Securities lending and sustainable finance: Addressing misconceptions

Securities lending and sustainable finance: Addressing misconceptions

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The compatibility of ESG principles and securities lending has come to the fore of late. Yet the industry has, and continues to, develop mechanisms to ensure that stock loan programmes can align with asset owners' and asset managers' sustainability and governance polices. Louise Fordham reports.

In December 2019, Japan's Government Pension Investment Fund (GPIF) announced its decision to stop lending securities from its foreign equities portfolio, drawing attention to the securities lending industry among corners of the financial sector and mainstream press where it is often overlooked.

The pension fund, which has approximately $1.5 trillion assets under management, made a not insubstantial $375 million in fees over the three years to 2018 from lending its international securities. Nor is the income generated from securities lending activities inconsequential for many asset owners and asset managers involved in the practice; according to figures from data provider IHS Markit, global securities lending revenues came in at $10.1 billion in 2019 despite being down 6.3% year on year.

In its announcement, GPIF stated that it would no longer engage in equities stock lending as it deems this to be inconsistent with the "stewardship responsibilities of a long-term investor". However, it will continue to lend from its debt securities portfolio.

In an interview with the Financial Time's Moral Money, GPIF's chief investment officer Hiro Mizuno, expanded on the fund's reasoning for ending its equities securities lending programme, citing the following as its key concerns: that short selling is incompatible with its long-term investment philosophy and its policy to engage with companies around ESG (environmental, social, governance); that recalling loaned stocks for voting is "contradictory" with its stewardship principles and belief that "asset managers should have a continuous and constructive discussion with corporates to make a decision on their proxy voting"; that there is a lack of transparency around who is borrowing its stocks and for what purpose.  

Both GPIF's decision and Mizuno's subsequent interview sparked a flurry of responses – ranging from counterarguments to messages of support, such as from Tesla's Elon Musk who exclaimed in a tweet: "Bravo, right thing to do! Short selling should be illegal!"

Mizuno said that GPIF "had heard from several asset owners that think they should discuss as well", but those active in the securities lending industry are more reticent about the impact the pension fund's decision will have on the number of asset owners and asset managers engaging in the practice.

Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting, says: "Whenever an important investor such as GPIF takes a decision it is worth examining the reasoning. Our view, reinforced by discussions with other major investors, is that the reasons for continuing to lend remain in place – additional direct income from lending and indirect benefits delivered via short sellers in terms of price discovery and added market liquidity."

Indeed, the conversation that GPIF's announcement has triggered could provide an opportunity to highlight the role securities lending plays within financial markets, dispel long-standing myths and misconceptions, and bring the work industry participants are undertaking to integrate ESG best practice into securities lending activities to the attention of a wider audience.

Nicolas J. Firzli, director-general at the World Pensions Council (WPC), the Paris-based international association of pension funds, says: "For many, sustainability (long-term fiduciary stewardship) and securities lending (a short-termist activity by design) seem incompatible in the ‘Age of Fiduciary Capitalism’…, but they needn’t be. If done properly, securities lending can actually empower pension investors, giving them more effective control over key ESG and fiscal parameters in the chain of ownership – including AGM voting rights, the cornerstone of corporate governance, and modern risk mitigation (collateral management, transparency)."

More than just short selling, more than short termism

As much recent attention on securities lending's ESG credentials has honed in on short selling and short sellers' "short-termist mindset", it is first worth noting that short selling is just one of a number of reasons why a firm looks to borrow stocks.

Secondly, in a December 2019 report, Undue short-term pressure on corporations, the European Securities and Markets Authority (ESMA) stated that it "is not aware of concrete evidence pointing to a cause-effect connection" between short selling and securities lending and the existence of undue short-term market pressures. It instead reiterated short selling and securities lending's contribution to market liquidity and price discovery.

Short selling could also be considered a tool in holding companies to account by highlighting poor corporate practices. In its May 2019 Responsible Investment Primer, the Alternative Investment Management Association (AIMA), noted: "Short selling is neither irresponsible nor unethical, and it can form a critical tool in responsible investment. For instance, a manager could short a company with poor environmental practices that were hidden from the public and which the market had failed to price in."

Pierpoint's Zimmerhansl says: "Short sellers have shown that they add to long-term returns by identifying malfeasance that isn’t spotted by long-only managers, and the very fact they exist and it is possible to short sell means that companies realise they are 'on the clock' and can’t take shareholders for granted. A market without short sellers has no policemen."

Perhaps though, as Andrew Dyson, chief executive officer at the International Securities Lending Association (ISLA), suggests, looking at short selling through an ESG lens could to a point be misleading. He explains: "Short selling is now seen as part of the established capital markets ecosystem, with numerous academic studies outlining the positive role it can play in areas such as efficient price discovery for institutional investors.

"In its simplest form, short selling is a platform for an investor to express sentiment either in a stock or an index, and as such may be no different to an index manager going over or underweight on the index that they are tracking. Furthermore, we now see robust regulation in the form of short selling rules that ensure opportunities to use short selling in an overly aggressive way by adopting techniques such as naked short selling, are effectively curtailed or banned."

Mechanisms and policies to support ESG principles

The focus on ESG, and particularly its environmental element, has gathered speed among asset owners and asset managers in recent years. Sustainable investing assets across Europe, the US, Canada, Japan, Australia and New Zealand increased by a total of 34% to $30.7 trillion in the two years to the start of 2018, according to the Global Sustainable Investment Alliance. Meanwhile, the United Nation's Principles for Responsible Investment (PRI) welcomed over 500 new signatories from around the world in the 12 months to August 2019, including 69 new asset owners.

While the wider financial spotlight may be on sustainable and socially responsible investing, the 'governance' component of ESG has long been a priority for many beneficial owners engaged in securities lending. Keith Haberlin, managing director and head of global securities lending at financial services firm Brown Brothers Harriman (BBH), says: "Balancing the responsibility to investors of adding lending revenue with exercising a responsibility to vote is nothing new. It’s something we have facilitated for our clients for over 20 years by recalling and restricting shares when there is an important issue which they would like to vote on. Most institutional investors realise that it’s possible to lend and still exercise good governance, and furthermore that providing liquidity in this manner facilitates more efficient and sustainable capital markets."

The PRI's guidance on stock lending recommends that organisations outline their approach and whether or when shares are recalled to vote, and suggests including an explanation of the reasons why an organisation has decided against lending shares. Similarly, the International Corporate Governance Network's Guidance on Securities Lending report states: "Investors should have a clear policy with respect to lending, especially insofar as it involves voting and/or the refusal to lend under certain circumstances. A lending policy should clearly state, inter alia, the lender’s policy with regard to the recall of lent shares for the purpose of voting them. All lending conducted by the institution, or on its behalf, should be pursued in accordance with this stated policy." Guidance from regional bodies tends to align with this, for example, Japan's stewardship code recommends that institutional investors have a clear and publicly-disclosed policy on voting, which should incorporate their policy on lending stocks if doing so across voting dates.

As BBH's Haberlin points out: "Securities lending programmes are not a one size fits all. Programmes and technology are available to restrict and recall securities either ahead of an important vote or because they do not want to facilitate short selling of a specific holding. Most beneficial owners adopt this approach versus not lending at all. Practically, it’s easier to recall when there are less actual lines of securities on loan so many beneficial owners find that an intrinsic value programme is a more appropriate approach when voting is a priority, than a volume-driven general collateral programme."

A securities lending policy should extend beyond voting restrictions and recalls, though. A comprehensive policy can assist an organisation in ensuring that its lending activities are in line with its investment principles and ESG policies at an organisational and fund level.

"For a securities lending programme to remain ESG compliant proper governance and processes need to be in place and agreed upon by all major stakeholders. Every beneficial owner should have policies on securities lending which cover recalling stocks for voting, the active restriction of individual stocks, tax, transparency, acceptable collateral and any other controls in place which cover the lending of securities," says Matthew Chessum, investment director, liquidity management at Aberdeen Standard Investments (ASI). "ESG considerations have always been at the forefront of our investment approach and our securities lending programme has been developed to remain fully aligned with the fund’s investment guidelines."

Increasingly the conversation around ESG compatibility has also advanced to focus on the collateral accepted by lenders. For example, if an asset owner or asset manager has an exclusion policy in place for certain types of assets because they conflict with their ESG values, then should this not also apply to securities held as collateral for stock lending purposes? Although a wide and flexible approach to collateral acceptability can provide advantages to lenders' programmes, beneficial owners can engage with providers to customise collateral eligibility parameters. BBH's Haberlin says: "From a collateral perspective, the solutions are focused on screening out non-cash collateral and collateral reinvestments based on ESG principles."  

Ongoing dialogue with agent lenders can help apprise beneficial owners about demand drivers for certain stocks, which can be further aided by market insights delivered by data providers. Thus while it may not be possible for lenders to know who the end-users of their on-loan stocks are, this information can offer a reasonable idea of activity around particular stocks and inform decision making regarding the recall/restriction of these stocks if they are uncomfortable with the apparent demand drivers, explains Chessum. He says: "Both agent lenders and beneficial owners now have access to in-depth market data which allows a participant to better understand their market footprint. There is more transparency regarding the reason behind individual borrows than ever before." 

Developing best practice for sustainable finance and securities lending

Significant strides have been made in the securities lending industry to clarify how ESG and securities lending best practice can be developed in harmony.

The World Pensions Council's Firzli says: "The WPC is engaged in several ‘ESG and securities lending’ initiatives in Europe, North America and the Asia Pacific area: some of them will be presented at the upcoming Singapore Economic Forum bringing together G12 and ASEAN pension executives, financial regulators and central bankers (Singapore, February 27-28) and the G7 Pensions Summit (Frederick, Maryland, June 12)."

Meanwhile, ISLA has included "empowering investors and stimulating good corporate governance to support the sustainable finance agenda" among the five key priorities listed in the manifesto for its 2019-2024 legislative term.

ISLA's Dyson says: "I think those of us involved in the industry have a collective responsibility to both educate and inform those parts of the market where concerns are being expressed. However, this has to be more than simply advocating that securities lending can coexist with good corporate governance – we have to take concrete steps to provide institutional investors with that confidence."

In December 2019, ISLA announced the formation of the ISLA Council for Sustainable Finance (ICSF) following 16 months of extensive preparations. The council will help to embed ESG and Sustainable Development Goals (SDG) into securities lending activities through the development of a new voluntary sustainable finance mechanism.

"Our primary goal is to trigger a series of changes throughout the industry to shift securities lending onto a sustainable pathway. This objective is undoubtedly ambitious, but it is a necessary step if we are to ensure responsible working practices and reliable growth," explains Dr Radek Stech, ICSF chair and founder of the Sustainable Finance – the Law – Stakeholders (SFLS) Network at Exeter Law School, who adds that the work of the council will demonstrate that sustainable finance and the ESG agenda are not incompatible with securities lending.

He continues: "During the formative months of the ICSF, we developed a set of Principles for Sustainable Securities Lending (PSSL). The implementation of these principles forms the backbone of our agenda for the coming months/years. We will publish a report on sustainable securities lending this coming summer. This will be an opportunity to take PSSL further and to reflect on securities lending (and dispel further misconceptions) in a rigorous and evidence-based manner."

The Principles have been driven by the beneficial owner community, and both these and the council itself have been designed to evolve alongside the industry with input from all stakeholders. ICSF held its first meeting in January 2020 and is set to formally launch in the first quarter of this year.

Dr Stech adds: "I am convinced that the council's work will increase the global confidence of institutional investors, regulators and the wider public in sustainable securities lending."

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