The latest move, announced in January 2020, highlights how ESG (environment, social, governance) is filtering into the investment processes at institutions and asset managers. So great has this change been that SRI (sustainable, responsible, impact) assets now account for US$30.7 trillion, a 34% increase from 2016.

ESG is now being integrated into agency securities lending programs that are designed to generate incremental revenues for institutional investors by making portfolios available for loan on a fully collateralized, temporary basis. In fact, IHS Markit reports that 2019 delivered the second highest annual revenues in the last decade with investors earning US$10.1 billion in fees. While a number of sceptics have recently argued that securities lending might be incompatible with ESG practices, Deutsche Bank’s experts suggest otherwise.

Facilitated by regulations such as the EU’s Action Plan on Sustainable Finance and local legislation (ESG disclosure requirements for pensions in the UK and climate change reporting for investors in France), ESG is fairly ubiquitous in European financial services. The US market, on the other hand, is widely perceived to be playing catch-up. Ashley Cooke, Head of Institutional ESG & Indexing Solutions at DWS Investment Management Americas Inc.*, says even though the US does not have legislation on ESG investing (unlike Europe) banks and other financial institutions are embracing the concept.

ESG may not be covered by Federal law or Securities and Exchange Commission (SEC) guidance, so a number of states are introducing progressive rules aimed at promoting sustainability. California, for instance, has instructed its two largest public pension funds - the US$360 billion California Public Employees’ Retirement System (CALPERS) and the US$228 billion (California State Teachers Retirement System (CALSTRS) – to publicly disclose the climate-related financial risks in their portfolios. Similarly, Illinois has legislated that public sector pension funds “develop, publish and implement sustainable investment policies.”

Elsewhere, lawmakers in Massachusetts, Minnesota, New Jersey, New York and Vermont are all in the process of introducing rules aimed at restricting publicly managed funds from investing in fossil fuels. Despite the lack of federal regulations presently about ESG, Sonelius Kendrick- Smith, Head of Corporate Treasury Solutions, Americas at DWS, anticipates the regulators may start scrutinising money market funds, who market themselves as being ESG. This is prompting more financial institutions to take note.

US institutional investors have also played a vital role in driving ESG adoption at banking groups and asset managers. “We have a broad range of clients including corporates, pensions and insurers,” says Cooke. “A lot of corporates will have sustainability programs influencing investment decisions at a treasury level. Meanwhile, insurers and pension funds have long-term liabilities and climate change risk they will need to consider when investing. This is something DWS specifically caters to: partnering with clients to address their concerns,” comments Cooke. As a result, more institutions are now factoring in climate change financial risk and stranded asset risk (i.e. being exposed to a worthless asset) into their long-term investment decisions.

Insurers and pension funds are long-term, strategic investors with liabilities stretching over decades. As a result of climate change (e.g. damage to physical infrastructure as a result of extreme weather) or industry decline (oil, gas, shipping, aviation) brought about by regulatory change, investors could be left holding assets that are un-sellable. This is known as a stranded asset. In response, some investors are now urgently divesting from assets vulnerable to potential price depreciation or default because of climate change.

Securities lending is an integral component of the shadow banking market. Moreover, securities lending has been widely adopted by institutional investors. According to the International Securities Lenders Association website (ISLA), the global supply of lendable assets stands at €21.3 trillion with €2.3 trillion on loan across all asset classes. For lenders, it allows them to charge a fee based on how much demand there is for a particular security. This can translate to a meaningful reduction in fund expenses. In particular, mutual funds and other collective investment vehicles have embraced the practice, making up about 41% of securities lending supply and 22% of loan volume worldwide, according to IHS Markit.

For borrowers, the practice enables them to conduct a range of activities that are critical to liquid markets, such as settling trades, obtaining high quality liquid assets (“HQLA”) to meet regulatory needs (Liquidity Coverage Ratio, or “LCR”), financing, and shorting securities in connection with various trading strategies. Popular and lucrative as securities lending may be, some critics say it does not always fully accommodate the ESG policies of institutional clients. For example, some investors point out that voting rights transfer to the borrower while securities are out on loan, while others are concerned borrowers could use their holdings to advocate short-term interests.

Deutsche Bank’s program accommodates ESG across all key facets of the service, including approved counterparties, restrictions, non-cash collateral filtering, reporting, recalling for proxy voting purposes, and reinvestment
Joseph Santoro, Deutsche Bank

This creates obvious governance concerns although Joseph Santoro, Co-Head Agency Securities Lending program at Deutsche Bank, and Head of Sales, points out the US has regulations in place to prevent abusive securities borrowing practices. “Federal Reserve Regulation T sets forth strict criteria when borrowing securities. Borrowing in order to vote is not a permitted purpose under Regulation T”. Further, SEC Regulation SHO has components designed to prevent abusive short selling”. Santoro added, “in terms of practical solutions, Deutsche Bank’s program accommodates ESG across all key facets of the service, including approved counterparties, restrictions, non-cash collateral filtering, reporting, recalling for proxy voting purposes, and reinvestment. DWS is our reinvestment manager and their recognized leadership in ESG adds yet another dimension to our offering, providing ESG designated funds across the ESG spectrum including ETFs, an ESG themed money market fund (ESGXX), separately managed accounts with an ESG overlay through private equity & debt impact investment strategies.”

Thomas Ryan, Co-Head Agency Securities Lending program at Deutsche Bank, and Head of Client Performance, highlights that, “ESG is one part of a larger securities lending genre, which is an agent lender´s ability to customize the mandate tailored to the beneficial owners need as opposed to being given a cookie cutter offering. To say to a client “here’s your program parameters” is the wrong end of the spectrum. “Please explain exactly how you want your program to run and we’ll work to implement it” is the right end of the spectrum”. Ryan added, “ESG as it pertains to securities lending is going to illustrate to the beneficial owners how flexible the agent lender community can be. Concurrently, as ESG becomes more of a focus for beneficial owners, the maintenance of ESG compliance could very well become one of the main pillars of a client’s program alongside the traditional pillars such as alpha generation, risk controls, indemnification, and fee split”.

There is also disquiet in certain quarters about securities lending and its role in facilitating short-sales, an activity which some argue goes against ESG principles. Most recently, the Japanese Government Pension Investment Fund (GPIF) said it would suspend securities lending for its equity portfolios, although its press release indicates such activity may be reconsidered in the future. GPIF cited its stewardship responsibilities and concern about the ability of its managers to exercise voting rights under its current stock lending scheme established in 2014, as well as a lack of transparency in terms of who is the ultimate borrower and for what purpose they are borrowing the stock. The International Securities Lending Association (ISLA) counters this by saying short-selling is an expression of market sentiment not too dissimilar to an index tracker being overweight or underweight a benchmark. ISLA adds regulators have adopted measures to restrict aggressive naked short-selling too.

Others argue shorting is compatible with ESG as it helps support price discovery and market liquidity, while simultaneously alerting the wider market to bad behaviour at companies. From one agent lender’s perspective, Ryan explained, “ESG is an expansion on long established constructs whereby a client works in tandem with an agent lender to maximize returns alongside a client’s desire to not have a security on loan, for a multitude of reasons. The more connected a client is to their agent lender the benefits derived usually come in tandem. If as a result of ESG that connection strengthens it’ll be a win-win for beneficial owners as that closer connection will reap benefits outside of the ESG scope and those added benefits will also most likely be economic ones”.

Securities lending also throws up other challenges. ESG-focused investors want guarantees that their securities are not being lent out to counterparties who may not meet their ESG standards. While lenders have always conducted due diligence on borrowers to ensure they are not a counterparty credit risk (i.e. by monitoring their financial condition, credit default swap spreads, etc.), Ryan says the program focuses on industry leading, reputable counterparties that generate underlying demand and the bank performs thorough KYC (know-your-customer) procedures. “As anyone who’s ever tried to setup a new counterparty here at Deutsche Bank can tell you, our internal protocols around KYC diligence are very, very, very robust.”

As securities lending transactions must be fully collateralised, investors with ESG mandates need assurances that the collateral being accepted does not breach their investment guidelines. Admittedly, a lot of collateral is posted nowadays as cash, but some investors may adopt an exclusionary policy towards non-cash collateral instruments such as sovereign bonds issued by countries with desultory human rights records or pollutant companies, for example. “Adjusting collateral schedules for ESG is another step down the path of increased customization. Putting in “cusip roots” to filter out perhaps defence contractors or securities issued by the counterparty is an exercise that’s been around for a long time. Whereas that’s previously been an exercise painting with broad strokes, larger subsets of excluded securities will most likely take it to a place of painting with finer strokes. The same applies to proxy voting. Proxy voting vendor services have increased their offerings enabling users to incorporate that data into their proxy stances. The stance of a beneficial owner taking a default option of wanting to vote all proxies has in some cases given way to voting depending on materiality and even parallel to the economic consequences. This is part of a larger trend we’ve seen which is that of beneficial owners incorporating alpha derived from securities lending into their investment decisions,” explains Ryan.

Establishing ESG compliance will help broaden and streamline that discussion to make sure that all parties in the securities lending chain are clear as to the ultimate ESG remitThomas Ryan, Deutsche Bank

Even though vast numbers of market participants talk passionately about implementing ESG policies, there is not one definition for what ESG actually is. This confusion is not helped by the growing volumes of competing and inconsistent ESG standards (e.g. the Financial Stability Board’s [FSB] Task Force on Climate Related Financial Disclosures [TCFD]; the UN’s Principles for Responsible Investment [PRI]; the UN’s Sustainable Development Goals [SDGs]; the EU’s incoming ESG taxonomy; the COP 25 principles, etc.). As there is no fixed, or widely accepted standard, ESG data can be used subjectively, which leads us to suggest investors ask a lot of questions to get comfortable with ESG investments while the industry works towards standardization.

“It is true that there are no universal ESG standards. Until then, we engage closely with our clients to structure ESG portfolios. DWS has done the homework to ensure our designated ESG strategies will hold up to scrutiny” says Cooke. Although ESG standards are quite interpretive, the securities lending industry has made impressive strides. Santoro says, “ISLA has established the ISLA Council for Sustainable Finance (ICSF), which will launch in Q1 2020. As part of this initiative, ICSF will introduce its Principles for Sustainable Securities Lending (PSSL), a voluntary sustainable finance mechanism for the securities lending industry”.

As well as standards, banks are liaising closely with clients to ensure they are educated about ESG. “We are in the various stages of education and building awareness about ESG with our clients,” says Kendrick- Smith. Cooke concurs, “We are well equipped to add value at any stage of this process. We have seen some early investors focus on one element of the Environmental, Social or Governance; at DWS we believe incorporating all three makes the most sense”.

Ryan adds, “Adjusting securities lending policies and practices has traditionally been handled on a one off basis and not part of a specific strategy or overlay. Establishing ESG compliance will help broaden and streamline that discussion to make sure that all parties in the securities lending chain are clear as to the ultimate ESG remit. In the event that an agent lender and a beneficial owner haven’t done the same exercise for the parameters of their securities lending program not related to ESG, the ensuing discussion of ESG compliance will then be part of an all-encompassing review and the beneficial owner will ultimately have a better framework in place across the board, not just for ESG.”

There are a number of misplaced perceptions about ESG in both securities lending and its overall adoption in the US market. Even though the Federal government has not imposed prescriptive ESG legislation, a lot of the states have, and it is an issue that is being taken seriously by US institutions.

At the same time, industry is developing far-reaching standards on ESG, and market leaders such as Deutsche Bank have robust policies and procedures to enable ESG in securities lending.

*DWS Investment Management Americas Inc. is one of the world's leading asset managers with more than $819 billion of assets under management as of June 30, 2019