Roy Zimmerhansl, Practice Lead at Pierpoint Financial Consulting, explains why the securities lending industry needs to embrace adaption and customisation in support of investors’ sustainability-led priorities.
The stats tell the story. According to the Association of the Luxembourg Fund Industry, more than half the money that flowed into European funds in 2020 went into sustainable products; with Morningstar confirming that a further 19% went into sustainable invest funds in Q1 2021, reaching nearly US$2 trillion. These are huge sums, but in the grand scheme of things, still relatively small and able to generate headlines leveraging chunky percentage growth figures. Nevertheless, the trend is clear. ESG will continue to expand and unlike many central bankers’ prevailing views about their economies, this ESG AUM inflation is anything but transitory.
It is perhaps unsurprising then that secondary investment activities including securities lending are at an even more nascent stage of development. When viewed through the ESG lens, securities lending has a surprisingly wide reach, encompassing governance, transparency, voting, taxation, sustainability and short selling. Given this rich source of topics, we have chosen three key issues that in our view need to drive the agenda.
Securities lending should follow investor objectives not lead
ESG-influenced Investors rightly focus on portfolio construction, the assets they hold and oversight of those investments. Yet such scrutiny is often overlooked when it comes to securities lending. Key areas for consideration are the portfolios they make available for loan and the collateral that is received when lending assets out. We are in the earliest stages witnessing a minority of ESG funds moving away from making their assets available for loan. Inevitably if that grew to a meaningful scale, lending fees would adjust and those willing to lend assets would reap the rewards. After all, a short sale fed by a stock loan is just one opinion on a stock. Ask holders of Tesla shares about the benefits of holding the stock AND collecting the fees from short sellers.
When an investor takes collateral for a stock loan, it becomes the legal owner, so it seems entirely logical that investors only accept collateral that they would be willing and able to invest in directly. This approach has for many years influenced collateral schedules for some lenders by disallowing collateral from ‘vice’ industry sectors. Yet this blunt tool seems inappropriate for a more nuanced ESG environment where two companies in the same sector may be taking different corporate approaches to sustainability. Issuer-level collateral approval differentiation is inevitable.
Governance is multi-faceted
We argue that institutional investors should have an overarching policy as to whether they lend or not. With over US$25 trillion in assets available for loan from investors globally, it is no longer the cottage industry of the 1990s and stakeholders have a right to know whether those entrusted with their money engage in lending, and reasons as to why not, if they don’t.
Participation of course brings governance obligations. Typically, this topic shifts quickly to voting, the manifestation of ownership engagement. It should be noted that, except for those rare instances where investors have agreed to term transactions, a lender is always entitled to get stock back for voting or indeed any purpose. We have already seen more active voting by lenders, and this is proof that lending and engagement can co-exist. It is our view that a two-tier Japanese style callable and non-callable market will emerge in some countries with price differentiation between the two.
Evolution comes from multiple DNA combinations
New ecosystems evolve over time, with survivors coping and adapting to the changes around them. Securities lending is a subtly important part of the plumbing of financial markets, contributing to liquidity, price discovery and operational efficiency and must continue to grow while reflecting the changing needs of institutional investors. Given the clear indications of growing ESG-awareness, securities lending must adapt to what investors require rather than continue to apply tried and tested large-scale solutions. One size doesn’t fit all today, let alone tomorrow.
This requires input from multiple stakeholders in addition to the efforts of the various regional securities lending trade associations which have been driving the agenda in recent years. Securities lending exists to serve the capital markets rather than the reverse. As such, ESG investors alongside regulators, exchanges, governance advisors, and others, including politicians, must have a say in practices, procedures and policy that shape the business over the coming years.
That is why we have supported the inclusive approach of the Global Principles for Sustainable Securities Lending initiative that began as a distinct entity in 2020, but has its roots in earlier incarnations.
Supporting sustainable investment goals
The easy decision for investors would be to say they have their hands full crafting the investment side of ESG and revisit securities lending as and when (or perhaps if) straightforward sustainable investing standards are created.
Yet that would mean forgoing a slice of the US$10 billion in annual fees the business generates year in, year out, in rising, falling or flatlining markets as well as having a detrimental impact on investing infrastructure and pricing in the more than 40 markets where securities lending is practiced.
The more difficult path, but the right one in our view, is that today’s technology enables mass-customisation to ensure securities lending supports the investment goals and objectives of engaged, aware investors and everyone has a role in moving it forward.
This article was co-authored by John Arnesen, Consulting Lead at Pierpoint Financial Consulting.