Practical Implications for Securities Lending 

Global Investor held their inaugural ESG Roundtable in June. It was moderated by Roy Zimmerhansl who led an engaging discussion with the diverse panel on ESG integration in portfolios to regulation to practical implications and much more. 

A portion of the 2023 ESG Roundtable is available in the video above. See below for a transcript of the highlights. 

Roy Zimmerhansl (RZ): Securities lending follows what investors want. So I think, Jane, if you can start with the, as far as what your customers are telling you and constructing that. What do you see as being the big demands? We’ve talked about voting, but what are the big demands today? What do you see the trends being going forward?

Jane Wadia (JW): Sure. I mean, probably the first point to make is what I said probably right at the beginning, which is as an asset manager, we’ve certainly been incorporating ESG considerations into our investment making decisions for years. So that isn’t new, and we’ve been doing that and it’s typically I think, one of the reasons that clients come to us and they like the fact that we’re looking at this extra financial criteria as well as financial criteria to deliver a particular risk/return profile, depending on the strategy that they’re invested in.

What we’re seeing more and more is moving beyond that, and clients coming to us, particularly institutional clients, but also distributors with whom we work with, for strategies where there’s more of a sustainability goal as part of the investment objective. So it’s much more explicit that not only am I targeting financial returns, but I’m also looking to deliver a sustainable objective. They vary, climate is by far the biggest area of demand and consideration that our clients are asking us for.

A concrete example of that could be a strategy whose investment objective is to deliver a financial return, but also have an explicit decarbonisation trajectory to reach net zero by 2050, for example. Therefore, the way that we would build that strategy is by not only looking at the securities that we want to hold, but also making sure that we’re allocating the capital to those companies that we think are most advanced on that journey, while supporting those that aren’t, but where we view that their commitments are credible and tangible, and we’ll get there.

The other area that we’re seeing a lot of demand for is what I would call impact investing strategies. A really good example of an impact investing type strategy would be a green bond portfolio.

Harpreet Bains (HB): If we’re talking about practical considerations, whilst not necessarily securities lending specific, I’m of the view that data is probably still one of the biggest integration challenges for market participants more generally.

In the dawn of the sustainability era, what we saw was a large scramble to develop approaches resulting in a substantial, if not exclusive, reliance on third party ESG data rating providers, but the increasingly tougher tone that we’re hearing from policy makers around rating providers, in my view means we’ll begin to see participants refining their data approaches in more comprehensive and compelling ways

The EU proposals for the new regulations are not a surprise and you can understand why, ESG ratings can significantly impact the constituents of an ESG index, therefore a call for greater transparency of models used, a deconstruction of what an ESG rating is actually representing was to be expected. Participants will need to be considerate of this as they define their future data strategies.

One additional point, before passing to Donia, is related to green labelling. Labelled funds continue to gain popularity especially in Europe as you would expect given the increasing investor sentiment for ESG products., I would welcome more explicit guidance or acknowledgements from the various different labelling agencies regarding securities lending as it would certainly help to finally dispel some of the ambiguity and doubt that we do continue to see with some lenders and new prospects.

Donia Rouigueb (DR): I fully agree with you and for instance, in France, there’s a socially responsible investing label called ISR which explicitly states that securities lending activity is permitted as part of the label. This label is overseen by the French Ministry of Economy.

Just to go back to the topic of data, it’s not only about how you construct an ESG rating, you also need to consider the cost of the ESG data.

RZ: I did a table not long ago, which took three ESG index providers, three big names, and they highlighted from their own reporting what they consider when they put an E rating on or an S or a G.

Here you are three leading indicators that for ‘E’ have some commonality, but also different considerations. So that’s got to present its own challenges, Jane, on the investment management side, let alone anything else.

JW: Interestingly, we were doing some work a couple of years ago on the ESG data providers, we do use a lot of ESG data and its ESG scores, but it’s gone way beyond that as well. We have all types of different data that we use in different ways and different providers as well. We were doing some work on the ESG scores, which where I guess all the ESG data started, and the correlation between the key providers is actually very low.

So you know, it’s an integral part of investing today, but it is also its own journey because effectively, we all know what net income means, or profit and loss or revenues. With ESG data, it’s much more complex than that and it is more nuanced, and to be fair, this is where the advantage of sometimes being part of a larger organisation is we actually have a team that’s dedicated to ESG quant data. It is one of the areas that is challenging for all of us because of that heterogeneity.

The element of having more common definitions to report on will also help I think with a little bit more harmonisation. Maybe just to pick up on the points that you were making around the securities lending elements and being able to still lend on portfolios that may have labels or other ESG sort of considerations.

RZ: Do you see clients being more active voters now and are you seeing that it’s actually intrusive, in terms of that.

DR: Definitely, and I will return to the definition where you have a broad spectrum of clients, some with big teams and other smaller ones, both of which are pushing ahead at the cutting-edge, and then other clients who are just following along. Almost all of our clients are paying attention to the ESG theme.

It really is about having the means to back up your ambitions, because as Jane said, you need a team of people dedicated to ESG, and some clients can’t afford it. There are institutional clients who are managing huge portfolios, but they’re not asset managers - They don’t have teams of compliance, risk, and middle office staff. We’re seeing a desire for greater engagement through voting but when you’re invested in hundreds of companies, it’s not just about recalling, you need to actually study the resolutions in order to vote strategically.

We provide the tools that assist in the voting process but the onus is really on the end-investor to read and understand thousands of annual reports, and establish a common policy position within the company and decide on the voting strategy. It takes a vast amount of time and effort.

HB: We have clients that are actively recalling for voting purposes, but then equally there are others that aren’t. For those that are recalling, we further see variation. Some apply a blunt approach, but others that consider for materiality in their decision-making process. It’s the point which was made earlier about how some ESG issues are going to be of a greater priority for a specific investment or industry, hence justify a loan recall, whereas in other cases, the decision is balanced against the revenue earned if the security remains out on loan.

RZ: Of course some investors have their investment managers, but many of them also have external advisors. They might have proxy advisors, they might have governance and stewardship advisors, that also now increasingly having a role in saying actually, this is something you should make certain that you’re actually considering to vote on. This is an important issue and having your own filters. This is in addition to what the investment manager does, and I’ve seen programs. Are you seeing that happening?

HB: A similar point I’d like throw in is the introduction of the new form N-PX rules in the US., which will require reporting of the number of shares that were put on loan and not recalled (even if attempted to recall). Whilst not intending to impact a funds determination on whether to vote or lend, there is a risk that these types of filings begin to influence client behaviour.

DR: That’s why I think education is key. Our discussion here is about the fact that you can have an ESG approach and still engage in securities lending. That’s the first thing that needs to be acknowledged but it’s sometimes still questioned by some not well informed people.

It’s a long journey, and we need to think about client education over the long-term. Once you demystify the fact that ESG and securities lending can be compatible, then you can tackle clients fears of over-complexity by demonstrating the solutions. This is where I speak as an agent lender and a custodian - we have the solutions to our clients to help our clients benefit from the additional potential revenues and have a voice in shareholder meetings.

RZ: There’s two more things to talk about on this topic. One is collateral and then the overall profitability and the decision making. The collateral – one thing you touched on Harpreet was the fact that you have enterprise approaches from an ESG perspective, but that doesn’t necessarily always filter through to the people practically implementing. There’s an investor that can’t buy a certain asset because it doesn’t qualify for the investment manager because doesn’t satisfy the ESG criteria, gets given to an investor as collateral, which of course they own unless in that circle they own unless it’s under a pledge arrangement. So how do you square that circle for a customer without doing exclusions or without being able to exclude at an ISIN level?

DR: As I said, we don’t have an opinion per se because we’re service providers, so we just tell our clients what is happening in the market and what the current status is. As of today, collateral is a guarantee – that is the whole debate.

The collateral is protection. Counterparty risk is the first risk you are exposed to when you engage in securities lending. If ever your counterparty cannot return your securities, you can sell the collateral to buy back your position. This collateral is therefore a type of guarantee, which is why it is never accounted for in your fund’s NAV.

RZ: But it is yours legally.

DR: Technically, it’s a temporary transfer of title transaction. So from an accounting point of view, it’s not yours, it’s a protection. It becomes yours the day that you don’t not get back your security. You have a master agreement saying that in case of default it becomes yours. You can sell it to buy back the equivalent securities position you initially lent.

So to me it is a protection from beginning to end. Now, once you’ve said that, you have collateral and this collateral means something, it’s part of a company and you have a lien on it and this is where there is a debate among our clients. Is the collateral purely a protection or am I supporting a third-party company that I’m not investing in by taking securities that they issued as collateral? Again, I cannot have an opinion as I’m a service provider, but I’m just laying the facts about how the mechanism works in terms of collateral.