The Global Framework for ESG and Securities Lending draws on invaluable insights unearthed by the Pan Asia Securities Lending Association and the Risk Management Association
Integrating environmental, social and governance (ESG) factors into securities lending will form an important contribution that finance needs to make to realise the United Nations’ Sustainable Development Goals.
This is why the Pan Asia Securities Lending Association (PASLA) and Risk Management Association (RMA) launched the Global Framework for ESG and Securities Lending (GFESL).
The GFESL, based on extensive market research, focuses on what the two industry associations consider to be “six main touchpoints” between securities finance and Environmental, Social and Governance (ESG) principles.
Rather than a prescriptive set of guidelines, the GFESL is a practical tool for market practitioners — particularly beneficial owners — in developing their own approach. It lays out best practices, standardised options and essential background information and covers voting rights, transparency in the lending chain, collateral and cash reinvestment, lending over record date, the short side of the market and rehypothecation of non-cash collateral.
The framework was partly born out of a consultation process PASLA conducted across the Asia Pacific region during Q4 2020, which attracted feedback from 150 senior industry professionals. This found that asset owners and managers want to take responsibility for managing ESG factors when lending securities, with 85 per cent seeking controls to address concerns over the compatibility of ESG principles with securities lending.
Additionally, insights gleaned from an RMA paper published in October 2020 also fed into the framework. Importantly, the paper highlighted that 95 per cent of global asset owners and managers surveyed believed securities lending and ESG could peacefully coexist. However, only 18 per cent always applied ESG principles to their securities lending programmes.
It was out of this research that the industry associations developed the first edition of the GFESL. Future iterations will be designed for other stakeholders in securities finance, such as exchanges and regulators.
The GFESL was welcomed by the International Securities Lending Association (ISLA). ISLA’S CEO Andrew Dyson says: “We are delighted to see the publication of these ESG guidelines for the investment community from PASLA and the RMA.
“Recognising that regional variances especially from a regulatory perspective will drive different outcomes, at least in the short term, it is vital that associations lead the way on defining best practice to fully align securities lending within an ESG investment framework across their various regions.”
Channelling this research into action via the GFESL, PASLA and RMA believe that transparency around ESG factors in securities lending can be significantly enhanced. A clear and widely-accepted decision-making framework should enable lenders to better define their approach, align it with corporate-level objectives, communicate it to other participants in the value chain and monitor its impact. “We see this initial framework as an important starting point but believe there is great potential to refine and iterate the GFESL in future,” the report states.
Regarding voting rights, the GFESL suggests that institutional investors that lend securities should consider developing a policy for recalling loaned securities based on ESG considerations in their proxy voting framework.
In the PASLA consultation, beneficial owners identified ‘exercising voting rights’ as the most important factor for securities lending from an ESG perspective. The majority suggested leveraging existing mechanisms to enforce the recall of loaned securities in order to fulfil their ‘stewardship’ responsibility. However, only 11 per cent of respondents believed that loaned securities should always be recalled ahead of an investee company’s Annual General meeting or Extraordinary General Meeting.
Under GFESL’s key recommendations for voting rights, lenders should develop an ESG-focused recall policy in their proxy voting framework and identify the types of resolutions on which lenders want to vote by company and by issue. They should also set out parameters that would trigger a recall or restrict further lending.
To boost transparency, institutional investors should implement minimum standards throughout the lending chain that reflect their sustainability framework.
Respondents to the PASLA consultation highlighted transparency in the lending chain as the second most important ESG factor, with 54 per cent of respondents suggesting that lenders should define acceptable or unacceptable borrowers. The GFESL recommendations advise that lenders should, in the short-term, implement effective minimum standards for counterparty selection, apply an ESG lens when selecting their direct counterparties and consider lending chain restrictions based on activity rather than the identity of end users.
In the longer-term, lenders should continue to improve their levels of education around transparency requirements and support industry initiatives to develop technology that delivers visibility over the onward lending of securities.
When they lend securities, investors should apply the same ESG standards to non-cash collateral as they do to their investment portfolio.
Interviews during the PASLA consultation reflected the view that lenders should apply restrictions to the types of collateral they accept, in the same way they apply ESG principles to portfolio management. Many market participants believed that there should be ESG considerations for reinvestment of cash received as collateral.
The GFESL’s recommendations suggest lenders should harmonise ESG standards applied to non-cash collateral they will accept in securities lending transactions and ESG criteria applied to their portfolio investment activity. These advise considering standardised ESG collateral sets as a core option, with customised overlay where necessary, setting clear parameters when communicating with agent lenders.
When lending over a record date, investors should establish a clear policy on lending securities and communicate this with agent lenders. It also recommends monitoring counterparty exposure to weed out unusual activity.
Many market participants surveyed made it clear that structuring a securities lending transaction for the purpose of benefiting from a tax differential was not ESG compatible. Nonetheless, brokers have an obligation to create dividends according to the after-tax dividend entitlements that the lender would have received had the securities remained in their custody.
The GFESL framework recommends that lenders establish a clear policy for lending over record dates and communicate with agent lenders to ensure compliance. In doing so, they should monitor counterparty exposure to identify any unusual activity.
Regulated and transparent short-selling is widely considered a crucial component of high-quality capital markets. It supports price discovery, creates liquidity and can help to act as a potential red flag against poor corporate governance or even fraud.
Although concerns were raised about the compatibility of short-selling with ESG principles, market participants and organisations widely believed that short-selling can be instrumental in achieving positive ESG outcomes.
More broadly, the GFESL advises that lenders should identify areas in which they see a conflict between their ESG considerations and short-selling and develop a short-selling policy that sets out the circumstances under which they will or will not lend.
Lenders should determine whether the known and potential implications of rehypothecation are compatible with their corporate-level ESG commitments, especially with regard
to governance.
Although rehypothecation can enhance market liquidity and increase returns for lenders, some believe that rehypothecation enhances systemic risk. The GFESL advises that lenders, brokers and end users should incorporate clear guidelines on rehypothecation into their programmes, based on whether they consider the practice to be responsible and compatible with their ESG principles.
