Green is the new black
13 October 2020
Members of ISLA’s ESG working group and Council for Sustainable Finance describe how responsible investing has taken centre stage in the global economic fightback against COVID-19
Image: retrorocket/shutterstock.com
Panellists
Matthew Chessum, investment director, liquidity management, Aberdeen Standard Investments
Andrew Dyson, CEO, ISLA
Stefan Kaiser managing director, EMEA/APAC securities lending product strategy, BlackRock
Chirag Patel, executive director, EMEA head of cross asset financing, Goldman Sachs
Given that ESG is a broad topic, what has the ISLA ESG working group been focusing on in 2020?
Andrew Dyson: During a year that has been dominated by the COVID-19 pandemic, we did see some of the core regulatory and policy initiatives coming out of the European Union pause, particularly during the first peak of the virus across Europe. After identifying the green agenda as a major priority, incoming European Commission President, Ursula von der Leyen promised in April to put the European Green Deal at the centre of the EU’s post-COVID recovery plan. These comments are important as they clearly link a post-COVID world to the developing green agenda, and this broad direction of travel will shape much of our thinking going forward.
In the middle of the year, we saw a detailed consultation from the European Commission on the Renewed Sustainable Finance Strategy. In this, the commission sought the views of how markets and trading eco-systems need to evolve to support the sustainable finance objectives across the EU 27.
In responding to this consultation, our environmental, social and governance (ESG) working group highlighted the importance of supporting the growth of ESG funds in the context of trading liquidity, price discovery and effective settlement. In this regard, the group stressed the importance of mobilising ESG securities within lending programmes to support the development of a broadly-based market ecosystem. The final key message that we delivered through our response to the consultation was that it was important not to create separate trading infrastructures for ESG securities, but rather regulators and other stakeholders need to work to incorporate more ESG securities into existing trading frameworks.
Stefan Kaiser: The initial focus was on responding to the EU consultation on sustainable finance. This consultation provided an opportunity to comment on how regulation around ESG might impact securities lending and highlight how the activity can contribute to achieving long-term policy goals. As investors’ focus on ESG increases, we need to explain why securities lending and sustainability are not in conflict and how the benefits that securities lending delivers can be preserved in an ESG framework.
Chirag Patel: The ISLA ESG working group has spent time this year on the European Commission’s consultation on Renewed Sustainable Finance Strategy focussing upon how the securities finance market can adopt and embrace ESG principles more seamlessly. Considerations include but are not limited to (i) the impact of ESG principles to various market participants (ii) incentivising broader market engagement/participation; and (iii) suggestions to the relevant regulatory bodies, in all cases taking into consideration the policies, rules and laws already in place. Key challenges include (i) infrastructure; and (ii) alignment across regions/financial markets which could act as a catalyst for further standardisation of ESG principles across the industry (e.g. long termism, sustainable investment, availability of data/benchmarks, corporate governance, etc).
ESG principles and securities lending can sometimes be portrayed as incompatible. Do you see this preconception disappearing, as responsible investment strategies become a clearer focus for the EU?
Matthew Chessum: A drive for strong governance and responsible stewardship has always been present within the securities lending industry. Voting requirements, recall management, programme transparency, tax and short selling have all been discussed at length in the past and have all been actively managed to ensure that best practice and strong governance guidelines are followed. ESG is neither new to securities lending or more importantly incompatible. Any preconceptions in regards to this are disappearing fast. As the importance of ESG investing continues to permeate all financial markets, the securities lending industry is well-placed to build upon existing best practices by both embracing and developing the Principles for Sustainable Securities Lending (PSSL) that were issued by the ISLA Council for Sustainable Finance in February. This will allow the industry to become an important leader in market led governance within this area.
Kaiser: The growth of ESG has raised the question of compatibility, but the focus on investment stewardship or the ‘governance’ component of ESG and short selling aren’t new. We firmly believe that short selling is a crucial contributor to efficient capital markets and that lending securities is not in conflict with effective engagement with companies. Earlier this year, we wrote a paper on securities lending and sustainability, based on the feedback we received, most ESG focused investors are not asking ‘if’ but instead ‘how’ securities lending should be conducted within their portfolios.
Dyson: There is no doubt that certain elements of the ESG agenda can create what looks like a natural tension with the broad objectives of a securities lending programme. However, we firmly believe with the right amount of rigour around how institutional investors organise their programmes, and with due consideration of best practice frameworks such as the PSSL, the two may quite happily co-exist. Securities lending programmes that have been calibrated to reflect the client’s ESG principles can achieve those twin objectives. For example, if a client has a clear and communicated strategy around voting, this can be implemented by their lending agent or partner, with securities being recalled for desired votes and other official record points, etc.
Patel: I think that the two can indeed be compatible however it will be reliant upon progress being made on infrastructure, the appropriate incentive structures and alignment at a (inter)national level and an improvement in the quality/uniformity of data available to market participants. The view from the working group was that investors do not need to sacrifice returns through responsible investing and with further guidance/policy steps from the EU investors should gain confidence in being able to make rational/responsible decisions in securities lending; a very recent example is the update to the Japan Stewardship Code earlier this year to factor in ESG concepts. Securities lending is essential to ensure liquidity/transparency, smooth functioning of capitals and revenue generation.
Some industry participants argue that the practice of short selling is not only consistent with long-term ESG investment strategies, but that the promotion of short selling is the best thing for a fair market. Do you agree?
Dyson: Short selling is now a part of the fabric around how markets function efficiently. It is a highly-regulated market with specific rules that require borrowers in most jurisdictions to identify a ‘borrow’ to cover a short position. During the recent market turmoil around COVID-19, whilst we did see some temporary bans on short selling, their implementation received a mixed reception from market participants and some regulators, many commentators feel that short selling is simply a way of expressing sentiment and is no different from going over or underweight an index. By supporting short selling, institutional investors are facilitating deeper and more transparent markets which are entirely compatible with any longer term aspirations they may have.
Kaiser: Securities lending is a well-regulated practice that contributes to capital market efficiency and also enables end-investors to generate additional returns on their investments. Market efficiency is a tangible benefit for end investors: the added liquidity supports the price discovery process. It can help prevent pricing bubbles from occurring and contribute to reducing trading spreads that in turn can bring down trading costs for investors.
Chessum: Short selling has always been an emotional topic with strong opinions on both sides of the argument. Recently, with the demise of Wirecard AG, we have witnessed first hand the fiduciary role that short selling can play in the market. Short selling is a market tool like any other. Selling an asset has no greater influence on the price than buying the same asset and fair pricing is reliant upon investors being able to express their views on individual stocks. There should be a clear distinction made between covered and uncovered short selling. Covered short selling does not artificially add to the free float and therefore does not have an exaggerated effect on pricing. I believe that the value that short selling brings to the market is better understood now than during any other point in history. Despite this, it does appear to be a convenient scapegoat during times of market dislocation and downward trends. Only recently, during the COVID sell off, some blamed short selling for the falling markets when the most plausible reason was that investors were liquidating assets in long only funds and starting to hoard cash.
Patel: Short selling with the appropriate governance at all levels should allow for a fair market to efficiently function, which in turn helps to give confidence to investors and other participants as to the true market depth, liquidity, access and price of an asset. Creating price transparency/efficiency in a fair market can therefore be consistent with long term ESG strategy. Short selling can also allow investors to hedge their ESG risk by influencing companies who fall short of their social responsibility expectations, e.g. potentially due to poor management, corruption, environmental impact, etc. Activist investors are one key party in ensuring these companies remain accountable, however there will need to be controls in place to allow such companies a chance to improve their compliance without impairing their efforts.
The activities of short sellers have dominated the headlines this year. Do these types of borrowers have a part to play in creating a sophisticated ESG-focused world?
Chessum: The recent ICSF published Principles for Sustainable Securities Lending includes covered short selling. This principle, unsurprisingly, generated a lot of debate within the council executive but the decision to make a firm commitment to the importance of covered short selling to financial markets was unanimous. The council recognises the role that short sellers can play in discovering important issues within certain companies. Short selling is likely to be employed further in the future to promote good corporate governance. Some long only managers may not only invest in those companies that are perceived to have strong ESG credentials but venture into short selling those that are considered to not be meeting their ESG obligations. Surely, this would represent the true spectrum of companies in relation to their ESG credentials.
Patel: Short sellers play a pivotal role in the securities lending market in an ESG-focused world and therefore aid general market dynamics with respect to the supply and demand of collateral; as specific ESG assets trade richly, short sellers help to create price efficiency in the market. Investors for example may have a positive impact in an ESG-focused world through exerting pressure on companies with poor ESG ratings to change their strategy at a senior level to be more compliant, i.e. incentivisation.
Dyson: As part of the developing ESG landscape, short sellers have an increasingly important role that they can play in providing scrutiny, and holding companies accountable for their ESG actions. 2020 has seen how the scrutiny afforded by the hedge fund community has bought issues into the spotlight that have previously been kept from public view. In this regard, short sellers are able to highlight those companies that are not adhering to their ESG deliverables. By highlighting so-called green washing, hedge funds bring very real accountability perhaps not seen elsewhere throughout the investment process.
Kaiser: There is plenty of empirical evidence available showing that short selling and price discovery are integral to well-functioning financial markets. Being able to express positive and negative views on a security are key in preventing pricing bubbles from occurring. In addition, a ban on short selling is shown to increase trading spreads that, in the end, investors pay for.
Over time, stock prices react to fundamentals and are not driven by short selling. Investors who participate in securities lending can benefit from lending revenues when there are questions about a company’s valuation and independently of that, from stock price increases when the fundamentals of a company improve. Securities lending and short selling are therefore consistent with the interest of long-term investors.
Part of the challenge with incorporating ESG into the securities lending world, is the lack of any uniformity in what is considered a highly rated ESG security. The ICSF is working to rectify this through its principles for sustainable finance. How is the Council progressing and what could its widespread adoption mean for the market?
Chessum: The ICSF has now established a set of principles that can be adopted by the market and incorporated into any securities lending policy. These principles were devised by a group of beneficial owners and published by ICSF to provide the market with some initial guidance on what needs to be thought about when devising ESG policies in relation to securities lending. As the ESG conversation evolves, so will the principles. A second version is already being looked at which will have additional principles attached which will cover important topics such as diversity and inclusion. Widespread adoption of these principles will lead to better governance and more aligned best practise. Whilst this list is not exhaustive, it does provide a sound starting point for any organisation looking to develop their internal policies.
ICSF understands that the principles that the market adheres to need to be accepted and agreed to by all market participants. This is why we are very pleased with the raft of new partnerships that have been made with the most sophisticated and prominent agent lenders and securities lending associations.
I would encourage beneficial owners in particular to consider full membership of the council given the focus on asset owners to incorporate ESG into the investment decisions. Going forward the council will be producing technical guidance on the principles and is expected to be a one stop shop for everything related to ESG and securities lending.
Dyson: 2020 has been a year when we have seen considerable interest in the work of the ICSF, with many firms from across our industry aligning themselves to both ICSF and the PSSL.
The PSSL have identified a number of key areas where the market needs to develop consensus around the taxonomy that will guide product development. As we look towards 2021, the ICSF will be tasked to develop those best practice type guidelines that will provide real substance to support PSSL. This will allow institutional investors and other industry stakeholders to develop relevant products against common standards.
Matthew Chessum, investment director, liquidity management, Aberdeen Standard Investments
Andrew Dyson, CEO, ISLA
Stefan Kaiser managing director, EMEA/APAC securities lending product strategy, BlackRock
Chirag Patel, executive director, EMEA head of cross asset financing, Goldman Sachs
Given that ESG is a broad topic, what has the ISLA ESG working group been focusing on in 2020?
Andrew Dyson: During a year that has been dominated by the COVID-19 pandemic, we did see some of the core regulatory and policy initiatives coming out of the European Union pause, particularly during the first peak of the virus across Europe. After identifying the green agenda as a major priority, incoming European Commission President, Ursula von der Leyen promised in April to put the European Green Deal at the centre of the EU’s post-COVID recovery plan. These comments are important as they clearly link a post-COVID world to the developing green agenda, and this broad direction of travel will shape much of our thinking going forward.
In the middle of the year, we saw a detailed consultation from the European Commission on the Renewed Sustainable Finance Strategy. In this, the commission sought the views of how markets and trading eco-systems need to evolve to support the sustainable finance objectives across the EU 27.
In responding to this consultation, our environmental, social and governance (ESG) working group highlighted the importance of supporting the growth of ESG funds in the context of trading liquidity, price discovery and effective settlement. In this regard, the group stressed the importance of mobilising ESG securities within lending programmes to support the development of a broadly-based market ecosystem. The final key message that we delivered through our response to the consultation was that it was important not to create separate trading infrastructures for ESG securities, but rather regulators and other stakeholders need to work to incorporate more ESG securities into existing trading frameworks.
Stefan Kaiser: The initial focus was on responding to the EU consultation on sustainable finance. This consultation provided an opportunity to comment on how regulation around ESG might impact securities lending and highlight how the activity can contribute to achieving long-term policy goals. As investors’ focus on ESG increases, we need to explain why securities lending and sustainability are not in conflict and how the benefits that securities lending delivers can be preserved in an ESG framework.
Chirag Patel: The ISLA ESG working group has spent time this year on the European Commission’s consultation on Renewed Sustainable Finance Strategy focussing upon how the securities finance market can adopt and embrace ESG principles more seamlessly. Considerations include but are not limited to (i) the impact of ESG principles to various market participants (ii) incentivising broader market engagement/participation; and (iii) suggestions to the relevant regulatory bodies, in all cases taking into consideration the policies, rules and laws already in place. Key challenges include (i) infrastructure; and (ii) alignment across regions/financial markets which could act as a catalyst for further standardisation of ESG principles across the industry (e.g. long termism, sustainable investment, availability of data/benchmarks, corporate governance, etc).
ESG principles and securities lending can sometimes be portrayed as incompatible. Do you see this preconception disappearing, as responsible investment strategies become a clearer focus for the EU?
Matthew Chessum: A drive for strong governance and responsible stewardship has always been present within the securities lending industry. Voting requirements, recall management, programme transparency, tax and short selling have all been discussed at length in the past and have all been actively managed to ensure that best practice and strong governance guidelines are followed. ESG is neither new to securities lending or more importantly incompatible. Any preconceptions in regards to this are disappearing fast. As the importance of ESG investing continues to permeate all financial markets, the securities lending industry is well-placed to build upon existing best practices by both embracing and developing the Principles for Sustainable Securities Lending (PSSL) that were issued by the ISLA Council for Sustainable Finance in February. This will allow the industry to become an important leader in market led governance within this area.
Kaiser: The growth of ESG has raised the question of compatibility, but the focus on investment stewardship or the ‘governance’ component of ESG and short selling aren’t new. We firmly believe that short selling is a crucial contributor to efficient capital markets and that lending securities is not in conflict with effective engagement with companies. Earlier this year, we wrote a paper on securities lending and sustainability, based on the feedback we received, most ESG focused investors are not asking ‘if’ but instead ‘how’ securities lending should be conducted within their portfolios.
Dyson: There is no doubt that certain elements of the ESG agenda can create what looks like a natural tension with the broad objectives of a securities lending programme. However, we firmly believe with the right amount of rigour around how institutional investors organise their programmes, and with due consideration of best practice frameworks such as the PSSL, the two may quite happily co-exist. Securities lending programmes that have been calibrated to reflect the client’s ESG principles can achieve those twin objectives. For example, if a client has a clear and communicated strategy around voting, this can be implemented by their lending agent or partner, with securities being recalled for desired votes and other official record points, etc.
Patel: I think that the two can indeed be compatible however it will be reliant upon progress being made on infrastructure, the appropriate incentive structures and alignment at a (inter)national level and an improvement in the quality/uniformity of data available to market participants. The view from the working group was that investors do not need to sacrifice returns through responsible investing and with further guidance/policy steps from the EU investors should gain confidence in being able to make rational/responsible decisions in securities lending; a very recent example is the update to the Japan Stewardship Code earlier this year to factor in ESG concepts. Securities lending is essential to ensure liquidity/transparency, smooth functioning of capitals and revenue generation.
Some industry participants argue that the practice of short selling is not only consistent with long-term ESG investment strategies, but that the promotion of short selling is the best thing for a fair market. Do you agree?
Dyson: Short selling is now a part of the fabric around how markets function efficiently. It is a highly-regulated market with specific rules that require borrowers in most jurisdictions to identify a ‘borrow’ to cover a short position. During the recent market turmoil around COVID-19, whilst we did see some temporary bans on short selling, their implementation received a mixed reception from market participants and some regulators, many commentators feel that short selling is simply a way of expressing sentiment and is no different from going over or underweight an index. By supporting short selling, institutional investors are facilitating deeper and more transparent markets which are entirely compatible with any longer term aspirations they may have.
Kaiser: Securities lending is a well-regulated practice that contributes to capital market efficiency and also enables end-investors to generate additional returns on their investments. Market efficiency is a tangible benefit for end investors: the added liquidity supports the price discovery process. It can help prevent pricing bubbles from occurring and contribute to reducing trading spreads that in turn can bring down trading costs for investors.
Chessum: Short selling has always been an emotional topic with strong opinions on both sides of the argument. Recently, with the demise of Wirecard AG, we have witnessed first hand the fiduciary role that short selling can play in the market. Short selling is a market tool like any other. Selling an asset has no greater influence on the price than buying the same asset and fair pricing is reliant upon investors being able to express their views on individual stocks. There should be a clear distinction made between covered and uncovered short selling. Covered short selling does not artificially add to the free float and therefore does not have an exaggerated effect on pricing. I believe that the value that short selling brings to the market is better understood now than during any other point in history. Despite this, it does appear to be a convenient scapegoat during times of market dislocation and downward trends. Only recently, during the COVID sell off, some blamed short selling for the falling markets when the most plausible reason was that investors were liquidating assets in long only funds and starting to hoard cash.
Patel: Short selling with the appropriate governance at all levels should allow for a fair market to efficiently function, which in turn helps to give confidence to investors and other participants as to the true market depth, liquidity, access and price of an asset. Creating price transparency/efficiency in a fair market can therefore be consistent with long term ESG strategy. Short selling can also allow investors to hedge their ESG risk by influencing companies who fall short of their social responsibility expectations, e.g. potentially due to poor management, corruption, environmental impact, etc. Activist investors are one key party in ensuring these companies remain accountable, however there will need to be controls in place to allow such companies a chance to improve their compliance without impairing their efforts.
The activities of short sellers have dominated the headlines this year. Do these types of borrowers have a part to play in creating a sophisticated ESG-focused world?
Chessum: The recent ICSF published Principles for Sustainable Securities Lending includes covered short selling. This principle, unsurprisingly, generated a lot of debate within the council executive but the decision to make a firm commitment to the importance of covered short selling to financial markets was unanimous. The council recognises the role that short sellers can play in discovering important issues within certain companies. Short selling is likely to be employed further in the future to promote good corporate governance. Some long only managers may not only invest in those companies that are perceived to have strong ESG credentials but venture into short selling those that are considered to not be meeting their ESG obligations. Surely, this would represent the true spectrum of companies in relation to their ESG credentials.
Patel: Short sellers play a pivotal role in the securities lending market in an ESG-focused world and therefore aid general market dynamics with respect to the supply and demand of collateral; as specific ESG assets trade richly, short sellers help to create price efficiency in the market. Investors for example may have a positive impact in an ESG-focused world through exerting pressure on companies with poor ESG ratings to change their strategy at a senior level to be more compliant, i.e. incentivisation.
Dyson: As part of the developing ESG landscape, short sellers have an increasingly important role that they can play in providing scrutiny, and holding companies accountable for their ESG actions. 2020 has seen how the scrutiny afforded by the hedge fund community has bought issues into the spotlight that have previously been kept from public view. In this regard, short sellers are able to highlight those companies that are not adhering to their ESG deliverables. By highlighting so-called green washing, hedge funds bring very real accountability perhaps not seen elsewhere throughout the investment process.
Kaiser: There is plenty of empirical evidence available showing that short selling and price discovery are integral to well-functioning financial markets. Being able to express positive and negative views on a security are key in preventing pricing bubbles from occurring. In addition, a ban on short selling is shown to increase trading spreads that, in the end, investors pay for.
Over time, stock prices react to fundamentals and are not driven by short selling. Investors who participate in securities lending can benefit from lending revenues when there are questions about a company’s valuation and independently of that, from stock price increases when the fundamentals of a company improve. Securities lending and short selling are therefore consistent with the interest of long-term investors.
Part of the challenge with incorporating ESG into the securities lending world, is the lack of any uniformity in what is considered a highly rated ESG security. The ICSF is working to rectify this through its principles for sustainable finance. How is the Council progressing and what could its widespread adoption mean for the market?
Chessum: The ICSF has now established a set of principles that can be adopted by the market and incorporated into any securities lending policy. These principles were devised by a group of beneficial owners and published by ICSF to provide the market with some initial guidance on what needs to be thought about when devising ESG policies in relation to securities lending. As the ESG conversation evolves, so will the principles. A second version is already being looked at which will have additional principles attached which will cover important topics such as diversity and inclusion. Widespread adoption of these principles will lead to better governance and more aligned best practise. Whilst this list is not exhaustive, it does provide a sound starting point for any organisation looking to develop their internal policies.
ICSF understands that the principles that the market adheres to need to be accepted and agreed to by all market participants. This is why we are very pleased with the raft of new partnerships that have been made with the most sophisticated and prominent agent lenders and securities lending associations.
I would encourage beneficial owners in particular to consider full membership of the council given the focus on asset owners to incorporate ESG into the investment decisions. Going forward the council will be producing technical guidance on the principles and is expected to be a one stop shop for everything related to ESG and securities lending.
Dyson: 2020 has been a year when we have seen considerable interest in the work of the ICSF, with many firms from across our industry aligning themselves to both ICSF and the PSSL.
The PSSL have identified a number of key areas where the market needs to develop consensus around the taxonomy that will guide product development. As we look towards 2021, the ICSF will be tasked to develop those best practice type guidelines that will provide real substance to support PSSL. This will allow institutional investors and other industry stakeholders to develop relevant products against common standards.
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