While environmental, social, and governance (ESG) practices have been in the background of securities lending for many years, Covid-19 has prompted many asset owners and managers to integrate them into the business.
“Two things have happened in securities lending. One is ESG-related, and the other relates to the benefits that asset owners and asset managers now attribute to securities lending and securities finance. These are the trends we saw accelerate the most during Covid,” says Mark Snowdon, head of Capital Markets, Asia Pacific for Northern Trust.
In securities lending, an asset owner/institutional investor loans out their shares to another institutional investor through a securities lending agent, which is typically a custodian bank, to generate additional returns on the shares. In this scenario, the asset owner would want to get the shares back should they need to use them for proxy voting.
The most obvious area of concern for asset owners seeking to marry their ESG policy with their securities lending programme is that when a security is on loan, they will lose the right to vote.
“On the surface, it may appear counter-intuitive to ESG principles, however, securities lenders have been successfully balancing the returns from securities lending with the requirement to exercise good governance for many years,” says Snowdon.
What the pandemic has done is to highlight the importance of sustainability in business while prompting investors to seek additional returns on their shares.
The key here is to be able to execute the lending programme efficiently without sacrificing the implementation of ESG policies. This depends a lot on good communication between the asset owner and the agent lender.
“ESG and securities lending can definitely co-exist in an efficient and effective manner but it takes care and communication to ensure that these two seemingly diametric elements of investment strategy can work together. But as long as there is a commitment to delivering client-centric benefits then it can succeed as a coordinated strategy,” Snowdon says.
In reality, ensuring that an asset owner who loans out their securities can meet their ESG obligations is often going to be a key driver of the relationship between that asset owner and the securities lending agent. The securities lending agent must have the ability to deal with this.
For ESG and securities lending to come together effectively, the asset owner and the securities lending agent have to agree on the following: first, what securities or assets are available to be loaned out; second, what collateral the asset owner/lender will accept in return for lending out their securities and how that collateral will be impacted by their ESG policies; and third, asset owners/asset managers have to undertake a conscientious decision-making process with regard to their investments and how these will be impacted by their ESG policies and securities lending requirements.
“In reality, collateral considerations are more of a tail risk because the only time a client may have direct exposure to that collateral is if the borrower defaults and that collateral cannot be liquidated, and needs to be transferred to the client. While the risk of this happening in the broader scheme is fairly low, it’s important to address nonetheless,” Snowdon says. “In partnership with a supportive, client-focused securities lending agent, the right balance is achievable, and will come from an agreed approach between the agent and the asset owner.”
A typical securities lending agreement will cover such points as which securities need to be voted on; which types of votes are important; whether voting on a percentage of shares is acceptable, or whether all shares need to be voted on; whether all markets are of equal importance when it comes to voting; and what revenue will investors be prepared to give up by recalling loans to ensure voting.
“Sustainability is a core element of ESG investing, and securities lending is important as it brings liquidity to capital markets generally, and enhanced returns to investors who lend. As such, it is important for all parties to understand how firms can integrate their lending programmes and their approach to ESG,” Snowdon says.