ESG principles in securities lending – the essential role of data
30 august 2022
As concerns around sustainable finance increasingly interact with securities lending businesses, the role of high-quality, highly available ESG data takes on new importance for market participants, in particular CSDs. Jacob Gertel, senior content manager, legal and compliance data at SIX, evaluates ESG impacts on the securities lending process and how data providers can provide the answers
Image: stock.adobe.com/garrykillian
Responsible investing is one of the most widely discussed issues within the securities business. Concerns around climate change, diversity, equality, governance and data privacy have driven environmental, social and governance (ESG) concerns to the top of corporate agendas, while asset owners, investors, lenders and borrowers are looking for ways to incorporate ESG principles into their investment strategies.
Regulators and policymakers are also exploring ways to incorporate and standardise ESG requirements within the regulatory framework. Although specific regulations covering ESG have yet to be codified, a wealth of academic literature, market surveys and pronouncements from the regulators themselves makes clear the direction of travel: ESG considerations will become standardised and embedded as part of a sustainable finance model.
ESG and securities lending
Demands for more sustainable finance now touch almost every area of the investment process, and that includes securities lending. Given its central role in, for example, meeting settlement and collateral requirements, liquidity provision, price discovery, hedging and central banks’ monetary policies, this should not come as a surprise. Indeed, a recent survey by the Risk Management Association’s Council of Securities Lending found that 95 per cent of respondents believe that ESG investing and securities lending can coexist.
Even though it is still currently a small minority that always consider ESG in their securities lending process, we are seeing a growing number of issuers, lenders and borrowers of financial instruments investigating the ESG footprint of their investment and lending decisions and the processes behind them.
For investors with an ESG agenda, this is often about directing capital in ways that encourage ’good’ behaviour – for example by raising the cost of capital for firms whose activities are deemed not to align with responsible investing. More generally, the decision to incorporate sustainability considerations into lending and investment decisions is more about building up a positive brand identity and avoiding the reputational damage and costs that stem from associations with firms that are losing social permission to operate.
At its most pragmatic, the decision to incorporate ESG thinking into investment processes is simply to avoid being left with stranded assets that are difficult to sell on in the future.
Challenges and questions
Whatever the driving factors, thinking about securities lending in this way does raise a number of fundamental questions. Without standardised regulation for combining the requirements of sustainable finance with those of securities lending, careful consideration is needed. Issues around who qualifies as an approved counterparty, which restrictions are in play, recalls for proxy voting and rules for reinvention, all fall under this umbrella.
Take the counterparty issue as an example. Questions naturally arise around whether and how far the ESG credentials of that potential trading partner should be considered. Additionally, there are challenges around how best to assess the ESG credentials of issuers whose securities are being purchased and whether to apply criteria such that certain securities are never lent at all. This has implications for the level of granularity required when looking at a basket of securities received as collateral, and whether a lender should examine individual components or take a more holistic view.
As to the borrowers in any transaction, should the borrower use their voting rights in cases where the securities come with voting rights, and if so, how? How does a lender respond to a borrower who would vote against the lender’s ESG principles and intentions? A lender who takes this stance would need to understand the borrowers’ own intentions, their beneficial owners’ identity and intentions and the borrower’s own ESG parameters and ratings.
These questions are important for lenders whose policy is to invest solely in sustainable products and would not want their borrowers to use borrowed securities in a way that is counter to its ESG values. The ‘Know Your Borrower’ (KYB) approach could mitigate such a risk, such that the lender approves the transactions only after a solid borrower screening and evaluation of their intentions, particularly where voting rights are concerned, has been conducted.
Borrowers can carry out similar Know Your Lender (KYL) checks, therefore ensuring that the lenders’ ESG principles are also in line with their own. KYB and KYL due diligence can both be supported by data on the corporate level: lender, borrower, ‘investee companies’, as well as the underlying securities of the securities lending transaction.
There are also internal processes that may need to be updated. Overall, adoption of ESG principles in securities lending raises questions about how industry participants can develop communication and reporting lines between managers of their securities lending programmes and ESG management within the organisation.
At a more technical level, when a beneficial owner wishes to measure the effectiveness of its ESG efforts in its securities lending programme, the measurement methodology needs to be both appropriate and adequate. That may require policies on when to recall on loan securities and how these kinds of customisations should be implemented, all the while taking into account any potential impact on overall flow and revenue.
As for proxy voting, a lack of timely information about proxy record dates and voting questions complicates the process of recalling stock that is on loan. When RMA survey participants were asked to name ‘measures that might facilitate the application of ESG principles to their securities lending programme’, 43 per cent said that they want more transparency around proxy record dates and questions.
Collateral, CSDR and data
One of the more interesting and consistent themes running through debates about ESG policies and securities lending is that of collateral.
In general, less collateral is required for securities lending of assets marked positive for ESG. That is good for market participants broadly. However, it is less good news for the EU’s central securities depositories (CSDs) which — facing the complexities of the penalty regime inherent in the Central Securities Depositories Regulation (CSDR) regime — have many more questions to think about.
As with other aspects of CSDR more generally, the Classification of Financial Instruments (CFI) code that describes the structure and function of any given instrument plays a critical role. To ensure that financial institutions involved in the transaction have the right CFIs, it is important to have a so-called golden source of data, which encompasses all the data in every system of record within a financial institution. Timely data generation, collection, enrichment, processing and distribution are therefore key factors for the integration of ESG into the securities lending process.
Ensuring that data is of sufficiently high quality and accuracy requires significant resource and expertise. Specialised data vendors like SIX, that have market leading coverage of regulatory and ESG data, offer the required data to support financial institutions with their lending processes. Indeed, the use of this valuable data is highly recommended since it reduces the process costs of ensuring an adequate securities lending transaction.
Data for ESG monitoring and compliance
Of course, the same standards apply to sustainable securities financing as they do to all other financial transactions. At SIX, we decided to delve deeper into the issue. We looked at aggregated information from existing reports and studies to clarify the different types of ESG-specific data that is required, along with its various attributes and challenges, including adoption, coverage, input data sources and metric offerings.
We found that the main concerns regarding ESG data are:
• The general lack of availability, with timeliness and coverage of given regions, markets, segments or instruments raised as specific concerns.
• The quality of the data inputs, as inconsistencies, reliance on self-reported data, lack of completeness, obvious errors and the use of subjective or unaudited information are all contributing factors to lower data quality.
• The risks associated with over-dependence on large volumes of data, with issues such as cybercrime, data ownership, theft and misuse all shown to be of significant financial relevance.
In this sense, data considerations for sustainable finance and securities lending are no different from other transaction types: availability, sourcing and quality are fundamental properties that any data provider should be able to guarantee.
However, there are also specific data requirements that any securities lending business needs to understand when monitoring their overall processes and individual transactions against internal or external ESG standards. At both pre- and post-transaction stages, data of the highest standard is necessary to perform the following key functions:
• Sanctions monitoring. As with any area of securities trading, both the lender and borrower, whether legal entities or private persons, need to be constantly screened against national and international sanctions regimes — as should all securities that are part of the transactions. Sanctions monitoring should be part of the pre-contractual processes around KYL, KYB and KYC standards, as well as throughout the contract lifecycle. If required, compliance professionals should alert the responsible and involved business units of any potential breaches or problems as soon as they are aware of them.
• Meeting both parties’ ESG preferences. Investment firms should be able to identify, define and understand ESG preferences, based on regulatory and industry standards. This can include, but is not limited to, any EU Sustainable Â鶹ӰÊÓ´«Ã½ Disclosures Regulation (SFDR) Principal Adverse Impact indicators. Preferences and indicators should be reflected in the investment firms’ ESG questionnaires and core IT systems. They should also be able to ensure that the lending transaction matches these preferences during the entire lifecycle of the transaction.
• Identifying ESG factors for issuers and securities. Investment firms should be able to define and introduce a process that ensures ESG indicators are sourced on issuer and security levels, so basic reference data of the securities involved in the transaction, such as voting rights, trading venues, restrictions and ESG data, should be clearly available. Firms also need to monitor any acute change to those lender or borrower preferences. In the event that such changes occur, they must be able to alert the relevant business units and trigger required actions. In the case of positive developments, this might include the modification of transactions, such as reduction of credit spreads. In the case of a negative development, the action might involve offsetting or even cancelling the transaction.
In general, we found that market participants from the buy- and sell-side are often unsure about how best to align their lending programmes with their ESG objectives. Agent lenders that participate in open dialogue on how to balance lending decisions with ESG philosophies will be in a stronger position to capture a rare opportunity to distinguish their programmes from those of their peers and competitors.
However, that can only be achieved with the highest standards of data availability, sourcing and quality from data providers able to meet the new demands that ESG-focused investing now places on all market participants, including for securities finance. Market participants that choose data providers that deliver high quality reference, pricing, corporate actions, sanctions and regulatory data alongside ESG data in a standardised, easy to deploy format will be able to more comfortably adapt their activity and meet the needs of their clients.
Regulators and policymakers are also exploring ways to incorporate and standardise ESG requirements within the regulatory framework. Although specific regulations covering ESG have yet to be codified, a wealth of academic literature, market surveys and pronouncements from the regulators themselves makes clear the direction of travel: ESG considerations will become standardised and embedded as part of a sustainable finance model.
ESG and securities lending
Demands for more sustainable finance now touch almost every area of the investment process, and that includes securities lending. Given its central role in, for example, meeting settlement and collateral requirements, liquidity provision, price discovery, hedging and central banks’ monetary policies, this should not come as a surprise. Indeed, a recent survey by the Risk Management Association’s Council of Securities Lending found that 95 per cent of respondents believe that ESG investing and securities lending can coexist.
Even though it is still currently a small minority that always consider ESG in their securities lending process, we are seeing a growing number of issuers, lenders and borrowers of financial instruments investigating the ESG footprint of their investment and lending decisions and the processes behind them.
For investors with an ESG agenda, this is often about directing capital in ways that encourage ’good’ behaviour – for example by raising the cost of capital for firms whose activities are deemed not to align with responsible investing. More generally, the decision to incorporate sustainability considerations into lending and investment decisions is more about building up a positive brand identity and avoiding the reputational damage and costs that stem from associations with firms that are losing social permission to operate.
At its most pragmatic, the decision to incorporate ESG thinking into investment processes is simply to avoid being left with stranded assets that are difficult to sell on in the future.
Challenges and questions
Whatever the driving factors, thinking about securities lending in this way does raise a number of fundamental questions. Without standardised regulation for combining the requirements of sustainable finance with those of securities lending, careful consideration is needed. Issues around who qualifies as an approved counterparty, which restrictions are in play, recalls for proxy voting and rules for reinvention, all fall under this umbrella.
Take the counterparty issue as an example. Questions naturally arise around whether and how far the ESG credentials of that potential trading partner should be considered. Additionally, there are challenges around how best to assess the ESG credentials of issuers whose securities are being purchased and whether to apply criteria such that certain securities are never lent at all. This has implications for the level of granularity required when looking at a basket of securities received as collateral, and whether a lender should examine individual components or take a more holistic view.
As to the borrowers in any transaction, should the borrower use their voting rights in cases where the securities come with voting rights, and if so, how? How does a lender respond to a borrower who would vote against the lender’s ESG principles and intentions? A lender who takes this stance would need to understand the borrowers’ own intentions, their beneficial owners’ identity and intentions and the borrower’s own ESG parameters and ratings.
These questions are important for lenders whose policy is to invest solely in sustainable products and would not want their borrowers to use borrowed securities in a way that is counter to its ESG values. The ‘Know Your Borrower’ (KYB) approach could mitigate such a risk, such that the lender approves the transactions only after a solid borrower screening and evaluation of their intentions, particularly where voting rights are concerned, has been conducted.
Borrowers can carry out similar Know Your Lender (KYL) checks, therefore ensuring that the lenders’ ESG principles are also in line with their own. KYB and KYL due diligence can both be supported by data on the corporate level: lender, borrower, ‘investee companies’, as well as the underlying securities of the securities lending transaction.
There are also internal processes that may need to be updated. Overall, adoption of ESG principles in securities lending raises questions about how industry participants can develop communication and reporting lines between managers of their securities lending programmes and ESG management within the organisation.
At a more technical level, when a beneficial owner wishes to measure the effectiveness of its ESG efforts in its securities lending programme, the measurement methodology needs to be both appropriate and adequate. That may require policies on when to recall on loan securities and how these kinds of customisations should be implemented, all the while taking into account any potential impact on overall flow and revenue.
As for proxy voting, a lack of timely information about proxy record dates and voting questions complicates the process of recalling stock that is on loan. When RMA survey participants were asked to name ‘measures that might facilitate the application of ESG principles to their securities lending programme’, 43 per cent said that they want more transparency around proxy record dates and questions.
Collateral, CSDR and data
One of the more interesting and consistent themes running through debates about ESG policies and securities lending is that of collateral.
In general, less collateral is required for securities lending of assets marked positive for ESG. That is good for market participants broadly. However, it is less good news for the EU’s central securities depositories (CSDs) which — facing the complexities of the penalty regime inherent in the Central Securities Depositories Regulation (CSDR) regime — have many more questions to think about.
As with other aspects of CSDR more generally, the Classification of Financial Instruments (CFI) code that describes the structure and function of any given instrument plays a critical role. To ensure that financial institutions involved in the transaction have the right CFIs, it is important to have a so-called golden source of data, which encompasses all the data in every system of record within a financial institution. Timely data generation, collection, enrichment, processing and distribution are therefore key factors for the integration of ESG into the securities lending process.
Ensuring that data is of sufficiently high quality and accuracy requires significant resource and expertise. Specialised data vendors like SIX, that have market leading coverage of regulatory and ESG data, offer the required data to support financial institutions with their lending processes. Indeed, the use of this valuable data is highly recommended since it reduces the process costs of ensuring an adequate securities lending transaction.
Data for ESG monitoring and compliance
Of course, the same standards apply to sustainable securities financing as they do to all other financial transactions. At SIX, we decided to delve deeper into the issue. We looked at aggregated information from existing reports and studies to clarify the different types of ESG-specific data that is required, along with its various attributes and challenges, including adoption, coverage, input data sources and metric offerings.
We found that the main concerns regarding ESG data are:
• The general lack of availability, with timeliness and coverage of given regions, markets, segments or instruments raised as specific concerns.
• The quality of the data inputs, as inconsistencies, reliance on self-reported data, lack of completeness, obvious errors and the use of subjective or unaudited information are all contributing factors to lower data quality.
• The risks associated with over-dependence on large volumes of data, with issues such as cybercrime, data ownership, theft and misuse all shown to be of significant financial relevance.
In this sense, data considerations for sustainable finance and securities lending are no different from other transaction types: availability, sourcing and quality are fundamental properties that any data provider should be able to guarantee.
However, there are also specific data requirements that any securities lending business needs to understand when monitoring their overall processes and individual transactions against internal or external ESG standards. At both pre- and post-transaction stages, data of the highest standard is necessary to perform the following key functions:
• Sanctions monitoring. As with any area of securities trading, both the lender and borrower, whether legal entities or private persons, need to be constantly screened against national and international sanctions regimes — as should all securities that are part of the transactions. Sanctions monitoring should be part of the pre-contractual processes around KYL, KYB and KYC standards, as well as throughout the contract lifecycle. If required, compliance professionals should alert the responsible and involved business units of any potential breaches or problems as soon as they are aware of them.
• Meeting both parties’ ESG preferences. Investment firms should be able to identify, define and understand ESG preferences, based on regulatory and industry standards. This can include, but is not limited to, any EU Sustainable Â鶹ӰÊÓ´«Ã½ Disclosures Regulation (SFDR) Principal Adverse Impact indicators. Preferences and indicators should be reflected in the investment firms’ ESG questionnaires and core IT systems. They should also be able to ensure that the lending transaction matches these preferences during the entire lifecycle of the transaction.
• Identifying ESG factors for issuers and securities. Investment firms should be able to define and introduce a process that ensures ESG indicators are sourced on issuer and security levels, so basic reference data of the securities involved in the transaction, such as voting rights, trading venues, restrictions and ESG data, should be clearly available. Firms also need to monitor any acute change to those lender or borrower preferences. In the event that such changes occur, they must be able to alert the relevant business units and trigger required actions. In the case of positive developments, this might include the modification of transactions, such as reduction of credit spreads. In the case of a negative development, the action might involve offsetting or even cancelling the transaction.
In general, we found that market participants from the buy- and sell-side are often unsure about how best to align their lending programmes with their ESG objectives. Agent lenders that participate in open dialogue on how to balance lending decisions with ESG philosophies will be in a stronger position to capture a rare opportunity to distinguish their programmes from those of their peers and competitors.
However, that can only be achieved with the highest standards of data availability, sourcing and quality from data providers able to meet the new demands that ESG-focused investing now places on all market participants, including for securities finance. Market participants that choose data providers that deliver high quality reference, pricing, corporate actions, sanctions and regulatory data alongside ESG data in a standardised, easy to deploy format will be able to more comfortably adapt their activity and meet the needs of their clients.
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