How can ESG drive new choices of collateral?

Financial Market participants are under pressure to incorporate ESG metrics into all aspects of their business activities. ESG represents a socio-economic priority both at the international level such as COP26 and the World Bank and ESF initiatives can be seen to extend into local national policies. For an individual firm its clients, shareholders, investors and even employees all seek reference to a formalized plan for managing ESG.

What is meant by ESG?

ESG stands for Environmental Social and Governance. ESG is a framework for analyzing companies and really assessing how are they compared to their peers in terms of performance against these metrics:

• Environmental: considers a water usage waste production and general kind of environmental behavior about how efficient companies are and managing their resources and also looking after the environment around them
• Social: it’s around how well companies treat their clients; how well do they treat their workers and then there also some diversity aspects around the management and workforce
• Governance metrics are around share class structure, governance structure within the company and how well-run the company is.

Taken in aggregate, this is a way of assessing a company by looking at how it impacts the broader society at large.

ESG requirements broadly impact the financial services value chain from determining which assets investors hold in their portfolios, to what assets and at what rates those portfolios will be financed, to downstream collateral management processes that support securities lending, collateral pledging, and asset servicing.

Recognizing the risk posed by climate change, the World Bank launched the « Strategic Framework for Development and Climate Change » to help stimulate and coordinate public and private sector activity to combat climate change. The World Bank Sustainability Bonds is an example of the kind of innovation the World Bank is trying to encourage within this framework.

What are sustainability bonds?

Sustainability bonds are a type of debt financial instruments classified as Socially Responsible Investment.

• A green bond is nothing more than a debt security that is issued by an organization for the purpose of financing and re-financing projects that contribute positively to the environment and or the climate, sometimes you’ll hear these referred to as climate bonds as well.
• A social bond is a debt security that’s issued by an organization for financing eligible social projects which are those that are designed to mitigate a specific social issue or seek positive social outcomes.
• A sustainability bond is just a bond that has both green projects and social projects, so it’s just a combination of the two and works the same way

How ESG impacts the collateral choices?

The acceleration of ESG investing and the rising ESG financing market is beginning to trickle down to treasury and collateral management policy. These policies govern how securities are lent to counterparties for short covering, proxy voting and the use of collateral to meet margin requirements across products and business lines.

In fact, early adopters are starting to extend the ESG conversation to securities financing across securities lending, repo and OTC derivatives. Market participants are now able to apply their environmental, social and governance (ESG) principles to the assets they are willing to use as collateral.

Collateral Framework: Greener collateralization practices by central banks will stimulate liquidity and harmonization of environmental data associated with financial assets, allowing the greening of collateral frameworks to move beyond the assets of non-financial corporations. For instance, the ECB is willing to consider relevant climate change risks when reviewing the valuation and risk control frameworks for assets mobilized as collateral by counterparties for Eurosystem credit operations. This will ensure that they reflect all relevant risks and rankings including those arising from climate change.

Securities Lending: Market participants are now able to apply their ESG-principles to the assets they are willing to accept or use as collateral.

However, there is no explicit guidance on how collateral posted in the context of securities lending transactions should be categorized or treated for sustainability purposes. While it is recognized that sustainability should be incorporated into the collateral acceptability framework, collateral may not be subject to the same ESG policy as the strategic investment assets of the fund.

Repurchase agreements correlated with ESG goals have demonstrated the ability to tie the economics of the trade to ESG performance, and green bond baskets can be financed at preferential terms under what is sometimes referred to as green repo.

Collateralized repos that support sustainability can be cheaper than green bonds or loans. Organizations looking to fund environmental, social and governance projects are turning to ESG-friendly repo trading and in particular a type of deal that bypasses the need to issue green bonds or loans. Past discussions of green repo have focused on the nature of the underlying collateral, arguing that green repo should use a green bond. But now, firms are beginning to put the proceeds of conventional bond repo to ESG-friendly uses, regardless of the ‘greenness’ of the underlying collateral, creating the potential to significantly expand green repos in a new direction and increase their green credentials as well.

This is the beginning of ESG financing, in a few short years, there may well be a new industry standard that defines these ESG repo transactions with a large community. The future assimilation of ESG in collateral management requires flexible technology architectures that can cope with today’s processes while scaling to meet future requirements across multiple financial actors that have implemented their ESG frameworks differently. For nearly 20 years MEGARA provides best-of-breed collateral management solution for core financial institutions, central banks and financial market utilities such as CCP’s.

Wassim Bouaziz 

Senior Business Lead