Clearing, ESG and Securities Lending – 2020 and Beyond

Ina Budh-Raja, EMEA Head of Product and Strategy, for BNY Mellon's Securities Finance program and Mike McAuley, Managing Director and Global Head of Product and Strategy, explain the growing role played by central clearing in securities lending and how the industry is assimilating the greater emphasis placed by clients on ESG.

How are changing regulations adding to the appeal of central clearing for securities lending?

Mike: We are at an important inflection point in the evolution of central clearing for securities lending. We have talked about it for a long time and it remains a nascent sector but I believe it could now become increasingly important and useful. In fact, it may become the most important distribution channel in the future growth of securities lending for beneficial owners.

Central clearing of securities lending through platforms like Eurex provides benefits to all parties in the transaction. Recent regulatory changes, such as the addition of the stressed capital buffer, have shifted the focus of most borrowers away from the balance sheet/SLR and onto risk-weighted assets (RWA).

These platforms provide a solution that aligns with this new focus on RWA. Clearing allows the borrower to face the CCP as its risk counterparty and benefit from the low risk weighting of the clearing house as well as the certainty of collateral enforceability.

For beneficial owners, central clearing can provide increased utilisation and revenue while reducing risk by diversifying counterparty exposure and transacting with a highly regulated market infrastructure entity whose only business is risk management.  For certain beneficial owners disadvantaged under the capital rules, central clearing provides borrowers with a lower risk weight and certainty with respect to collateral enforceability, allowing those beneficial owners to access the market as a preferred counterparty.

I see Eurex and other platforms as important distribution channels for clients. The CCP distribution channel is probably the only place in securities lending where demand currently exceeds supply.  This means that clients enjoy premium pricing and increased utilisation. I would expect this to continue for a long time until it becomes oversupplied. In addition, transacting through a highly regulated CCP means lower risk which is further improved by the indemnification provided by lending agents.

What new requirements do CCPs impose on beneficial owners?

Mike: For models like Eurex, although no cash collateral is accepted, cleared transactions are not complicated and are almost identical to existing non-cleared transactions.  To clear their transactions, beneficial owners must be members of Eurex Clearing. To accomplish this, Eurex has created the Specific Lender License that allows beneficial owners to become limited members of Eurex Clearing without any of the obligations of a traditional clearing member, other than agreeing to the clearing terms and conditions, which is basically the equivalent of the Global Master Securities Lending Agreement (GMSLA) for the non-cleared transactions. That means no default fund contributions, no margin requirements, and no loss mutualisation.

Cleared transaction begin like any other lending transaction: the agent and the borrower negotiate the loan and agree to clear it with Eurex.  The borrowed securities and the collateral are delivered to Eurex which then accepts the transaction and completes settlement. Upon novation, Eurex becomes the borrower to the lender and the lender to the original borrower.

The transaction is then governed by the Eurex Clearing terms and conditions, which is similar to and operates much like the GMSLA does for existing non-cleared transactions.

The CCP also provides agent lenders with more capacity to provide indemnification by allowing them to better manage the regulatory constraints of single counterparty/large exposure limits and CCAR. In addition, clearing will help to preserve demand as borrowers become more capital efficient through increased internalisation and use of synthetics. Central clearing may become an important distribution channel for beneficial owners who may not be able to access the market synthetically.

How are uncleared margin rules changing clients’ approach to collateral management?

Mike: A key change over the next year will be the expiration of the exemption for European pension funds in September 2021 as well as smaller companies preparing themselves for the uncleared margin rules (UMR). While this doesn’t generally create big issues around initial margin which can be posted in securities, it does create potential challenges with respect to variation margin. Most firms require this in cash, meaning the need for liquidity may increase, especially in light of market volatility like we saw earlier this year in response to the outbreak of Covid-19.

In the long-term, clients will need to become more efficient in meeting their collateral requirements. They will need to have an aggregated view of their assets and liabilities across their entire organisation.

For example, a pension fund may hire 20 managers, who in turn hire prime brokers and clearing firms. The challenge is to make the best use of the client’s assets, including cash, across the entire fund. That means they require an aggregated view of all their available collateral and all of their obligations across all transaction types both cleared and uncleared, repo, and securities borrowing all in one place.

Until the process has been centralised in this way, it will be very hard to carry it out efficiently. The new rules are putting aggregation and the ability to optimise collateral across all assets classes spanning the entire business at the forefront of change. That means finding the right partner to help them aggregate, optimise, transform, and execute.

How is the growing focus on ESG on the part of asset owners and regulators changing the requirements on securities lending participants?

Ina: The growing focus on ESG over the past few years and gradual mindset change by asset owners, has been remarkably accelerated by Covid-19.  Where initially beneficial owners were most concerned with the governance pillar of ESG, the global pandemic has shifted the focus more broadly to the societal and environmental pillars.   Driven by a recognition that a health crisis has become a societal crisis and an impending economic crisis, there is a changing sentiment and realisation that as an industry we cannot ignore the risks of future crises, with the next possibly being a climate crisis, which threatens to dwarf the economic impacts of the pandemic, with devastating results.  Consequently, there is more immediate focus now on the E and the S, as well as the G. 

Crucially, we are increasingly seeing asset owners align with the UN Societal Development Goals (SDGs) and the UN Principles for Responsible Banking (UN PRI), as well as making commitments to the Taskforce on Climate Related Financial Disclosures (TCFD).   Essentially I think we are seeing asset owners embrace the evolution of a new agenda, whether that be ‘Build Back Better’ or the ‘Great Reset’, as championed by the World Economic Forum, or the ‘SDG-driven world economy’ a notion pioneered by the World Pensions Council. Whatever term we choose to use, the reality is, ESG will become an over-arching theme permeating all products and services with expeditious pace over the course of this decade.

The question we are all familiar with is whether securities lending is indeed compatible with ESG.  We certainly believe it is and going further, would argue that it is not only compatible, but is complementary to ESG objectives. 

Conducted properly, securities lending is a valuable ESG tool.  There is a clear expectation from regulators that every sector in financial services will play its part in generating funding for the global sustainable agenda.  Securities lending has an important role in keeping markets moving, promoting market integrity and enabling markets to be made in ESG stocks.  More broadly, securities lending is a vital tool for market liquidity, effective price discovery and efficient functioning markets; it is an essential component of the market infrastructure required for the effective allocation of capital to sustainability projects, to enhance the flow of climate-aligned capital to support the urgency of transition to net zero, in line with objectives of the Paris Agreement.

Turning to the much-debated topic of short-selling, we have once again seen, this time in the case of Wirecard, how short selling is an effective mechanism for scrutinising corporate behavior and governance, and has, in fact, exposed misconduct and poor ethics.  From an ESG angle then, there may be an opportunity for short selling to become a tool for impact investors to express a view, by providing a healthy challenge to verify the legitimacy of ESG stocks and potentially root out greenwashing.

In terms of impact on securities finance, the fact is securities lending is inherently intertwined with the G, in respect of voting, stewardship and transparency.  As agent, we need to ensure our lending programme is adaptive to our clients’ governance and stewardship policies, to enable clients to execute on their ESG strategies, by engaging in securities lending in a thoughtful, well-governed manner.

Looking at voting, recalling securities has always been a feature of a dynamic agency lending programme. Securities may be recalled at any time if a lender intends to exercise voting rights.  Beneficial owners can reconcile their ESG requirements with securities lending, and evidence to their stakeholders that they are successfully fulfilling their long-term stewardship responsibilities, whilst at the same time exercising their fiduciary duty to generate revenue for their investors.  That said, it will be imperative for agents to operate robust recall processes with optimal success rates, through increased automation; in the future state, predictive recall capabilities utilising AI could be a material differentiator.

Moving on to transparency, there are a number of safeguards in place from which clients can take comfort.  The post-2008 financial crisis regulatory reform agenda has ensured that securities lending has emerged into the clear light of day, with unprecedented levels of transparency bringing a new confidence to this market.  

Finally, we expect to see more nuance when it comes to collateral choices. Historically there have always been clients who have negatively screened certain collateral stocks.  Going forward there is a need for ESG rating integration into collateral buckets, enabling clients to evaluate collateral from a sustainability perspective and properly attribute risk, incorporating the financial risks of negative externalities, e.g. pricing in the financial risks of climate change and the true cost of carbon emissions  or conversely, pricing in the benefits of decarbonisation technologies.

There is an opportunity here, but also challenges to be solved for, given the lack of harmonisation of ESG criteria, inconsistencies in ratings tools and the bespoke investing strategies from client to client, depending on their thematic drivers under the E, S or the G.  Triparty collateral managers face a challenge to maintain an omnibus collateral structure with the benefits of scalability, alongside the bespoke ESG collateral parameters set by clients.  There is inevitably a cost to customisation, where utilisation and revenue will be impacted.  This is where regulatory convergence and clear taxonomies would be helpful to the market, in at least establishing some areas of common understanding and consistent interpretation.

There is also the question of whether pledged collateral will be out of scope for consideration of ESG factors, on the basis that the collateral receiver of pledged stocks is not generally considered the legal shareholder.  It will be interesting to see how regulators view this and whether clients carve out pledged collateral from the scope of their ESG parameters.  That approach would certainly seem to align with the shareholder analysis adopted in relation to SRD II and we welcome the European Commission’s proposal announced last week under the CMU action plan, to introduce an EU-wide definition of a ‘shareholder’, which should have some positive implications for consistency of market approach on ESG collateral stocks.

What role are regulatory changes playing in ESG adoption?

Ina: By providing important safeguards to securities lending participants, regulations are playing a vital role in increasing investor confidence in the compatibility of securities lending with ESG concepts.

In Europe over the course of 2020, the SFTR transaction reporting regime has introduced granular transparency on securities lending transactions, including all lifecycle events and collateral.  In excess of 150 data fields are reported to trade repositories on a T+1 basis.  DAC 6 transparency requirements require market participants to report arrangements where the main benefit is, or can reasonably be assumed to be, a tax advantage.  SRD II adds a further layer of protection through the identification of shareholders and voting rights, as well as increased duties around corporate event notification to shareholders. This will enable investors to be better equipped when applying their ESG policies on governance and voting. For example, enabling investors to make well-informed decisions on voting on issues material to their ESG strategy, whether that be on diversity & inclusion issues, environmental & climate change matters, human capital management, cybersecurity, business ethics, or other matters.

In addition to these new regulations are the protections provided under the MiFID II investor protection regime, coupled with the Market Abuse Regime, and applicable Market Codes, including the Bank of England Money Markets Code, the 2020 UK Stewardship Code and industry contractual agreements. 

Looking at the broader regulatory landscape, we see a swathe of forthcoming ESG-specific regulation in the pipeline, front-led by Europe, such as the EU Sustainable & Green Agenda, the SFDR, EU taxonomy, as well as imminent changes to MIFID II, UCITS and AIFMD, all of which seek to incorporate ESG considerations into every aspect of portfolio management.  These regulations cement the centrality of ESG as a reality – they will embed sustainability risks into all products.  Fiduciary duties of asset managers will be redefined to include assessment of ESG factors, such as the financial and non-financial risks of climate change, for example. 

The lack of harmonisation of global ESG regulation presents a current challenge though and we see this highlighted when we look at the recent statements from the US Department of Labor detailing that 401(k) plan fiduciaries must not take ESG into account within fiduciary duties, unless they can evidence pecuniary benefits from an ESG investment strategy.   This is a very different approach to the changes mandated by UK and EU regulators, where it is becoming clear that ESG considerations should form an integral part of an investment manager’s role, irrespective of financial implications.

What progress is needed around the harmonisation of ESG ratings?

Ina: The lack of regulatory convergence across the different regions gives rise to the need for the industry to establish consensus-based best practice standards.  We recognise that standardisation is not an achievable goal, as ESG is values-based and not rules-based and as a result there is a breadth of different approaches being taken both at investor level and between regulators.  Therefore, there is a critical dependency to establish market guidance principles on ESG compatible securities lending.

BNY Mellon recently partnered with the ISLA Council for Sustainable Finance (ICSF) in support of global principles for sustainable securities lending (GPSSL).  ICSF is a beneficial owner led standard setter, which is aimed at defining market best practice for sustainable securities lending and foster collaboration towards liquid markets.  The GPSSL will be helpful in serving as a flexible framework to drive a more consistent approach across this industry.

In terms of ESG ratings, we see a plethora of vendors in the market offering ESG rating tools and data analytics, however the lack of standardised underlying criteria presents a challenge for investors.  Greater regulatory harmonisation, taxonomies and technology will help to solve for this over time.   BNY Mellon has launched an ESG Analytics application, to help investors manage, monitor and analyse ESG factors across portfolios, by scoring portfolios against key ESG and sustainability metrics, using a consolidated view of the market, including multiple vendor outputs, combined with crowdsourced data, tailored to a client’s bespoke ESG specifications.  This tool has been developed to help investors address the challenges around lack of harmonisation of ESG ratings and enable them to rate their portfolios according to strategic ESG drivers, across the E, the S and the G.