New standards
21 January 2020
The industry faces some key milestones in 2020 with SFTR, CSDR and Brexit all on the horizon. But, underlying trends including the continued discussions around ESG and short selling will also continue to demand attention in the year ahead
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January 2020. The start of a new year and a decade. Much has changed and more is due to change as the new year gets under way. Two issues that have been on the horizon are now suddenly much closer and their impact will be appearing in sharp relief very soon: Brexit and the Securities Financing Transactions Regulation (SFTR). The new regulation commences in April and is the first implementation of the Financial Stability Board’s (FSB) transparency directive, but there is much to do before then to get the market live and compliant with the new era of transparency. Brexit, on the other hand, has been a somewhat more flexible deadline over the past three years; until now, that is. The December election in the UK delivered the government the kind of majority that will allow them to take decisive actions and deliver certainty of timing, irrespective of whether you agree with it in principle or not.
These are not the only changes that are affecting our market. A long laundry list of physical and tangible changes could be made and an analysis of each one documented. However, there are other changes afoot, perhaps as a reflection of trends in the wider financial markets, that are a little less tangible. Securities lending has always had its detractors, most commonly linking it with the market mechanism of short selling, where an investor can make a return on a falling share price rather than where a rising one can benefit the holder of a long investment. Much has been written about the whys and wherefores of this practice, seeking to prove definitively one way or another that it does or not damage long-term investments and does or not provide for efficient price discovery of a financial instrument. The data behind these arguments will not be re-examined here. Instead, what’s more interesting is the underlying concern that seems to be driving some organisations to exit lending, just as many others are joining.
The Government Pension Investment Fund (GPIF) of Japan, reputed to be the world’s largest pension fund managing $1.4 trillion of assets, mostly through outsourced fund managers, made a very public announcement recently regarding its decision to cease lending its foreign equity assets. Debt instruments will continue to be lent and domestic Japanese equities remain unavailable to borrowers. The decision to abandon around $115 million of annual revenue (averaged over 2015 to 2018) attributed to this activity was considered a price worth paying to support the fund’s environmental, social and governance (ESG) objectives. The executive managing director and chief investment officer of GPIF, Hiro Mizuno, cited a lack of transparency with regard to who is borrowing shares and for what purpose as a significant factor in the decision to curtail lending. Further, with an investment time horizon of 100 years, the GPIF has made it clear that focusing on short-term gains and strategies conflict with meeting its overall investment objectives. With such a bold move, just as other funds and fund managers are increasing their involvement in securities lending to boost revenues, it begs the market to question whether there has been a fundamental shift away from simply monitoring the financial returns of a fund as a way of measuring its success.
In December, the International Securities Lending Association (ISLA) launched its Council for Sustainable Finance (ICSF). The announcement indicated that this launch had been the culmination of some 16 months of preparation work, suggesting that this was not a knee-jerk reaction, but perhaps the considered response to a growing trend in the wider financial markets. The stated objective of this council of experts is the promotion of “sustainable securities lending” through the promotion of new and relevant principles that will assist the adoption of ESG principles into securities lending practices.
It will be interesting to see how this works in practice and how such principles can be implemented, particularly when many consider there to be a potential conflict between a fund managers fiduciary responsibility to its clients to make the best returns possible and some of the new ESG objectives.
Applying ESG-like principles to investing might be a relatively simple process to undertake. Restricting investments in tobacco companies or weapons manufacturers, for example, is a binary decision once a fund has determined its investment principles. However, the physical lack of eligible securities to invest in could lead to crowding and result in over inflation of asset prices. If this does occur, it could become a serious issue that, in fact, fuels additional short selling activities. It is telling that the $1.4 trillion GPIF fund states that just $28 billion is invested in ESG compliant funds: 2 percent of its total portfolio.
Applying ESG principles to securities lending activities could be extended relatively simply to exclude banned assets from permitted acceptable collateral schedules in securities lending programmes, but again could present risks in excessive issuer concentration or lack of market liquidity. ESG principles are also likely to extend much further, including voting on shares held as well as potentially not even lending them, as GPIF has chosen to do.
The GPIF has stated that transparency was a key issue for it, and specifically the impact of not knowing whether its assets were being borrowed to facilitate short selling activities. Given the implication that GPIF may have continued to lend its assets if it could guarantee they would not be used for short selling exposes the real underlying reason for this decision – the belief that such actions can drive prices of assets downward. For such an argument to be true goes against most fundamental asset pricing principles, not to mention ignoring the existence of many alternative mechanisms through which an investor can profit from a falling asset price. What it does highlight is the almost sentimental view that it is somehow distasteful to profit from an asset falling in value.
On that measure, t GPIF has likely erred in its logic. Having a 100-year investment time horizon makes the value of an asset from one day, week or month to the next almost completely irrelevant to its long-term strategy. Refusing the available securities lending revenue is, therefore, arguably a fiduciary mistake but only if the measure of success of the fund is no longer accounted for in terms of overall financial provision for the pensioners it serves, but a more intangible measurement of compliance with ESG principles.
Few can claim to have not noticed the general shift in investment funds on offer today, including the rise in ESG-style funds and “responsible investing” as a new-age mantra. For some, the simple financial returns of an investable asset are not the sole, or perhaps even key, determinant in the decision to invest. Balancing the activities of the securities finance industry with ESG principles will not be an easy task, but the opening of ideas for fund performance beyond the traditional basis point returns is likely part of the solution.
These are not the only changes that are affecting our market. A long laundry list of physical and tangible changes could be made and an analysis of each one documented. However, there are other changes afoot, perhaps as a reflection of trends in the wider financial markets, that are a little less tangible. Securities lending has always had its detractors, most commonly linking it with the market mechanism of short selling, where an investor can make a return on a falling share price rather than where a rising one can benefit the holder of a long investment. Much has been written about the whys and wherefores of this practice, seeking to prove definitively one way or another that it does or not damage long-term investments and does or not provide for efficient price discovery of a financial instrument. The data behind these arguments will not be re-examined here. Instead, what’s more interesting is the underlying concern that seems to be driving some organisations to exit lending, just as many others are joining.
The Government Pension Investment Fund (GPIF) of Japan, reputed to be the world’s largest pension fund managing $1.4 trillion of assets, mostly through outsourced fund managers, made a very public announcement recently regarding its decision to cease lending its foreign equity assets. Debt instruments will continue to be lent and domestic Japanese equities remain unavailable to borrowers. The decision to abandon around $115 million of annual revenue (averaged over 2015 to 2018) attributed to this activity was considered a price worth paying to support the fund’s environmental, social and governance (ESG) objectives. The executive managing director and chief investment officer of GPIF, Hiro Mizuno, cited a lack of transparency with regard to who is borrowing shares and for what purpose as a significant factor in the decision to curtail lending. Further, with an investment time horizon of 100 years, the GPIF has made it clear that focusing on short-term gains and strategies conflict with meeting its overall investment objectives. With such a bold move, just as other funds and fund managers are increasing their involvement in securities lending to boost revenues, it begs the market to question whether there has been a fundamental shift away from simply monitoring the financial returns of a fund as a way of measuring its success.
In December, the International Securities Lending Association (ISLA) launched its Council for Sustainable Finance (ICSF). The announcement indicated that this launch had been the culmination of some 16 months of preparation work, suggesting that this was not a knee-jerk reaction, but perhaps the considered response to a growing trend in the wider financial markets. The stated objective of this council of experts is the promotion of “sustainable securities lending” through the promotion of new and relevant principles that will assist the adoption of ESG principles into securities lending practices.
It will be interesting to see how this works in practice and how such principles can be implemented, particularly when many consider there to be a potential conflict between a fund managers fiduciary responsibility to its clients to make the best returns possible and some of the new ESG objectives.
Applying ESG-like principles to investing might be a relatively simple process to undertake. Restricting investments in tobacco companies or weapons manufacturers, for example, is a binary decision once a fund has determined its investment principles. However, the physical lack of eligible securities to invest in could lead to crowding and result in over inflation of asset prices. If this does occur, it could become a serious issue that, in fact, fuels additional short selling activities. It is telling that the $1.4 trillion GPIF fund states that just $28 billion is invested in ESG compliant funds: 2 percent of its total portfolio.
Applying ESG principles to securities lending activities could be extended relatively simply to exclude banned assets from permitted acceptable collateral schedules in securities lending programmes, but again could present risks in excessive issuer concentration or lack of market liquidity. ESG principles are also likely to extend much further, including voting on shares held as well as potentially not even lending them, as GPIF has chosen to do.
The GPIF has stated that transparency was a key issue for it, and specifically the impact of not knowing whether its assets were being borrowed to facilitate short selling activities. Given the implication that GPIF may have continued to lend its assets if it could guarantee they would not be used for short selling exposes the real underlying reason for this decision – the belief that such actions can drive prices of assets downward. For such an argument to be true goes against most fundamental asset pricing principles, not to mention ignoring the existence of many alternative mechanisms through which an investor can profit from a falling asset price. What it does highlight is the almost sentimental view that it is somehow distasteful to profit from an asset falling in value.
On that measure, t GPIF has likely erred in its logic. Having a 100-year investment time horizon makes the value of an asset from one day, week or month to the next almost completely irrelevant to its long-term strategy. Refusing the available securities lending revenue is, therefore, arguably a fiduciary mistake but only if the measure of success of the fund is no longer accounted for in terms of overall financial provision for the pensioners it serves, but a more intangible measurement of compliance with ESG principles.
Few can claim to have not noticed the general shift in investment funds on offer today, including the rise in ESG-style funds and “responsible investing” as a new-age mantra. For some, the simple financial returns of an investable asset are not the sole, or perhaps even key, determinant in the decision to invest. Balancing the activities of the securities finance industry with ESG principles will not be an easy task, but the opening of ideas for fund performance beyond the traditional basis point returns is likely part of the solution.
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