Beyond Mechanics: The Intersection of Securities Lending and ESG Investing Bridget Realmuto LaPerla Head of ESG Research, State Street Associates Travis Whitmore Securities Finance Research, State Street Associates In early December 2019, one of the world’s largest pension funds announced that it “decided to suspend stock lending until further notice.”1 This is one example of a growing number of asset owners evaluating their securities lending practices due to environmental, social and governance (ESG) concerns as long-term investors.2 Concerns have been raised that short sellers (borrowers) could potentially undermine long-term stewardship efforts by mispricing or not considering ESG characteristics.3 1 The immediate impact of these • Lenders have attempted to integrate ESG, events on the world’s lending but with fewer examples of borrowers with ESG investment philosophies, some supply was limited. For context, lenders are concerned about the potential in June 2019, global on-loan negative impacts on their long-term ESG balances were around US $2.45 trillion, stewardship efforts due to borrowers mispricing these characteristics representing a small proportion of the US $18.47 trillion available • While research indicates that short selling within lending programs.4 does not destroy a company’s long-term value, the relationship between short selling However, as the number of asset owners with and material ESG performance is unclear these ESG-related concerns grows, the lending supply may further decline. And, between What are the ESG concerns 2018 and 2019 the United Nation’s Principles of long-term investors? for Responsible Investment (UNPRI) reported A growing number of asset owners and a 16% increase in the number of asset owner managers are voicing concerns that securities signatories committed to ESG investing, bringing lending limits their ability to exercise proper the total to over 2,300 signatories with more than stewardship on underlying investments, US $86.3 trillion in assets under management.5, 6 highlighting three key concerns: In this editorial, we attempt to form a perspective 1. The transfer of stock ownership rights. on the intersection of ESG investing and When stocks are on loan, the voting rights securities lending based on academic findings. for those shares are also transferred. After an extensive literature review, there are This is inconsistent with the wishes of four main findings that we cover: asset owners who mandate that their asset managers need to conscientiously exercise • Empirical evidence supports foundational voting rights on all their shares. assumptions in financial theory, which suggests that short selling, facilitated by 2. There is a transparency concern because securities lending, improves market efficiency owners do not have clarity on who and allows for the proper allocation of capital borrows shares nor the reasoning behind those decisions.7 • Increasing number of regulations and investor demands are driving the adoption of sustainable investment strategies 2 3. Underlying these points is the perception The two primary considerations that short sellers (borrowers) destroy long-term value due to a misalignment in when examining short selling’s the longer-term investment time-horizon impact on capital markets are of lenders (beneficial owners). This raises Liquidity and Price discovery. issues of “short-termism,” which can be defined as the “excessive focus on on market efficiency. Event studies analyze short-term results at the expense of the impact of short-selling constraints and long-term interests.”8 regulations on various events (e.g., bans during the 2008 financial crisis). Lastly, Asset owners are not the first institutions time-series and cross-sectional analysis uses to direct concerns at short sellers. Financial daily or intra-day stock-loan data to examine the regulators have historically viewed short impact of shorting flow at securities level. selling with a level of skepticism, especially during times of financial turmoil. For example, The two primary considerations when in the 2008 financial crisis, the Securities and examining short selling’s impact on capital Exchange Commission (SEC) pointed to short markets are liquidity and price discovery. sellers as a reason behind the sharp decline in Liquidity is the ease with which an asset can be prices and banned short selling on sold or bought and is commonly proxied for by 9 799 financial stocks. The continued debate the bid-ask spread. In illiquid markets, bid-ask has attracted interest from academics, which spreads are wider resulting in costlier trades. we can turn to for a better understanding Price discovery is a critical process in financial of the role of short sellers in capital markets. markets in which the proper price of an asset is determined based on the incorporation of all What is short selling’s role in capital markets? available public information. Before tackling whether short selling harms Liquidity: In theory, the impact of short-selling long-term value, we need to understand constraints on liquidity is ambiguous. Numerous its role in capital markets. Empirical studies studies have shown that short sellers are that explore short selling’s role in markets informed market participants – increases tend to fall into three main categories: in borrowing rates or shorting demand are (1) cross-country variation, (2) event studies correlated with abnormal negative returns.10, 11 and (3) time-series and cross-sectional analyses. Removing informed sellers reduces the Each research methodology provides a different asymmetry of information and narrows perspective on the securities lending market. bid-ask spreads. At the same time, the market mechanism is disrupted and revelation of Cross-county variation studies use variations information is slower, which could widen spreads. in regulations and market practices across countries to study the impact short selling has 3 Empirical findings from all three types of 2. Event studies: Price discovery was slower academic studies tend to agree that short selling for stocks impacted by the short-selling bans constraints reduce liquidity at the single-stock during the 2008 financial crisis, especially and broader market level: where negative news was concernced.15 1. Cross-county variation: A study of 3. Time-series: Prices of stocks with 111 countries found that in countries where short-selling constraints (such as low short selling is more feasible, turnover, lending supply) are less informative. a proxy for liquidity, was 15% higher. Evidence also suggests increased “shorting That is, there is increased liquidity of market flow reduces post-earnings-announcement indices when short selling is possible.12 drift for negative earnings surprises”.18, 19, 20 2. Event studies: Financial stocks subject to shorting bans during the 2008 financial crisis Is short selling detrimental resulted in spreads that were two to three to long-term value? times wider while controlling for previous The studies cited above provide empirical 13, 14, 15 behavior. evidence that short selling is important for efficient capital markets and when viewed 3. Time-series: Suggest that short sellers holistically, suggest that short selling is not can be liquidity suppliers when spreads detrimental to long-term value. Additionally, are especially wide, providing there are several specific studies that found a stabilizing force in the stock market.16 no statistical difference in excess returns of Price discovery: The theoretical impact stocks for which short sales were banned of short selling on the speed of price and for those stocks in which short selling 21, 22,15 discovery is clearer than it is for liquidity. was permitted. To summarize, a body of Short-selling constraints restrict traders academic evidence indicates that short sellers with negative information from expressing their are informed in that they anticipate price sentiment, slowing the speed with which bad declines. However, they are not responsible news is incorporated into market prices. for driving asset prices down. Empirical evidence from the three categories What does this mean for investors? tends to agree with this theory: While it is often claimed that the short-term 1. Cross-county variation: An analysis horizon of borrowers is at odds with of 46 equity markets reveals that long-term objectives, existing literature suggests countries that permit short selling, this is not the case and instead, reveals short incorporate information into prices selling to be an important market mechanism. quicker. Additionally, short sales Moreover, evidence indicates that short sellers’ restrictions don’t reduce negative presence in a market increases liquidity. skewness of returns at the stock level.17 4 Increased liquidity means reduced transaction seeking alpha opportunities, tilting towards costs on average, while price discovery low carbon strategies experiencing positive helps investors get more accurate prices and contemporaneous flows improves returns. potentially prevents disruptive price bubbles. In addition, we observed a low correlation between strategies in the United States and Basic financial theory suggests and Europe. This was particularly salient after 2016, empirical evidence supports the idea that when almost all US decarbonization factors short selling, facilitated by securities lending, experienced outflows after the change in improves market efficiency and allows presidential administration, an effect not seen 23 for the