describes at CalSTRS is not universally employed. Only 20% of respondents to the RMA's study said there was regular interaction at their institution between those who manage securities lending and those who manage ESG issues. Another 44% characterized that interaction as occurring only "from time to time."



The largest lenders are among the most interested in linking their loans to the strategies of their preferred borrowers. However, transparency from lender to borrower is currently limited due to the a) fungible nature of the securities on loan, b) nuances of clearing and settlement practices, and c) confidential terms of certain provisions in the brokers' and borrowers' agreements. Lending in full compliance with ESG principles will require more information about the borrowing trader’s policies and intentions. For example, ESG-orthodox lenders may prefer that borrowers post collateral that is itself compliant with the lender’s specific ESG principles. Fortunately, some of that transparency may become possible for ESG lenders as their regulatory reporting datasets become more robust. Blackrock Managing Director Stefan Kaiser boldly predicted such a future at RMA's October 13 virtual conference,


I think it's the SFTR ...regulation that's coming in that will require management companies at the entity and at the product level to provide a lot more disclosure around ESG. So I think that [SFTR] is probably one of the most impactful regulations in regards to ESG. And that has a knock-on effect with plenty of others out there that will provide a greater incentive for advisers, for management companies, [and] benchmark providers ... to move in the direction of ESG.


As discussed in our December 4, 2019 post, ESG-compliant Solutions to Stock Lending Bans, fintech advances in the application of SFTR datasets through distributed ledger technologies (DLT) may also bring more transparency to securities lending transactions. DLT opens the possibility that lending agents can give their concerned lenders the ability to a) screen their ultimate borrowers, b) limit their trades and c) give assurances that borrowed shares are not being used for purposes that are counter to the lender's own ESG principles. And, if the borrower is a broker-dealer, then non-directed and unvoted shares in the firm's depository account can be assigned to the ESG-compliant lenders, either for a fee or for preferential access to deep and desirable stock pools.


Learning Curve

The RMA's survey results make it clear that asset managers and sovereign funds are still in the early stages of squaring ESG investing and securities lending. Best practices will develop over time as more and more beneficial owners articulate their preferences and better understand the potential costs and benefits of applying ESG strategies. At the moment, however, fifty-five percent of survey respondents ranked "greater education about available options" as the top priority when it comes to applying ESG principles to their lending programs. It is undoubtedly in the best interests of the vendors and participants in the securities lending markets to assist in that process -- enthusiastically.






[1] Russel Investments. 2020 Annual ESG Manager Survey. Russel Investments, 2020. https://russellinvestments.com/publications/us/document/2020-Annual-ESG-Manager-survey-results.pdf. Accessed 13 October 2020.


[2] Despite general optimism that securities lending programs and ESG investment principles need not clash, there still seems to be some hesitation in practice. Notably, only 18% of survey respondents said they always apply ESG principles to their securities lending programs. 18% are planning to, and 39% responded that they don't consider ESG principles at all at this point. Academic studies on the effect of ESG-based investing on returns and risk profiles remain divided, which could account for some of the hesitations on the part of asset managers to commit fully at this time. Plagge, Ph.D., Jan-Carl. Is there a performance cost to ESG investment? Institutional.vanguard.co.uk, Vanguard, 8 June 2020, https://www.institutional.vanguard.co.uk/portal/site/institutional/uk/en/articles/research-and-commentary/topical-insights/performance-cost-esg-investment. Accessed 15 October 2020.


[3] Long-term investors have some valid concern regarding proper stewardship and applying ESG principles to securities lending. According to State Street:

  1. The transfer of stock ownership rights. When stocks are on loan, the voting rights for those shares are also transferred. This is inconsistent with the wishes of asset owners who mandate that their asset managers need to conscientiously exercise voting rights on all their shares.

  2. There is a transparency concern because owners do not have clarity on who borrows shares nor the reasoning behind those decisions.

LaPerla, Briget Realmuto, and Travis Whitmore. Beyond Mechanics: The Intersection of Securities Lending and ESG Investing. Statestreet.com, State Street associates, October 2020, pp. 2-3 https://on24static.akamaized.net/event/27/26/55/6/rt/1/documents/resourceList1602518257411/statestreetssaesgsfpaper1602518248119.pdf. Accessed 14 October 2020.