ESG | Sustainable Finance Disclosure Regulation (SFDR)
As we begin to see a glimmer of what a post-COVID world might look like, many things will start to change, especially attitudes to working and the wholesale return to offices over the coming weeks and months. The idea of ‘what is work’ seems to have shifted towards a softer and more inclusive approach that no longer sees simple time in the office as a key measure of either productivity or success. Whilst retail outlets in and around stations and other transport hubs, together with those businesses that support our offices will want to return to a more recognisable world, many of these enforced changes will persist and become permanent. As I look past the current world of lockdown and towards the freedom that the vaccines may afford us, there is a real sense of change in many areas, including financial services.
We have already seen governments link their post-pandemic recovery plans with the wider desire to develop a truly sustainable economy, with the reaction to the pandemic increasingly forcing the pace of change. A simple reliance on either government expenditure or regulatory oversight will not be enough to deliver on these ambitious plans, however. It is vitally important that the private sector plays a full and meaningful part in this process. In particular, the global investment management industry has a crucial role in ensuring the deployment of capital to support the longer-term sustainable agenda, as well as proactively managing its investment portfolios through active stewardship around the themes of an ESG investment framework. As we take these broad themes forward, it is important that we think about the role of securities lending in supporting the development of ESG-related markets.
Over the past few weeks, I have noted two clear themes that raise questions about the ability of ESG-led investment strategies to reach their full potential.
First, we have seen several institutional investors deciding to either suspend lending of their ESG portfolios, or withdraw them completely from lending programmes. Recognising that securities lending is a discretionary activity, it is often easier to say ‘no’ when confronted with something that looks different and arrives with some regulatory uncertainty circling around it. This is exactly the situation we are facing here in Europe, where a lack of clarity in and around the Sustainable Finance Disclosure Regulation (SFDR) probably leaves all of us with more questions than answers. Therefore, I can understand that some feel that it might be expedient to stand away from lending these securities, at least in the short term. Reasons given, appear to reference the compatibility between ESG and securities lending. We firmly believe that a well-run and prudentially managed securities lending programme can happily run alongside an ESG investment mandate.
As you drill into this idea about the co-existence of securities lending and an ESG investment framework, many of the reasons cited for not lending these securities appear to fall away and not stand up to intellectual rigor. For example, much has been said about ESG and voting and how when securities are lent, the voting right transfers to the borrower. Of course this is correct, however any lender who is familiar with this area will confirm that all lending agents and specialist intermediaries can work with their lending clients to ensure that the client has the relevant security back in their custody account, if they want to exercise their right to vote at an AGM (for instance). The second example I would highlight, is the role that securities lending can play in supporting short sellers. It has been confirmed time and time again through independent research and by the regulatory community that short selling in general is a force for good, allowing hedge funds and other short sellers to bring companies to account where their share price bears no relation to the facts behind that firm. As so-called ‘greener’ markets evolve, wouldn’t we expect that level of scrutiny from the buy-side of the investment spectrum?
Another factor that is often lost when we see specific groups deciding to stand away from lending, is those very same institutions that subsequently want deep secondary market liquidity and efficient price discovery. Without the support of institutional investors for securities lending across ESG markets, these securities will trade less frequently, and suffer from a lack of market liquidity which, in turn will lead to a widening of bid-offer spreads.
The final piece of this complex jigsaw, is that of revenues. Securities lending delivers relatively low risk incremental returns over time, which can drive outperformance or lower fees where lending revenues are used to offset management costs. Without this annuity-type revenue, retail investors will inevitably pay more to enter these markets.
The second theme I wanted to explore, is the role of securities lending in the context of ESG itself, and how it should be seen through a sustainable lens. As we look at the developing ESG investment landscape, we are seeing substantial flows of assets into ESG funds. Recently, Morning Star reported that ESG funds took in some $350 billion in new investments in 2020, compared to $165 billion in 2019. This shift in investor sentiment tells us that securities lending markets must respond to these trends with creative and at times novel solutions to support their development. We have already discussed the important part that securities lending can play in supporting the development of the capital markets ecosystem more broadly, but some recent commentary would seem to put lending at the very centre of this debate. Whilst not wanting to underplay the importance of our markets, securities lending has itself become the story. I would argue that this is not the right way to view the challenges that we face at this time, or as we grapple with the increasingly complex array of regulation and policy guidance in this area. Much has been said and written about whether securities lending should be classified as a so-called ‘green’ product that supports sustainable objectives. The absence of any credible definitions from the regulatory community does not help this debate, and indeed I have seen some various institutions attempting to comply with regulation, possibly inadvertently classifying securities lending as a sustainable product. I am not sure it is wise, at this stage, to make assumptions, but rather proactively engage with regulatory authorities to aid their understanding of the product. We should be looking at the role that securities lending can play in the sustainable value chain, and ask ourselves what actual contributions the act of lending a stock makes to sustainable objectives such as the Paris Climate Accord net zero target. If we look at lending in that way, we may conclude that it is not a sustainable product in its own right, but crucially, can support those institutional investors who do have those first order ESG obligations.
Many of you reading this may conclude that this interpretation would lead to a point where securities lending is deemed as incompatible with a sustainable agenda, and I have seen that position already being adopted by some. However, that would fundamentally be missing the point. Whether securities lending is deemed to be a sustainable product is almost immaterial, and to an extent will ultimately be decided by the regulatory community. It is what it does to support the development of a broadly-based capital markets ecosystem that is the crucial point here, no different to how the development of the Capital Markets Union across Europe must consider the provision and support of secondary market liquidity, amongst other things.
Consequently, much of our focus in this area will be working with our broad membership community to develop best practice and guidance that can allow institutional investors to align their securities lending programmes with their ESG objectives. One of the traditional selling points that underpins the operation of a securities lending programme, is that it should not interrupt the day-to-day operation of the institutional investor in terms of key areas such as the purchase and disposal of securities, voting, and wider governance obligations. In many ways, this is no different for ESG portfolios, and reflects how a well-constructed securities lending program can support the aims and objectives of a particular fund, as well as contributing to a wider holistic market dynamic.
Many of the themes that I have touched upon here will be explored in more detail in our forthcoming white paper, which we have produced in collaboration with Allen & Overy and our wider stakeholder community.
The white paper will be launched at ISLA’s 11th Virtual Post Trade Conference later this month.
Andrew Dyson, CEO