As asset owners continue to integrate environmental, social and corporate governance into their investment and operations processes, integrating ESG considerations into securities lending programs is a consideration on the agenda.
Natalie Floate, head of market and financing services, Asia-Pacific, at BNP Paribas Securities Services
Securities lending arrangements permits the beneficial owner of a security to lend it for a specified period of time, with the borrower agreeing to return an equivalent security at the end of the period. Securities lending agreements are indemnified with high quality collateral. Beneficial owners use securities lending programs to generate incremental income to a portfolio, and securities lending can be used as part of various strategies, including shorting, hedging and arbitrage.
“Before we look at securities lending itself, we should be taking a step back and looking at short selling,” said Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting. “The reality is, it’s with us now, has been with us for 400 years, more regulators are putting it in place post-GFC than since, so it’s part of financial market operations. It’s a part of a market that aids in price discovery, brings liquidity, from a regulatory point of view, smooths the peaks. Short selling is also a big market. You have the full spectrum of investors – ETFS, mutual funds, insurance companies, sovereign wealth funds, pension funds, etc.”
Many asset owners such as superannuation funds have established securities lending programs, usually through custodians, and those programs are tailored to considerations such as proxy voting, to recall securities in time to participate in AGM votes and other corporate actions.
“It is important to understand how firms can integrate their lending programs and their approach to ESG,” said Mark Snowdon, head of capital markets, Asia Pacific at Northern Trust. “The most obvious area of focus on marrying an effective ESG policy with a securities lending program results from the fact that when a security is on loan, the investor loses the right to vote. On the surface, this runs counter to ESG principles, however securities lenders have been successfully balancing the returns from securities lending with the requirement to exercise good governance for many years.
In partnership with a supportive, client-focused securities lending agent, the right balance is achievable, and will come from an agreed approach between the agent and asset owner.”
The agreement will cover considerations such as which securities need to be voted on, which type of votes – all or contentious-only – are important, whether voting on a percentage of shares is acceptable, or do all shares need to be voted, are all markets of equal importance when it comes to voting, and what revenue will investors be prepared to give up by recalling loans to ensure voting.
“Some investors will want to vote on all equities with no exceptions, Snowdon said. “Others will be happy to vote on a percentage of each equity, or on contentious votes only, or in certain markets, or a combination. A securities lending agent such as Northern Trust will structure a bespoke solution to take these requirements into account, including the automated recall of securities that an investor wants to vote on, thereby marrying lending returns with adherence to the ESG policy. Of course, voting is less of a concern for a fixed income lending program, and some investors may choose to restrict their lending to non-equities only.”
ESG considerations play into other areas of a securities lending program – in terms of the type of collateral usually high quality equities and fixed income, for example.
“If you’re participating in sec lending, you’re getting collateral,” said John Arnesen, consultancy lead, Pierpoint Financial Consulting. “When you receive collateral, you’re the legal owner of that collateral, so if you look at your portfolio and asses it from the ESG filters, your collateral should reflect the front end screens. All the way along, you may end up holding assets that don’t match your ESG policies.”
Clients approve collateral conditions, including ESG considerations, said Natalie Floate, head of market and financing services, Asia-Pacific, at BNP Paribas Securities Services.
“ESG criteria and objectives can be integrated into a securities lending programme,” Floate said. “Securities lending programmes can be built around the objectives of the investor. As a simple example, investment managers who have restricted certain assets from their portfolios such as holding tobacco securities for example, could restrict these same securities from being held as collateral in their securities lending programme.”
BNP Paribas does not typically see clients basing counterparty arrangements on ESG critiera today, Floate noted.
“ESG is still a topic that is evolving and many of our clients have started to make changes first to their core investment activities;,” she said. “However securities lending can sometimes be impacted indirectly by changes to these core investment strategies. On the securities side for example, in Australia there has been a large focus on active proxy voting by Australian funds which has impacted securities lending as we are required to recall securities to facilitate our clients voting instructions. In regards to counterparties, and particularly in an agency programme, the client will defer to the agent lenders’ standard or approved borrower list for counterparty selection. At BNP Paribas when we review our borrowers, reputation (including ESG) is a category we take into account.”
Arnesen reinforced Floate’s perspective on awareness of ESG criteria in securities lending programmes.
“A few people are aware of it, but I think a relatively small number have thought it through,” Arnesen said. “We’re really bringing this to people’s attention, but it’s mainly being thought through by a few leading edge investors. However, the background to this is that the technology is such that customisation is easier than it ever has been. If you have collateral managed in triparty arrangements, it’s only about getting the schedules correct, and once the schedules are in place, the execution can all happen behind the scenes.”
Snowdon of Northern Trust noted that collateral is held off balance sheet for the investor, and thus doesn’t form part of the investment book unless a borrower defaults and the collateral cannot be liquidated.
“The other element where we have seen increased focus from ESG investors is on what is acceptable collateral for a securities loan,” Snowdon said. “A key principle of a securities loan is that only collateral that is in line with an investor’s agreed schedule can be accepted, and some ESG investors ask that the collateral held is also in line with their ESG policy. This brings into focus one of the interesting challenges of ESG principles and the multitude of different approaches adopted.
“Despite the emergence of ESG benchmarks, indices and the development of principles for the assessment of companies and responsible investment, each individual investor decides which principles matter most to them. For example, for some the focus is low carbon footprint investing, whereas others may view this through a more ethical lens and focus on the exclusion of companies and stocks which might be considered as controversial. Northern Trust works with its clients to optimise the approach to restricting these collateral ‘assets’ by discussing requirements and eliminating issues where possible.”
However, it is more than possible to include ESG criteria in securities lending programmes.
“If you are an investor, and you have ESG criteria and accessible assets, those criteria 100% can be reflected in what you want to do,” Arnesen said. “The point is you don’t have to come up with a new policy, just extend the policy into the full extent of your program. Have some governance around the collateral that you’re getting.”
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