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.