ESG in the derivatives markets: curb your enthusiasm January 2022

Dan Harris

There is a low intensity war between politicians and the derivatives markets. It flares up every few years when there is a market dislocation. Industry bodies are thus permanently engaged in defending the derivatives markets. “Derivatives are not financial weapons of mass destruction; they improve liquidity, and they provide the tools for effective risk management,” they repeat, like a mantra, every time the prospect of tighter regulation rears its head.

And they are right. Yet to many politicians and the wider public, Warren Buffett’s famous put-down has turned all other messaging into white noise.

Short selling is another example. “It does not drive down prices; it, too, improves liquidity, plus it generates returns for the benefit of pensioners, allows market participants to express negative sentiment AND improves pricing efficiency,” they say, like these transactions are magic beans. Again, the case “for” proves nothing in the eyes of the wider public if regulators keep banning short selling.

This siege mentality, borne out of legitimate concerns over taxation and over-regulation, should not be overdone when it comes to ESG. Yet there are distressing signs that this is precisely what is happening.

In the ESG space, their arguments tend to rely on broad-brush statements or hyper-technical examples. “ESG is not the exclusive domain of long-term investors; absolute return funds can also apply ESG policies… and derivatives are an essential part of their risk management,” they say. Boiled down, this feels more like wanting to join the bandwagon than an intellectual case for derivatives in this space. At other times, they argue that “derivatives are so flexible they can be linked to ESG targets”. Again, true, but this is really in praise of innovative contractual drafting, which is not confined to derivatives.

Despite everything that derivatives can indisputably offer, derivatives referencing equities or bonds present real challenges on the ESG front. We should not skirt around this. It is an elementary observation that the difference between holding the cash position and the derivative is, of course, the difference between a proprietary interest and a personal right. This used to matter just on insolvency; it now matters in a world of stewardship and corporate engagement.

For swap holders, the ability to vote or standing to engage with the company simply doesn’t exist. The response is, of course, that you cannot, and do not need to, steward something you don’t own.

But this is only half the story. These trades tie up billions of dollars of securities as hedges. The banks, as ultimate account holders of these securities, nevertheless opt to abstain when it comes to corporate matters. The idea that such a large part of the free float is excluded from ESG considerations is not widely talked about.

To the casual observer, a contract that specifically says it is concerned with cash flows, and cash flows alone, is out of sync with today’s values. He or she doesn’t buy the explanation that it is “only” a derivative once he or she discovers that it also provides the excuse for the hedging party to then sit on its hands and cover its mouth.  

Evolution takes time. Swap holders are typically not permitted to cross the Rubicon and pass through their voting preferences. Lawyers are concerned that any control of the hedge by the end-user could “recharacterise” the trade as a nominee arrangement, bringing with it a host of adverse consequences. Whilst such concerns are less of an issue than they used to be following expansion of share disclosure rules and alignment of tax rates, the overall concern still stands.

As always, operational and commercial considerations dominate. Banks are not hedging one-for-one, but often across a book which includes clients’ short positions. Further, a swap dealer will not want to be seen to act against management, particularly if the company is a client of their investment banking arm. Yet these risks are already disclosed and bargained for.

It is a counsel of despair that concludes that nothing can be done. A bank’s own ESG policy, applied to cash hedges, and which is properly disclosed, is perhaps the first step. Swap clients can then decide whether that policy, to which their swaps are exposed, accords with their own policies. That would require not only an operational fix, but a wholesale change in attitude amongst the dealer community. On the other hand, those who take the plunge will be rewarded with swap balances for showing the courage of their convictions.

This is not an abstraction. There are companies in the real economy with real governance issues. For other companies, their social and environmental impact is opaque. For so long as the derivatives market leaves in its wake vast tranches of company securities voiceless, those companies are not properly held to account. But they should not rest on their laurels. When this first step is taken, companies will quickly find that they will subject to increased scrutiny.


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