There is widespread opportunity for the finance industry to support the principles of sustainable securities lending, however progress might be measured or guided by regulators and central banks, says FIS’ David Lewis
From plant-based detergents and burgers to the rise of renewable energy, everything is turning green. While the move to electric cars is accelerating and renewable energy is replacing some fossil fuel power generation, the last couple of weeks of chaos in the UK brought home the reality of just how dependent our economy and social fabric remain on petrol and diesel.
Moving toward a greener and more environmental way of life is a vital part of a sustainable future, and many would say that such changes are long overdue, but the journey there won’t be easy. The application of ESG principles to many areas of our lives – and, in particular, the world of finance – is one of the most talked-about subjects of recent years. Alignment with such principles has now become a commercial prerequisite to many, including in the finance and investment industry. But what about the grand proclamations and advertising? And how can making money and being green coexist?
One does not have to be particularly cynical to question the sudden interest your broadband or online betting provider, for example, has on your mental health. It could be said that this just represents the bandwagon many organisations are jumping onto, but it does also represent a real change in corporate responsibility toward customers and the wider environment. Uncontrolled, it can lead to what is becoming known as greenwashing, where the claimed green credentials do not entirely live up to the reality. In the world of finance, this has attracted the attention of regulators that want to be sure that any investment or service purchased by a client matches what they believe they are buying.
This presents significant challenges for many providers and financial service companies. The challenge of finding enough ESG-compliant companies and securities has been discussed before, highlighting the potential risk of crowding bringing inflated asset prices and disappointing returns as a result. Where inflated asset prices appear, so do short sellers. Short sellers and, by association, securities lenders have attracted unwanted and arguably unwarranted criticism over the years, including the suggestion that such activities go against the objectives of long-term investment.
Fiduciary demand
So, if long-term investments and improved shareholder engagement are demanded by the governance part of ESG, how can this be balanced against the fiduciary demand placed on investment managers to make adequate returns without the support of securities lending income and the reassurance that overpriced assets will be rooted out?
Short selling has long been identified as a key tool in uncovering inflated asset prices and fraudulent activities in security issuers. There is a multitude of examples where activist investors have very publicly exposed wrongdoing, but there are many more mundane, less visible examples where simple market anomalies (rather than wilful maleficence) have been exposed and asset prices corrected.
On that basis, the incremental revenue gathered from lending securities is a key part of the social requirements of ESG, earning additional income for investors by renting out assets held for the long term. Equally, supporting short selling should form part of the fabric of a responsible investment governance regime, helping to reduce the likelihood of overpaying for investments and boosting potential returns over time. However, some may need persuading on this second point.
To achieve that, proof will no doubt be required and, as a data provider in this space, FIS Securities Finance Market Data (the new name for Astec Analytics Lending Pit), has delivered that transparency for almost 20 years. Analysis of fund-level lending performance can provide a clear indication of the additional revenue benefits that accrue from securities lending without disrupting or distracting the fund from its overall investment objectives. Correlating short interest with price movements is also statistically identifiable, with multiple papers published on the generation of alpha using short selling signals.
Loan data and price correlations
Research undertaken by an FIS client provided a clear correlation between securities lending data (as a proxy for short interest) and price movements. While this may not be particularly surprising to many, some may be surprised to learn that the stronger correlation was in fact on long positions rather than short. In other words, a reduction in securities lending activity was the signal indicating a potential floor had been reached and a buying opportunity may be presenting itself. Too often those that criticise the actions of short sellers ignore the fact that price discovery can act both ways.
Going one step further, as an original signatory to the Global Principles for Sustainable Securities Lending (GPSSL), FIS is demonstrating its commitment to supporting sustainable securities lending through the provision of key analytical data. The GPSSL supports a range of nine principles through which securities lending might operate to become a more sustainable industry. Of these, number six covers short selling and its objective to expose fraud and misdeeds as well as support price discovery and market efficiency. Interestingly, its neighbour at number seven addresses the need for good corporate governance through voting and shareholder engagement with issuers. This could be taken as a subtle indication that these principles need not be in conflict but are, in fact, aligned toward the proper management of investors’ funds balancing revenue generation with good governance.
Getting to green is a laudable goal, and progress can be measured in actions and data. Regulators may well get more involved, and not just about fair practices ensuring the descriptions of funds matching up with their actual behaviour. It is also possible that other organisations might believe it is part of their role to influence the markets transition.
Recent statements by the European Central Bank (ECB) President and the Governor of the Bank of England have indicated that they may bring the firepower of their respective bond purchase programme to favour corporate bonds issued by companies that satisfy their climate change requirements. Selling “brown bonds” and purchasing “green bonds” can bring cost-of-financing advantages to such companies. On many levels, these actions may be well supported, although some might question whether attempting to influence the market in such a manner might be outside the typical remit of a central bank.
However progress might be measured, guided or encouraged by regulators or central banks, there is ample opportunity for the finance industry to make its own choices and support the principles of sustainable securities lending.
