Balancing the returns from securities lending with the requirement to exercise good governance has been an established practice for securities lenders for decades. However, a recent decision by one of the world's largest pension funds to pause their securities lending program (due to concerns about exercising their voting rights) has provoked questions about whether the two disciplines can co-exist in an environmental, social, and governance (ESG) context. But with sustainability at the heart of ESG investing, and securities lending at the heart both of improving investor returns and facilitating sustainable capital markets, it is important to examine how firms can strike the right balance.
At the broadest level, the $20 trillion of securities which are made available to lend by investors are recognized by both exchanges and regulators as critical to the proper and sustainable functioning of capital markets. Without securities lending, the ability to sell short and cover trade fails disappears - meaning there is no market making, hedging, or true price discovery, all leading to less efficient and more volatile markets.
This is why securities lending is referred to as the oil upon which the engines of financial markets rely, and why many investors decide to lend securities. Without it, markets would splutter and eventually seize. Not only do many firms feel securities lending fulfills their responsibility to optimize returns for their investors; they’ve also been vocal that it contributes to sustainable capital markets.
Why then are some firms having trouble reconciling securities lending with their ESG goals?
Because when a security is on loan, the investor loses the right to vote. On the surface, this runs counter to ESG principles.
More practically, however, the industry has had a solution to this issue since its inception, with established procedures to restrict and recall securities from being on loan before important votes. The onus then is on each lender to determine whether it’s in the best interests of the funds’ investors to vote on a given position (and forego the additional lending revenue) or leave it on loan.
A lender could absolutely recall every position on loan ahead of a proxy vote. In most cases though, lenders have a materiality test where they recall shares to vote on important events relevant to the company’s performance or ESG principles, versus leaving shares on loan to generate revenue for less material matters.
Securities lending programs are not “one size fits all.” When considering a lending style, a salient factor is that it’s far easier to fulfill voting responsibilities when fewer securities are on loan at a given time. Therefore, a value-oriented program, focused on prioritizing revenue from a handful of high-income generating stocks versus a volume program focused on lending a larger number of lower-income generating stocks could be an option for an investor prioritizing governance. A value oriented approach has the added benefit of reducing credit and other operational risks associated with securities lending though such an approach would limit the absolute returns from a securities lending program. This would necessitate consideration of the trade-offs between securities lending income, risk and governance responsibilities.
Outside of governance, the other most obvious intersection between securities lending and ESG is whether facilitating short selling is consistent with sustainable investing. Not all short selling is driven by hedge funds taking negative bets on companies. Market making, hedging and arbitrage strategies all require short selling which is why an established short selling and securities lending framework are requirements for providers such as MSCI to include a country in their indices.
However, even when used to express outright negative views on companies short selling can improve the sustainability of markets by mitigating price bubbles and alerting the market to fraudulent accounting practices as was the case with Enron and more recently Hanergy and China Huishan Dairy. Supporting the role that short selling plays in efficient markets, when regulators have implemented short selling bans, they have often resulted in increased volatility, reduced liquidity and wider two-way spreads. Indeed, former SEC Chairman, Christopher Cox, went as far as to say that the short selling bans he introduced during the 2008 financial crisis were “a mistake” with “costs [that] outweighed the benefits.” With all of this said, there will always be specific situations where a portfolio manager wishes to ensure that for whatever reason, they are not supporting shorting activity in a given company’s stock. As with the governance process, the means are available to restrict lending in these instances.
It would be a shame if good governance and securities lending were viewed as separate competing issues. The success of ESG investing more broadly will be to demonstrate to investors that you can have both compelling returns while investing responsibly, and a thoughtful securities lending program can be a key part of this proposition.
The views expressed are as of December 17, 2019 and are a general guide to the views of Brown Brothers Harriman (“BBH”). The opinions expressed are a reflection of BBH’s best judgment at the time.
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