Collateral | Sustainability
While securities lending can at times be a complex and interconnected business, driving real alpha for lenders and other markets participants, at its very heart it is a very simple premise; a lender temporarily passes ownership of a security to a borrower for a fee. With that transfer passes legal ownership together with various rights and obligations, including the right to any votes that are associated with that security. In an earlier blog, I had already discussed how lenders need to think more carefully about how they align the aims and objectives of their stewardship responsibilities and wider ESG sentiments, with those of their lending programmes.
Whilst I firmly believe it is possible for securities lending to co-exist within an ESG investment framework, there is clearly work to be done. In our recent white paper entitled, ‘Framing securities lending for the sustainability era’, produced jointly with Allen & Overy, we highlighted the need for the industry to set standards around this area. As more lenders are likely to recall securities for specific votes, amongst other things, there needs to be clarity around areas such as recall periods, and most importantly a clear and agreed process if a security fails to reappear in time for the client to exercise their vote. Whilst CSDR is providing something of a regulatory imperative that will impact us all, it is incumbent upon ISLA and other associations to drive through the establishment of standards to both create certainty as well as minimise the prevalence of fails. As we delve deeper into this issue, we will progressively need to align these standards through best practice, which will in turn facilitate standard outcomes to known trading and life cycle events, such as within the Common Domain Model (CDM) environment. The full potential of the CDM and what can be done with the building blocks it creates, can only fully be realised against standardised business flows.
The theme of standardisation, or the lack of it, feeds through into another key area that was highlighted in the paper, namely the role of collateral. As more institutional clients contemplate lending ESG portfolios, determining whether securities collateral is equivalent to the loaned securities, or whether cash is reinvested consistently with those ESG objectives, this will present an important challenge for the industry. Given the wide range of potential combinations of ESG objectives and the lack of current standardised definitions, standardisation of collateral selection or appropriate reinvesting of cash may prove unwieldy. At a moment when we are all looking for standardisation as part of a drive towards greater efficiency, trying to fulfil an increasing array of demands around ESG collateral screening could lead to more bespoke solutions that are inevitably expensive and potentially less efficient. We could, in my view, also see knock-on impacts around liquidity, particularly where collateral screening is defined too narrowly and therefore limits what can be accepted. A borrower for example may have to incur additional funding costs just to source specific collateral. Similarly, excluding certain assets could needlessly maroon them and drain liquidity from the market.
Solutions over and above increasingly long exclusions lists have yet to appear and offer scalable outcomes. I have already mentioned that the current lack of standardised definitions is acting as a break on the development of new and novel solutions, and that it is likely to continue until we see more from the regulatory community. Looking towards the rating agencies to offer that consistent approach, at least in the interim, also looks problematic. Variation between results in ESG ratings is significant, correlations between major ESG ratings providers ranging from 38 to 71%, as compared with credit ratings which have a 99% correlation (according to a study published by Berg F and Kölbel J and Rigobon R in 2020, titled ‘Aggregate Confusion: The Divergence of ESG Ratings’. This simply underlines how important it is for groups like ISLA to establish some form of best practice that will at least allow lenders to look at these questions on a consistent basis.
We can see how important the concept of standardisation is for our trading practices, where a lack of clarity can lead to inconsistent outcomes, especially where recalls are associated with time critical corporate events. Similarly, ESG has presented our markets with a new set of challenges around the management of collateral, and how that is aligned with ESG principles. Needless to say, the answers to these questions are not uniform and will take considerable effort and resources. Having said that, I believe ISLA has an increasingly important role to play in advocating to both regulators for the clarity we strive for, but also to develop open and pragmatic solutions. Many of you reading this will be familiar with the great work that is being led out of our ESG and Collateral Steering Groups, where mutualisation of these challenges is providing a key forum for debating these issues. Finally, set against this backdrop, we must perhaps accept that whilst it may not be feasible to achieve standardisation of outcomes, at least in the short term, consistency of process could be achieved by agreeing principles as to how a security or investment is determined to meet the lender’s ESG objectives. ISLA is ideally placed to help deliver that consistency of approach.
Andrew Dyson, CEO