Securities finance embraces ESG principles

By Oliver Wade

As environmental, social and governance issues continue to climb towards the top of the agenda for many firms, Global Investor considers the impact of ESG on the securities finance industry and how beneficial owners, agent lenders and borrowers are reacting.

The incorporation of sustainability principles in securities lending programmes has accelerated in recent years as more stringent requirements in terms of regulation and transparency have led to a significant increase in the involvement of lenders.

Earlier this year ISLA launched its Council for Sustainable Finance (ICSF), highlighting the important role of ESG and the motivation to align the securities finance industry with these principles. The ICSF issued its Principles for Sustainable Securities Lending which can serve as first steps to ensure appropriate standards are met.

Xavier Bouthors, a senior portfolio manager in the treasury team within fixed income solutions at NN Investment Partners refers to an increase in external and internal demands in relation to ESG portfolios participating in securities lending.

“For example, voting rights are associated with investor engagement and are not exercisable when a security is on loan, so how can these valuable voting rights be protected? This is pushing the securities finance industry to align with the ESG agenda and incorporate sustainable parameters,” he says.

His colleague and fellow senior portfolio manager, Martin Aasly, acknowledges that there has been a mixed reaction to the ESG focus, ranging from the Japanese Government Pension Investment Fund GPIF suspending its equity securities lending to Dutch pension fund PGGM confirming its participation in securities lending.

“Overall we see beneficial owners looking at combining ESG in their securities lending programme from various angles, such as protecting voting rights or adding criteria on collateral eligibility,” he says. “Agent lenders also have to adapt and offer beneficial owners suitable structures and we see some of them rethinking aspects of their agency programmes to enable recalls and restrictions around AGMs or collateral account arrangements. Borrowers are also adapting by helping to facilitate changes to beneficial owners’ lending programmes.”

Collaboration with responsible investment teams is key to developing the right policies for funds participating in securities lending, adds Bouthors. “The securities finance industry is impacted by growing interest in ESG and all participants have to work together.”

Dimitri Arlando is DataLend EMEA team lead at EquiLend and its representative on the ICSF. He suggests that while it is still too early in this shift to understand the full impact on the securities finance industry, market participants are considering the evolving needs of these underlying investors and beneficial owners.

“Recalling securities for voting purposes is only one consideration of ESG in securities finance,” says Arlando. “There are other factors to consider, such as if the collateral provided meets the beneficial owner’s ESG criteria.”

Another issue is that there isn’t currently a global standard for ESG or a consistent framework that can be applied, which makes solutions difficult to construct. “That is why the work being done by organisations such as the ICSF is vital,” he adds. “The Principles for Sustainable Securities Lending and the group’s partnership with industry participants will help beneficial owners navigate the ESG waters while fully participating in securities finance.”

Arlando says agent lenders must ensure that they recall securities in a timely manner to allow beneficial owners to vote when required. “What started as infrequent recall requests has evolved into a new norm for ESG investors participating in the securities finance market. Agent lenders have been very successful in ensuring that ESG investors can still participate in and earn incremental revenue from their portfolios through lending.”

There is a misconception that securities finance and ESG are incompatible but that couldn’t be further from the truth. The securities finance industry has been quick to adapt in order to accommodate the ESG requirements for all participants whether they are beneficial owners, agents or borrowers.

That is the view of Paul Wilson, managing director and global head of securities finance at IHS Markit, who refers to three primary areas of focus:

• Where required, assessing the relative merits of retaining securities on loan or recalling in order to exercise voting rights, ensuring the decision is in the best interests of the underlying investor

• Ensuring collateral accepted is consistent and compliant with the underlying ESG policy of the lender accepting the collateral

• Strengthening securities lending governance and programme oversight, control and understanding.

He says beneficial owners, agent lenders and borrowers have reacted positively to this trend to ensure the ESG requirements of participants - especially lenders and underlying investors - are maintained.

“For example, best practice around dealing with upcoming proxy votes has evolved,” he explains. “Best practice includes assessing each scenario including the magnitude of the vote itself, restricting certain strategic holdings from lending prior to an upcoming vote date, understanding the revenue to be forgone by recalling in order to vote and then determining the best course of action.”

According to Wilson, the combination of analytics that measure the liquidity of loans to determine if and when a recall of the loan should be initiated and specific notification of proxy dates as soon as they are announced provides lenders with appropriate metrics to make better informed decisions.

“One area we have been working on with beneficial owners is the governance aspect of ESG as for many, securities lending is an outsourced function,” he continues. “In addition to good self-imposed ESG practice, regulators in Europe and the US have been suggesting an increased level of oversight, governance of outsourced functions and securities lending. We have built a wide variety of reports, tools and analytics that take away the heavy lifting for beneficial owners and provide them with independent, actionable information across their securities lending programme.”

While ESG is ubiquitous in European financial services – facilitated by regulations such as the EU’s Action Plan on Sustainable Finance and national legislation such as ESG disclosure requirements for pensions in the UK and climate change reporting for investors in France- the US market is playing catch-up, although banks and other financial institutions are embracing the concept according to Sonelius Kendrick-Smith, head of corporate treasury solutions - Americas DWS.

“Admittedly, a lot of collateral is now posted as cash, but some investors may adopt an exclusionary policy towards non-cash collateral instruments such as sovereign bonds issued by countries with poor human rights records or polluting companies,” he says.

Adjusting collateral schedules for ESG is another step down the path of increased customisation. Putting in ‘CUSIP roots’ (the CUSIP number is a unique identification number assigned to all stocks and registered bonds in the United States and Canada) to filter out defence contractors or securities issued by the counterparty is a widely used strategy.

“Whereas that was previously an exercise in painting with broad strokes, larger subsets of excluded securities will most likely take it to a place of painting with narrower strokes,” says Kendrick-Smith. “The same applies to proxy voting. Proxy voting vendor services have increased their offerings, enabling users to incorporate that data into their proxy stances. The stance of a beneficial owner taking a default option of wanting to vote all proxies in some cases has in some cases given way to voting depending on materiality and even parallel to the economic consequences.”