ESG and securities lending
The Global Framework for Environmental, Social and Governance (ESG) and Securities Lending (the Framework) has just been updated by the Global Alliance of Securities Lending Associations. The Framework is intended to provide practical guidance for a securities lender to consider when lending securities within the framework of its ESG policy. There is little Financial Conduct Authority (FCA) or other regulatory guidance that addresses ESG in the context of securities lending, and in particular collateral in securities lending transactions. The Framework provides welcome industry guidance to market participants such as investment funds, pensions trustees and financial institutions.
The Framework covers five key considerations:
- Voting rights
- Collateral management
- Lending over record date
- Facilitation of short selling
- Transparency in the lending chain
The FCA stated in 2022 that although “[the FCA] do not consider securities lending as being incompatible with ESG… a firm should clarify its securities-lending policy and the steps it takes to ensure this is coherent with the sustainable investment strategy.”
The Framework is a key step in increasing and harmonising ESG compliant securities lending strategies and market practice in the global financial system. This Framework is part of a broader national and international movement to increase the green initiative in the securities lending market. Internationally recognised initiatives, such as the United Nations-supported Principles of Responsible Investment (PRI), influence national policies, industry groups and individual organisations, through a public demonstration of a commitment to responsible investment.
Entities that engage in securities lending will need to consider their regulatory obligations, industry standards, and voluntarily adhered to principles (such as those published by the PRI) when establishing a securities-lending policy.
The Framework will have wider relevance to other markets, such as the repo markets and derivatives markets.
Introduction to securities lending
Securities lending is prominent in the financial system. It provides liquidity to equity, bonds, and money markets, and also income to investors.
Securities lending is where an owner of certain securities (the Lender) transfers those securities to another party (the Borrower), and the Lender and the Borrower simultaneously agree that the Borrower will transfer equivalent securities back to the Lender on demand or on an agreed maturity date.
The Borrower provides securities or cash to the Lender as collateral for the duration of the securities lending arrangement. Collateral can be provided as a security interest or posted on a full title transfer basis. It is usual that the value of the collateral is equal to or greater than the value of the securities being borrowed. Collateral mitigates the Lender’s counterparty credit risk.
Although the word ‘lending’ can be found in its title, in legal terms a securities lending transaction is not a loan. Instead, each leg of the transaction is an absolute transfer of legal and beneficial title to the securities in question.
There are some important consequences that arise following such a transfer of securities. The Borrower has the right to sell the received securities on to a third party on a full title basis (known as rehypothecation rights), and if the Borrower retains those securities, it can exercise any voting rights under the transferred securities.
Under a securities lending transaction, the Borrower pays to the Lender a fee. The Borrower also pays to the Lender any economic benefit that the Borrower receives by owning the transferred securities such as a dividend, coupon or interest payments.
ESG and securities lending
The Framework’s key five considerations:
a) Voting rights. The Framework emphasises that Lenders should develop a recall policy for securities that have been transferred under their securities lending programme. Such a recall policy could be aligned with the Lender’s own ESG investment policy. Whilst it is not pragmatic for Lenders to use recall rights before every corporate event, Lenders should evaluate the materiality of the vote in the context of the Lender’s own ESG policy against the potential lost income if lent securities were recalled.
It is worth noting that a Lender can recall securities at its discretion under most standard market documentation.
b) Non-cash collateral, cash reinvestment and reuse. A Lender can prescribe ESG standards to determine what non-cash collateral is acceptable to meet margin requirements under a securities lending agreement. ESG eligibility of collateral can be linked to certain industry sectors or types of individual securities. As there is no common ESG standard for categorising collateral, a Lender will need to consider what collateral is eligible according to its own bespoke policy. A Lender might also want to align cash collateral re-investment with its own ESG investment portfolio strategy.
A Lender may need to comply with the EU’s and UK’s Securities Financing Transaction Regulation (SFTR) with respect to any re-use or investment of collateral, and so it might choose not to reuse such collateral.
As practical guidance, the Framework recommends that Lenders (and their agents) incorporate clear guidelines on the scope of the permitted reuse of collateral under their securities lending programmes.
Until the Framework’s publication, there had been little discussion or analysis as to whether the same ESG principles that apply to a securities lending programme, should also apply to acceptable collateral. In the FCA’s Discussion Paper on Sustainability Disclosure Requirements and investment labels (DP21/4) (October 2021), the FCA welcomed views on securities lending in the context of sustainable investing, but this did not explicitly extend to request views on whether acceptable collateral also had to meet ESG criteria.
c) Lending over record date. The Framework emphasises that Borrowers and Lenders should be aware of and comply with the tax rules in all applicable jurisdictions to a securities lending transaction.
d) Facilitating participation in the short side of the market. The Framework describes a number of positive roles for regulated and transparent short-selling of securities in the context of ESG. Short-selling is subject to the requirements of a number of regulatory regimes that should be factored into any securities-lending programme (such as, in the European Union, the Short Selling Regulation (Regulation (EU) No 236/2012) which was incorporated into the UK’s statute book following Brexit).
The Framework also acknowledges the PRI’s article “Shorting and responsible investment: A review”: Shorting and responsible investment: A review | Discussion paper | PRI (unpri.org). This article goes into more detail than the Framework on ESG in the context of short-selling.
e) Transparency in the lending chain. A Borrower receives full legal and beneficial title to securities transferred by a Lender. A Lender will have no visibility as to how the Borrower uses those securities.
The Security Financing Transaction Regulation ((Regulation (EU) 2015/2365) in the European Union, and also onshored under the European Union (Withdrawal) Act 2018 so as to be directly applicable in the United Kingdom) and the European Union’s Shareholder Rights Directive (implemented in the UK in part) has enhanced transparency through disclosure and approval requirements. There is similar legislation in the United States.
The Framework suggests that Lenders can enhance on-lending transparency and ESG compliance of lent securities through a careful selection of Borrowers and carrying out due diligence on counterparty Borrowers’ own ESG policies.
Lenders’ securities lending policies are likely to be a part of a broader ESG policy at investment portfolio level or an entity’s overarching financial purpose and strategy. As a word of caution, securities lending policies or agreements that are too narrow are likely to adversely affect liquidity and may not have the desired results.
Many of the issues discussed will also apply to derivatives and repo trading policies and strategies.
Industry guidance will continue to evolve to reflect international and national requirements, market practice, current ethics, and an increased understanding and harmonisation of the meaning of ESG. The Framework will be updated, but this second edition is welcome guidance to assist securities lending market participants as to some of the contractual and practical issues that they should consider in the context of ESG.
Michael Wright, Chairperson of the South African Securities Lending Association, believes “it is crucial that the market has a shared understanding of how ESG and securities lending are compatible with each other… [the Framework] provides a global framework for managing these touchpoints.”