ISLA responds to FCA consultation on sustainability disclosure
27 January 2023 UK
Image: ImagESine/unify.com
The International Securities Lending Association has published a response to the Financial Conduct Authority’s consultation on sustainability disclosure requirements.
This response engages with content of the FCA’s CP 22/20, Sustainability Disclosure Requirements and Investment Labels, issued in October 2022. Among the discussion points raised in the CP, the FCA calls for industry feedback relating to the role of securities lending and short selling in the context of sustainable investment.
ISLA’s response, signed by the Association’s director of regulatory affairs Farrah Mahmoud, seeks to clarify and reiterate key messages relating to securities lending best practice and to respond to concerns raised by respondents to the FCA’s earlier discussion paper 21/4 of January 2022.
First, it responds to a concern advanced in industry feedback to DP 21/4 that “by engaging in securities lending an investor would be unable to exercise their voting rights and hence fulfil their stewardship objectives effectively”.
ISLA indicates that the practice of securities lending should never impede an investor's ability to vote. Recalling securities for voting is common practice, it notes, and the right to do so is a standard feature of industry contractual documentation.
The Association confirms that lenders should have a enterprise-wide investment policy in place regarding stewardship and voting and that this policy should specify the parameters for proxy recalls.
ISLA also engages with concerns raised in the DP 21/4 consultation that “by lending, an investor may facilitate the short selling of securities issued by companies that they consider to have strong sustainability credentials”.
The association observes that there is often a misconception that ESG considerations “can only be incorporated into a long-only buy and hold investment strategy”. In response, ISLA highlights that short selling can also contribute to positive sustainability outcomes.
In doing so, it refers to the work of the United Nations, Principles for Responsible Investment working group, which specifies that ‘shorting can be one way to express the view that an entity, security or asset is mispriced and not adequately incorporating ESG factors or systemic risks into its business activities, governance structures or future scenarios’.
Third, with regard to application of sustainability screening for assets accepted as collateral in securities lending transactions, ISLA advises that in the absence of clear regulatory guidance, there remains “a lack of clarity and consistency in the market” on the extent to which ESG policies should apply to received collateral.
With this in mind, ISLA requests policy guidance from the FCA on whether collateral should integrate the same level of ESG screening as a fund’s long portfolio or, alternatively, whether eligible collateral guidelines should intentionally apply broader and more liquid parameters to manage risk.
“While it is recognised that all fund assets must embed ESG criteria,” ISLA notes, “it should be noted that collateral does not form part of the funds’ assets.”
“Equally, irrespective of whether the fund’s long portfolio ESG policies are applied to collateral, it will be essential to embed sustainability into the acceptability framework for collateral as a matter of good risk management under emerging prudential requirements such as Basel 3.”
Additionally, ISLA addresses concerns relating to the identify of counterparties in back-to-back transactions, “given that some lenders may not wish to enter into transactions with parties that do not share their values and standards”.
ISLA points out that although agent lenders, acting on behalf of the underlying lender, may conduct due diligence in selecting suitable borrowers, it is ultimately the underlying lender which must approve and conduct oversight over the borrower.
For title transfer transactions, the underlying lender will not typically have insight into which downstream firms are involved in onward lending transactions. However, in the UK the regulator will have information on transaction counterparties through reporting under the Securities Financing Transactions Regulation (SFTR) and, where appropriate, reporting of net short positions under the Short Selling Regulation (SSR).
Referring explicitly to the securities lending implications of the sustainability disclosure proposal, the FCA has commented:
"Securities lending plays an important role in the market and provides investors with additional income. We do not consider securities lending as being incompatible with ESG, as securities lending arrangements can be tailored to meet the ESG objectives of the lending and borrowing parties. So, we are not proposing any specific constraint to the ability of strategies that involve securities lending to qualify for one of the FCA sustainable investment labels.
“As part of our implementation guidance, we are proposing that, where applicable, a firm should clarify its securities-lending policy and the steps it takes to ensure this is coherent with its sustainable investment strategy."
Andrew Dyson, ISLA's CEO comments, "We welcome the statements made by the UK regulator, and the Association looks forward to any future policy advice around the securities lending product."
The consultation period for FCA CP 22/20 closed on 25 January.
Through this initiative, the FCA proposes that all products that use a sustainable investment label, or that adopt sustainability-related features that are integral to their investment strategy, should provide additional pre-contractual product-level sustainability disclosures from June 2024.
This response engages with content of the FCA’s CP 22/20, Sustainability Disclosure Requirements and Investment Labels, issued in October 2022. Among the discussion points raised in the CP, the FCA calls for industry feedback relating to the role of securities lending and short selling in the context of sustainable investment.
ISLA’s response, signed by the Association’s director of regulatory affairs Farrah Mahmoud, seeks to clarify and reiterate key messages relating to securities lending best practice and to respond to concerns raised by respondents to the FCA’s earlier discussion paper 21/4 of January 2022.
First, it responds to a concern advanced in industry feedback to DP 21/4 that “by engaging in securities lending an investor would be unable to exercise their voting rights and hence fulfil their stewardship objectives effectively”.
ISLA indicates that the practice of securities lending should never impede an investor's ability to vote. Recalling securities for voting is common practice, it notes, and the right to do so is a standard feature of industry contractual documentation.
The Association confirms that lenders should have a enterprise-wide investment policy in place regarding stewardship and voting and that this policy should specify the parameters for proxy recalls.
ISLA also engages with concerns raised in the DP 21/4 consultation that “by lending, an investor may facilitate the short selling of securities issued by companies that they consider to have strong sustainability credentials”.
The association observes that there is often a misconception that ESG considerations “can only be incorporated into a long-only buy and hold investment strategy”. In response, ISLA highlights that short selling can also contribute to positive sustainability outcomes.
In doing so, it refers to the work of the United Nations, Principles for Responsible Investment working group, which specifies that ‘shorting can be one way to express the view that an entity, security or asset is mispriced and not adequately incorporating ESG factors or systemic risks into its business activities, governance structures or future scenarios’.
Third, with regard to application of sustainability screening for assets accepted as collateral in securities lending transactions, ISLA advises that in the absence of clear regulatory guidance, there remains “a lack of clarity and consistency in the market” on the extent to which ESG policies should apply to received collateral.
With this in mind, ISLA requests policy guidance from the FCA on whether collateral should integrate the same level of ESG screening as a fund’s long portfolio or, alternatively, whether eligible collateral guidelines should intentionally apply broader and more liquid parameters to manage risk.
“While it is recognised that all fund assets must embed ESG criteria,” ISLA notes, “it should be noted that collateral does not form part of the funds’ assets.”
“Equally, irrespective of whether the fund’s long portfolio ESG policies are applied to collateral, it will be essential to embed sustainability into the acceptability framework for collateral as a matter of good risk management under emerging prudential requirements such as Basel 3.”
Additionally, ISLA addresses concerns relating to the identify of counterparties in back-to-back transactions, “given that some lenders may not wish to enter into transactions with parties that do not share their values and standards”.
ISLA points out that although agent lenders, acting on behalf of the underlying lender, may conduct due diligence in selecting suitable borrowers, it is ultimately the underlying lender which must approve and conduct oversight over the borrower.
For title transfer transactions, the underlying lender will not typically have insight into which downstream firms are involved in onward lending transactions. However, in the UK the regulator will have information on transaction counterparties through reporting under the Securities Financing Transactions Regulation (SFTR) and, where appropriate, reporting of net short positions under the Short Selling Regulation (SSR).
Referring explicitly to the securities lending implications of the sustainability disclosure proposal, the FCA has commented:
"Securities lending plays an important role in the market and provides investors with additional income. We do not consider securities lending as being incompatible with ESG, as securities lending arrangements can be tailored to meet the ESG objectives of the lending and borrowing parties. So, we are not proposing any specific constraint to the ability of strategies that involve securities lending to qualify for one of the FCA sustainable investment labels.
“As part of our implementation guidance, we are proposing that, where applicable, a firm should clarify its securities-lending policy and the steps it takes to ensure this is coherent with its sustainable investment strategy."
Andrew Dyson, ISLA's CEO comments, "We welcome the statements made by the UK regulator, and the Association looks forward to any future policy advice around the securities lending product."
The consultation period for FCA CP 22/20 closed on 25 January.
Through this initiative, the FCA proposes that all products that use a sustainable investment label, or that adopt sustainability-related features that are integral to their investment strategy, should provide additional pre-contractual product-level sustainability disclosures from June 2024.
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