Environmental, social and governance (ESG) has been the subject of significant focus for securities lending (defined in a previous Review article as "the temporary transfer of stocks or bonds from an investor to a borrower in exchange for a fee") market participants over the past year. For instance, research published in October 2020 by the Risk Management Association (RMA), which surveyed 44 institutional investors in the US, suggests that securities lending needs to evolve to integrate investors’ ESG principles, given that only 18% of the investors surveyed for the research were applying such principles.

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In May 2021, the RMA teamed up with the Pan Asia Securities Lending Association to launch a global framework for ESG and securities lending. Its recommendations include developing a policy for recalling loaned securities based on ESG considerations; applying an ESG lens to the selection of direct counterparties; and applying the same ESG standards to the non-cash collateral they are prepared to accept when they lend securities as to those they apply to their investment portfolio.

In June 2021, a white paper commissioned by the RMA and authored by State Street Associates proposed best practices for asset owners and agent lenders looking to integrate sustainable investing considerations into lending programmes.

Securities lending is a significant source of revenue for institutional investors and the fund sector. The global securities finance sector generated US$4.5bn in revenue for lenders in the first half of 2021, according to DataLend, and many active and passive fund managers engage in securities lending to help boost a fund’s performance or to offset the costs of managing a portfolio.

The challenge of standardisation

In April 2021, Roy Zimmerhansl – founder of Pierpoint Financial Consulting – presented a CISI webinar on the topic of securities lending and sustainability. He believes a lack of standardisation is a challenge for agent lenders. In a separate interview, he told The Review: "Each investor that lends will be able to determine which counterparties they will lend to and identify acceptable collateral … But there are few if any widely accepted standards for ESG in the same way as an investor could say they would accept S&P 500 equities or G10 government bonds."

BNP Paribas Securities Services is one of the agent lenders that act on behalf of lending clients to generate revenues for those clients by lending their securities upon agreed terms with approved counterparties. Its global head of agency securities lending trading, Andrew Geggus, agrees that the absence of standards is an issue. "Applying an ESG strategy to a securities lending programme has to be done from the ground up with the help of the agent lender," he says. "As there is no ‘one size fits all’ when it comes to ESG, this really is a matter of carefully managing the customisation of the lending programme to apply ESG parameters while retaining as much revenue as possible from the activity."

The lack of ESG data for private assets is particularly challenging. Regulations such as the Sustainable Finance Disclosure Regulation and the framework regulation (the so-called green taxonomy) do not ensure that a company or investment is 100% ESG compliant.

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"As there are no universal ESG standards, agent lenders use sustainability data subjectively, developing internal tools and applying their own methodologies of ESG principles," says Jean-Pierre Gomez, head of regulatory and public affairs at investment services company Société Générale Securities Services.

The S and G of ESG

Governance is probably the most important single component of ESG from a securities lending perspective given the importance of voting rights. Andrew says agent lenders need to work with lenders to understand their goals when it comes to good corporate governance and not just implement a full recall for voting policy if there is the opportunity to help the lender optimise their revenue while retaining their voting rights on the items they wish to have greater influence over.

The environmental aspect deals with collateral exclusion, which has proved to be a challenging topic. For example, investors might look at fossil fuel-producing companies as non-ESG and restrict or exclude them from acceptable collateral or portfolio compositions. However, if these companies were also the largest investors in sustainable energy, the ‘non-ESG compliant’ tag could hinder the development of these energies if investors were unwilling to put their money into the companies developing them.

Almost half (46%) of respondents to BNP Paribas’ ESG global survey 2019 suggest social is the most difficult element to analyse and embed in their strategies. "One positive impact we are seeing on the social side is the progress being made on offering careers in securities finance to people from all walks of life," says Andrew. "There is great work being done by sector working groups and firms to help promote diversity and inclusion."
Both the investor and the agent need to be confident in the quality of the counterparty

For example, the International Securities Lending Association supports a number of networks and groups that promote diversity and inclusion, including the Women in Securities Finance group and RegTech Women, a professional network that promotes the role of women in the regulatory technology industry.

Proxy voting vendor services have increased their offerings, enabling users to incorporate ESG considerations into their proxy stances. For example, if a company proposes a new director, portfolio managers and analysts may be able to assess the candidate’s experience and effectiveness at other companies to determine if they would be an appropriate addition to the board, and perhaps suggest other individuals from different backgrounds that they believe would also be well suited to the role.
Hot tip
Roy Zimmerhansl: "Keep just one share of each line of stock you lend, so you can be sure to get the heads-up on important corporate actions."

In the CISI webinar, Roy suggests that if an investor feels strongly about voting at a particular meeting, they could recall any shares on loan. "Lending half and voting half probably wouldn't satisfy them – either they wouldn't be making the full weight of their votes count or they wouldn't be generating the maximum revenue by lending all their shares."

He points out in the webinar that unless specifically agreed on a per transaction basis, shares on loan are always able to be recalled for voting and recommends never lending 100% of a holding.

Counterparty quality

Aside from ESG considerations, both the investor and the agent need to be confident in the quality of the counterparty. Securities owners should look at the risk level they are willing to take when picking counterparts to face off to, taking into account factors such as indemnification of borrower default.

Fee splits are negotiated between the securities owner and the agent lender and are impacted by considerations such as the size and composition of the investor’s assets and restrictions on the programme (such as limits on term lending, collateral acceptability and counterparty selection). 
"Unfortunately, there is still a stigma attached to securities lending due to bad practice"

"An investor with a globally diversified portfolio of equities and government bonds that has a wide range of investment-grade counterparties, accepts a broad spectrum of equities, bonds and exchange-traded funds as collateral, and can do fixed term trades, should be able to get favourable rates," says Roy.

In this scenario the agent would absorb all transaction charges, operate and manage the pre-trade, trade and daily post-trade maintenance of transactions, and indemnify the investor against borrower default.

According to Andrew, agent lenders need to consider whether they are getting the appropriate value for indemnification of risk and the service level being offered. "Asset owners and asset managers need to consider the fee split as just one element of a broader offering and service level – the cheapest may not always necessarily be the best choice."

Considering tax

For all the positive developments outlined above, the securities lending sector has been tarnished by its association with cum-ex dividend schemes (method used by traders to hedge the difference in value between shares cum- (with) and ex- (without) dividend, making use of put options, according to the European Parliament) that have allegedly generated billions of euros for banks and stock traders through fraud and speculation involving dividend taxes.

Roy explains that these alleged abuses have for many years been clamped down on by tax authorities and domestic custodians that collect tax on behalf of relevant authorities. "Unfortunately, there is still a stigma attached to securities lending due to bad practice and ignoring the fact that firms can still benefit from tax rate differentials if they comply with tax regulations," he adds.

Jean-Pierre says the cum-ex scandal has changed the way securities lending is conducted by prompting increased transparency and vigilance. He notes that the European Securities and Markets Authority has identified several measures, including directly and automatically linking any tax reclaim to the underlying distribution of dividends and entrusting a single entity with responsibility for collecting the withholding tax and issuing the relevant certificate.

Looking ahead, Andrew believes the securities lending sector will have to adapt to demand for a much greater level of flexibility and customisation at the lender level. The agents who do this in the most efficient and effective way will reap the benefits in terms of larger and more regular lending mandates.