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The golden rule of global financial communication
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Performance Magazine - Issue 39 ⬤ Published on 21 July 2022
Can securities lending and responsible investment strategies be compatible?
An overview of public studies and academic research
Partner, Risk Advisory - Regulatory Risk
Managing Director, Risk Advisory - Regulatory Risk
With the support of Pauline Nguyen, Consultant
To the point
According to statistics from Datalend, the global securities lending industry generated US$9.28 billion in revenue for lenders in 2021. This represents a 21.2% increase from the US$7.66 billion in 2020 and a 7.2% increase over the US$8.66 billion in 2019, making 2021 the biggest year for lending revenue since 2018.
It is now essential for fund managers to properly manage environmental, social and governance (ESG) topics, given their increasing link to significant outperformance and their regulations becoming increasingly prescriptive. Meanwhile, driven by rising international interest in responsible investment approaches, regulators and industry stakeholders have been closely involved in this topic.
With the entire asset management industry and its investors focusing on responsible investment and sustainability, securities lending is also coming under scrutiny, due to being seen as incompatible with ESG investments. The fundamental question is to what extent securities lending impacts long-term sustainability and shareholder commitment. Therefore, this article aims to summarize the view of public studies and academic research on the securities lending environment and its compatibility with sustainable finance.
It is commonly accepted in financial academic literature1 that securities lending plays an essential role in maintaining healthy and well-functioning capital markets while providing a myriad of benefits to asset owners. However, as securities lending is often linked with short selling, its use by funds promoting an ESG approach or responsible investment can be questioned.
On the one hand, academic writers view securities lending as a secure way for lenders to earn incremental revenues and bolster their performance while also a relevant tool to satisfy borrowers’ daily operations. In addition, some academic papers, including those of the International Organization of Securities Commissions (IOSCO), highlight that securities lending contributes to effective liquidity and price discovery in financial markets, reduces volatility and costs for end-investors, and is not detrimental to long-term value.
On the other hand, investors are increasingly looking at integrating sustainability into their portfolio strategies and applying responsible approaches. However, while incorporating responsible criteria in investment strategies is becoming mainstream, these approaches seem to ban the use of securities lending.
Many working papers1 from global academic and industry perspectives demonstrate that securities lending enhances market efficiency and sustainability. These sources support the argument that the lack of securities lending damages market quality, and that its use significantly enhances the price discovery process, improves market liquidity, and reduces spreads. According to these perspectives, securities lending is the grease that oils global market efficiency.
In addition, securities lending and short selling support market efficiency by incorporating negative information into market prices more quickly, preventing disruptive price bubbles. Empirical findings have also shown that constraining securities lending and short selling reduces liquidity. In other words, this regulated practice contributes to capital market efficiency, by enhancing market liquidity and stability while generating additional returns for end-investors.
Moreover, the European sustainable and responsible investment (SRI) labels—which aim to guarantee the quality of responsible investment—authorize the use of securities lending. For example, important SRI labels (such as the French and Belgian) clarify the specific conditions and guidelines for their acceptable use in their frame of reference. These SRI label requirements result in the close supervision and selection of counterparties, monitoring of borrowers’ motivations, and repatriation of securities on loan before the exercising of voting rights to maintain strong shareholder engagement.
In addition, the Sustainable Finance Disclosures Regulation (SFDR), in force since March 2021—the latest regulatory step on the topic and a major part of the EU Action Plan for sustainable growth regulation—does not provide any specific recommendations regarding securities lending activities. However, as products with a sustainable investment objective (under article 9 of the SFDR) should invest almost 100% of their assets in sustainable assets, using securities lending for these funds implies setting up specific rules to ensure the sustainability of borrowed assets.
Public studies1 support the view that, by creating the right ecosystem for their use, responsible investors using an SRI label can effectively continue to engage with companies while actively lending their assets. In conclusion, an analysis of the extensive literature available as well as regulatory standards shows no evidence suggesting securities lending could detract from sustainable investment strategies.
Using securities lending for article 9 SFDR funds implies setting up specific rules to ensure the sustainability of borrowed assets.
Public documents show that market participants have adopted responsible behaviors for these operations and are committed to implementing a secure framework for developing their securities lending activities.
For example, Stuart Jones, PASLA’s chairman, said: “There are three core topics that normally come up: proxy voting, collateral and transparency […] These cover whether and how asset owners should have their shares returned to them to allow them to vote at annual general meetings (AGMs), what collateral they were given in exchange for the shares—in case these did not meet asset owners’ ESG requirements —and whether borrowers of shares could lend them on further without informing the owner.”
Market participants have designed this framework with precise procedures on investment stewardship, shareholder engagement, and ethical conduct regarding transactions and client interactions while considering the main purpose of optimizing client returns and protection.
For example, in a Deloitte survey of 71 responsible funds managed by 25 major asset managers, 90% are allowing securities lending for their funds according to their prospectuses on all or part of the scope. However, when the prospectus allows securities lending, only 61% seem to have actually used securities lending in 2020, according to the fund’s annual report. Most of the time, these asset managers define for their securities lending activity (i) a maximum amount, i.e., securities lending cannot exceed a specific weight of portfolio net assets and (ii) a maximum number of days for the loan contract (without specifying quantitative norms).
Furthermore, some market participants set up specific rules, such as the ability to recall or restrict loans on particular securities to ensure shareholders can vote at AGMs, or the meticulous assessment of counterparties before the loan contract is issued, which incorporates corporate social responsibility and SRI considerations.
Finally, another core issue for asset managers is transparency to their investors. It is seemingly crucial for market participants to maintain smooth communication, guarantee the traceability of trade flows, and ensure that the exchange of information during the securities lending transaction remains fluid (especially for responsible fund managers).
By implementing good initiatives and procedures regarding stewardship and engagement, counterparty selection and transparency, and a secure legal ecosystem for transactions, market participants should be able to carry out securities lending activities through a sustainability lens.
1 Please refer to the whole study to see the exhaustive list of the academic papers and public studies references: https://www2.deloitte.com/content/dam/Deloitte/fr/Documents/risk/Publications/deloitte-securities-lending-and-responsible-investment.pdf
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