Outreach Blog

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."

 

Transparency

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.

 

 

Notes 


 

 

[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.

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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



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