Buy-side traders start to cool on ESG-deficient dealers

With sustainability front of mind, asset managers are starting to introduce environmental, social, and governance considerations into their choice of trading counterparties. And as managers begin to factor ESG metrics into their counterparty reviews, some are going so far as to limit their interactions with dealers that don’t stand up to scrutiny.

Royal London Asset Management has been integrating ESG into its counterparty assessments for over a year. It began the exercise as an extension of its counterparty due diligence process. “Governance concerns at a bank are more material to you as a counterparty because you’ve got the potential for financial loss,” says Ashley Hamilton Claxton, head of responsible investment at the firm.

Its derivatives team has since shied away from one counterparty whose reputational risks raised red flags with the desk.

“If the traders had two equal opportunities, one with this bank and one with a different bank, they would opt, given similar benefits to customers and best execution, to trade with the bank that had fewer ESG reputational concerns,” says Claxton. “Over time, where they felt there was enough liquidity, they would take opportunities to move assets away from that bank.”

Although ESG considerations have long been a key element in investing decisions, their influence is yet to be felt routinely in buy-side trading desks’ choice of where to send their orders. And while some now see an increasing opportunity to actively influence their bank counterparty’s ESG actions, others limit the engagement to a trader’s own organization—and some question whether traders have any role to play at all.

Dutch pension fund advisory Cardano has included ESG factors in counterparty evaluations for two years now. The firm relies on metrics from an external provider. Max Verheijen, director of financial markets at Cardano, says it has recently taken a closer look at one counterparty whose governance scores raised a red flag.

The process involves engaging with the counterparty and giving them time to make improvements. Without progress after a certain period of time, Cardano may recommend to clients that they leave the dealer off their approved counterparty lists.

“Clients are asking more and more about ESG. They are relying on monitoring of counterparties on our side, and we think we have to include ESG factors in that as well,” says Verheijen.

Managers have a responsibility to achieve the best outcome when trading for their clients. This responsibility for “best execution” is legally binding in Europe and weighs on trading decisions at funds globally. Removing a counterparty for ESG reasons could pose challenges as a result.

Clients are asking more and more about ESG. They are relying on monitoring of counterparties on our side, and we think we have to include ESG factors in that as well

Max Verheijen, Cardano

David Walker, head of fixed income dealing at M&G Investments, says he would like to see his desk and others develop a set of principles that considers a counterparty’s ESG metrics in conjunction with a manager’s best execution requirements. The conversation is in its infancy at the UK-based manager, but Walker thinks it could factor into counterparty assessments and interactions.

“If, from an ESG point of view, we found that a counterparty ranked twentieth in an asset class with us broke a couple of the principles we have, maybe as a business we would take the view that we don’t want to continue with that counterparty because we’re not getting any value-add and they’re not as green as others,” he says.

It’s that hypothetical scenario that former credit portfolio manager Ulf Erlandsson thinks can make a real difference and be done with little impact on a trading desk’s ability to achieve best execution. 

Erlandsson, who serves as founder and chief executive of the Anthropocene Fixed Income Institute (AFII), says managers can systematically assess their trading partners on environmental metrics—like the difference between the fee-revenue banks earn from underwriting fossil fuel funding and supporting green projects—and decide not to trade with poorly rated dealers that also fall low on their counterparty lists. He dubs the process “the box” after a phrase used to describe the chilling of trading relations.

“Everyone who’s been trading fixed income has at some point put a counterparty of theirs in the box. Why not utilise that to put pressure on banks who provide a lot of balance sheet to fossil fuel funding?” says Erlandsson. “I’m not asking for them to go and try to save the world – just single out the really bad ones and apply a bit of pressure.”

No idle threat

A threat to trading revenues is not an insignificant concern for large dealers. Data from benchmarking and analytics firm Coalition Greenwich show fixed income, currencies and commodities trading revenue from the 12 largest investment banks globally totalled $49.3 billion in the first half of 2021 and averaged $42 billion for the first half of the previous five years. Revenues from the investment banking division, which includes debt and equity underwriting fees, averaged $23 billion for the first half of the six years through 2021.

Erlandsson argues that managers can still make a difference even if they don’t pick on their most important—and possibly largest—dealers, which could jeopardize their best execution obligations. Buy-side threats that make underwriting bonds for fossil fuel companies riskier can make those companies’ costs of financing rise and encourage greener activities.

“If you manage to get some negative exposure on a bank that has done a ‘bad’ bond deal, then other banks will price that negative reputational risk when setting fees expectations on the next ‘bad’ deal,” says Erlandsson. “Such demands for higher fees from issuers with reputational risk could drive the cost of capital on their deals higher even more effectively than divesting or shorting bonds.”

MUFG and Wells Fargo sat at the bottom of AFII’s 2021 rankings, which grade dealers based on the proportion of deal revenue earned from underwriting fossil fuel bonds compared to green alternatives. Crédit Agricole and BNP Paribas topped the list of dealers with the most green-friendly operations.

Erlandsson says he has had numerous conversations with managers about the idea but is not aware of any that have implemented it yet.

Others view an exclusionary method like one based on AFII’s box as too extreme.

“I don’t think we’re at the position where we would ban working with a counterparty solely on ESG issues, although [they] are part of our consideration when dealing with counterparties,” says Royal London’s Claxton.

“Our approach at the moment is to engage with the large banks as debt and equity holders. I can see it from one perspective of trying to make a statement around climate risk, but if it’s truly about integrating into your investment process, it feels quite blunt and singular in focus,” she adds. “Climate risk is massively important, but it might not be the only important and material risk to that counterparty bank.”

Internal option

Asset managers may be better off making changes internally to make counterparty engagement more effective, says Duncan Higgins, a former UBS executive who recently founded Sustainable Trading, a membership network and forum for the industry to address ESG questions. 

“Given investor pressure on corporate ESG performance is already there and going to be some of the most effective pressure on those organisations, do we want to have a process within trading that looks at those same things, or do we see that there’s an opportunity to focus on a different way to engage on aspects of ESG that are in the control of the trading desk,” Higgins says.

Initiatives focusing on diversity and inclusion or examining the energy usage of data and infrastructure systems would complement an asset manager’s company engagements, he adds.

Client questions about asset managers’ ESG initiatives are likely here to stay. Several managers contacted by Risk.net said they were looking at how to integrate ESG metrics with their trading desks specifically. Claxton says Royal London’s derivatives head regularly receives questions from clients on the topic.

Even so, it seems to be just the thin end of the wedge: “I’m surprised we don’t get more questions,” Claxton says. “I do expect it will become a bigger part of clients interrogating us on ESG.”