Wanted - Climate Data

This month’s main article, Wanted - Climate Data, discusses the increasing prominence of ESG investing, and gives a high-level overview of the SEC’s proposal to mandate climate-related disclosures as part of routine financial reporting.

Also included are the following themes:

• Credit Vista: Assessing the Stability of Stablecoins

• Trading Vista: Point Counterpoint
  

Economic Vista: Wanted - Climate Data

Steve Johnson, CFA, Portfolio Manager

Investing with an emphasis on ESG considerations has become increasingly popular across the investment management industry in recent years. Global sustainably invested assets (another name for ESG) reached $35.5 trillion in 2020, up from $30.7 trillion at the end of 2018 and $22.8 trillion at the end of 2016.¹ According to Morningstar, in the US alone, the number of investment funds dedicated to ESG grew to 584 as of December 2021, up from 392 at the end of 2020.²

The SEC’s recent proposal to mandate climate-related disclosures as part of routine financial reporting represents a watershed moment for US ESG investors. If the final rules achieve the objective of facilitating consistent, comparable and reliable climate-related information, investors will have access to a deluge of decision-useful climate data.

Assessing risks and opportunities

As the prominence of responsible investing has increased, investors have naturally demanded better information about how climate conditions impact their investments. Institutional investors assess that climate change could impact investment portfolios in several ways. First, physical risks from climate events like natural disasters or rising sea levels pose direct threats to businesses and their physical assets (e.g., a manufacturer that faces rising risk of wildfires or hurricanes near its main manufacturing plants). Second, transition risks associated with the global effort to transition to a lower-carbon future present the potential of changes to, among other things, climate-related regulation or litigation; disruptive lower-carbon technologies; and changing consumer, employee and investor behaviors that could impact current business strategies (e.g., an automotive company that begins to encounter consumers who no longer prefer emissions-heavy vehicles). Lastly, transition opportunities may also exist due to the move to a lower-carbon economy (e.g., a business with newfound cost savings from the use of renewable energy, or development of new products or services catering to changing marketplace preferences). Investors want to understand these risks and potential opportunities, and to do that they need data.

To its credit, the investment community has not sat idly by in the search for climate disclosures, but rather has taken an active role, banding together to collectively implore companies to provide and governments to mandate climate-related data and disclosures. Investor associations representing trillions of dollars in assets have either explicitly asked governments to mandate climate disclosures or implicitly requested such data through development of investment strategies using climate data inputs. Below, we highlight a few of these organizations and the sizable assets behind them:

• The Investor Agenda’s “2021 Global Investor Statement to Governments on the Climate Crisis” has now been signed by 733 institutional investors representing more than $52 trillion in assets under management (AUM).³ It asks governments to, among other things, commit to implementing mandatory climate risk disclosure requirements.
• The United Nation’s Principles for Responsible Investment has 4,902 signatories representing $121 trillion in AUM⁴ committed to, among other things, seeking appropriate disclosure on ESG issues.
• The Net Zero Asset Managers initiative now consists of 273 asset manager signatories representing $61.3 trillion in AUM⁵ committed to supporting the goal of zero global greenhouse gas (GHG) emissions by 2050.
• The Climate Action 100+ consists of 700 investor signatories representing $68 trillion in AUM committed to engaging the world’s largest corporate GHG emitters⁶ to reduce their emissions.
• The Paris Aligned Investor Initiative of 118 institutional investors representing $34 trillion in AUM⁷ is responsible for the development of the Net Zero Investment Framework, a blueprint for enabling investors to decarbonize investment portfolios toward net zero emissions by 2050.
• The Glasgow Financial Alliance for Net Zero (GFANZ)⁸ has 450 members across the global financial sector, representing more than $130 trillion in AUM aligned toward achieving net zero GHG emissions.

In addition to these organizations with varying climate initiatives, several third-party frameworks have been developed to help companies appropriately disclose climate-related risks to the investment community. Chief among investor-led climate disclosure initiatives is the Taskforce on Climate-Related Financial Disclosures (TCFD). The TCFD, which is sponsored by the Financial Stability Board and chaired by Michael Bloomberg, issued climate disclosure recommendations back in 2017 that have set the foundation for the current state of climate disclosures, having been embraced by regulatory and voluntary climate disclosure regimes globally. The TCFD framework identifies 21 disclosures over four key areas — governance, risk management, strategy and metrics — along with guidance for specific sectors. As of October 2021, the TCFD disclosure recommendations had more than 2,600 supporters globally, including 1,069 financial institutions responsible for $194 trillion in AUM and the support of over 120 regulators and government entities.⁹ Clearly, investors have mobilized to create and urge decision-useful climate disclosures.

The intention of the SEC’s climate disclosure proposal is to continue the global momentum of regulated climate data disclosure. The proposal, which at the time of this writing wasn’t final, aims to require public registrants and filers to include information on, among other things, climate-related risks and potential impacts, governance of climate-related risks and risk management processes, GHG emissions, climate-related financial statement metrics and climate-related targets and goals. The proposal is intended to significantly increase the frequency, comparability and usability of climate-related disclosures. Today, companies responding to investor demand do voluntarily disclose some climate data. However, the disclosures are inconsistent in approach, location and frequency given the voluntary nature. As an example, as of July 2022, only 53% of the companies in the Russell 1000 Index (a proxy for 1,000 of the largest US public companies by size) have disclosures aligned with the TCFD recommendations or have plans to do so.¹⁰ Those that do disclose do so in various locations like a company website or as part of an additional annual ESG report, requiring investors to search to track down the data. Disclosures can also come at inconsistent times and frequencies, muddling comparability.

Momentum builds

The SEC intends to alleviate these hurdles by proposing what registrants should disclose, where they should disclose it and how frequently. Investors in turn would begin to receive an influx of data needed to evaluate the evolving climate risks faced by and opportunities presented to companies within their investment portfolios. At the same time, the increased cost and burden for climate disclosure would fall squarely on public companies’ shoulders. Only time will tell if or when any exact SEC regulation becomes official, but for now investors can rest assured they are not just shouting into the wind. Investors’ collective demand for additional climate disclosure is being heard across the globe.

SVB is proud to have announced a $5 billion sustainable finance commitment and carbon neutral operations goal earlier this year. 

<sup>1. Source: http://www.gsi-alliance.org/
2. Source: Morningstar Direct
3. Source: https://theinvestoragenda.org/focus-areas/policy-advocacy-2021-gis/
4. Source: https://www.unpri.org/
5. Source: www.netzeroassetmanagers.org/
6. Source: www.climateaction100.org/
7. Source: www.parisalignedinvestment.org/
8. Source: www.gfanzero.com/about/
9. Source: https://www.fsb-tcfd.org/
10. Source: Bloomberg</sup>

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Credit Vista: Assessing the Stability of Stablecoins

If equity or bond investors are mulling a difficult first half, imagine how crypto investors are feeling right now. Bitcoin has been halved. At least one major crypto fund has imploded. And one high-profile algorithmic stablecoin previously pegged to the US dollar (USD) has “broken the buck.” Despite the challenging crypto backdrop, we wanted to step back and provide a high-level overview of stablecoins.

Loosely defined, stablecoins are a cryptocurrency that aim to offer price stability by being pegged to a fiat currency. Stablecoins can be further broken down into a variety of categories, but the ones we’ll focus on are the stablecoins backed by reserves equal to an amount outstanding that maintain a peg to the USD.

The use case for stablecoins is relatively straightforward. A stablecoin can act as a medium of exchange in cryptocurrency markets and comes with a degree of decentralization — or the ability to operate outside of traditional banking channels. To some degree, it can operate outside a central bank’s controls. Stablecoin, as a form of a virtual USD, offers a store of value without leaving the crypto ecosystem and the ability to convert crypto to fiat with (allegedly) low volatility. The emergence of stablecoins as an asset class has led some central banks to consider the issuance of a digital dollar, which is commonly referred to as a central bank digital currency (CBDC). This might be attractive to crypto and crypto-adjacent investors as it would, in theory, offer lower fiat-like volatility compared to the traditional cryptocurrency volatility profile.

As a medium of exchange, one of the most useful versions of a stablecoin would be an entity that would take an investor’s dollar, deposit said dollar into the fed funds system and then issue a stablecoin to the investor. Thus, it would function similarly to the traditional bank deposit system. While the above process is fundamentally sound, it would also effectively create a CBDC that is not issued or controlled by the Federal Reserve. We feel it is highly unlikely that a crypto entity would be granted a charter and access to fed funds markets at this time.

While not an exact comparison, an entity called The Narrow Bank (TNB) tried to create a system whereby a consumer could give TNB their deposits, which would go directly to the Fed while TNB collected a tiny spread between interest paid to depositor and interest earned while parked at the Fed. Predictably, the Fed denied TNB a charter, saying they had objections to what they call “Pass-Through Investment Entities.” There is significantly more to unpack regarding TNB and pass-through entities, but if the Fed is resistant to this proposal, we find it hard to believe it is going to grant a crypto firm access so it can effectively issue what would be a digital version of a USD. If a digital central bank currency is created, it will almost surely come from the central bank itself. Fed Chair Jerome Powell threw even more cold water on the idea in July 2021’s Fed minutes, saying, “My point with stablecoins was that they’re like money funds, they’re like bank deposits, and they’re growing incredibly fast, but without appropriate regulation. If we’re going to have something that looks just like a money market fund or a bank deposit or a narrow bank and it’s growing really fast, we really ought to have appropriate regulation and today we don’t.”

So, if stablecoins are unlikely to emerge as a de facto digital USD, is there another path forward? In terms of creating a medium of exchange pegged to the USD, a viable stablecoin should be fully or even over-collateralized by reserves in traditionally low-risk instruments, such as US Treasuries, agencies or repurchase agreements, and not collateralized in risk assets such as other cryptocurrencies. This is the essence of a fiat-collateralized stablecoin.

In the event of high redemptions, which can undermine stable pricing, we think that good governance can act as a mitigating factor, with better visibility into the collateral through audited financials. Terra, an algorithmic stablecoin that did not keep 1:1 collateral and instead used a supply function to issue coins, lost its peg and unraveled earlier this year. What can investors learn from this situation? When assessing the stability of a stablecoin, it seems to boil down to quality of underlying collateral and how it can handle large redemptions. Traditional money market funds are subject to rule 2A-7 of the Investment Company Act of 1940, which strictly governs daily and weekly liquidity levels in the event of abnormally high redemptions. There are no similar governance measures for stablecoins.

Stablecoins for income?

We have covered the use of stablecoins as a medium of exchange, but the headline that grabs the attention of most investors pertains to stablecoin staking or yield-earning programs. Earlier this year, you could go to any crypto exchange and see advertisements for these lucrative programs. These were easily identifiable as they offered annual percentage rates (APRs) north of 10%. What may not have been clear then (but has become a lot sharper now) are the risks and the underlying mechanics of these transactions.

For simplicity, we will focus on programs using a fiat-collateralized stablecoin that are also collateralized by the counterparty. In effect, this staking acts as a reverse-repo transaction, where an investor provides a short-term loan through this staking program to a counterparty, loaning their stablecoin of choice for a fixed term (generally between 90 and 360 days). A third party can act as a custodian, and the counterparty that is paying the (usually above market) APR for the term loan of stablecoins will often provide over-collateralization — typically in the form of a non-stablecoin cryptocurrency — to the custodian.

But there must be risks given the prevalence of the double-digit APRs. These are term loans that are collateralized in cryptocurrencies where price fluctuations could more than offset any over-collateralization. For example, if a trade was over-collateralized by 25%, an investor would lend $100 worth of stablecoin and the counterparty would then provide $125 worth of collateral to the custodian. In this example the collateral might be Ethereum, and the margin of safety for an investor to receive their principal in full would be Ethereum’s price staying within 25% for the term of the loan. However, given the volatility associated with Ethereum, is this over-collateralization enough? Maybe not. The characterization of staking programs as a place to park stablecoins for low-risk yield is, in our view, misleading.

The verdict

We realize that stablecoins and staking programs are complex and can vary significantly. We are offering only broad brushstrokes on a complicated and developing market. In general, we see that stablecoins appear to have some usefulness within the crypto ecosystem, primarily as a medium of exchange and store of value. But as a yield-earning vehicle, things get tricky and, potentially, much riskier. So, if the passive income opportunity associated with some stablecoin appears too good to be true, it probably is. There’s still no such thing a free lunch, even in crypto markets.

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Trading Vista: Point Counterpoint

Jason Graveley, Senior Manager, Fixed Income Trading

Traders appear to have settled into a routine where every important economic data point seemingly corresponds to another move in Treasury yields. Any change in the economic outlook creates a new near-term narrative and, coincidentally, more uncertainty around the path of monetary policy. The Federal Reserve’s trajectory for its new, less-accommodative policy is ever-evolving, and this presents additional challenges for investors.

Despite rates moving up more than 1.50% off the zero bound, the increase in volatility has refocused attention on the front end. The best representation of this is the continued prominence of the Fed’s Reverse Repo (RRP) facility, which continues to set new balance records. If we look at the trajectory of the facility, utilization has tripled year over year with balances surging from $730 billion to more than $2.3 trillion at June 2022 quarter end. Balances are expected to remain above $2 trillion for the remainder of the year, and some projections estimate this to continue growing, assuming RRP rate adjustments don’t decouple from fed fund rate hikes. So far there has been a parallel shift in RRP rates with each fed funds increase.

RRP rates, along with a continued decrease in Treasury bill supply, have resulted in a sizable shift in money market fund composition. Treasury supply continues to be at the forefront of allocation discussions, as the quantity of Treasury bills has fallen more than $1.3 trillion from its peak in the summer of 2020. This dwindling supply, coupled with surging front-end balances, has left a significant disparity in money market supply and demand. To fill this gap, money market funds have repeatedly turned to the RRP facility or other repo lines. If we look at the current makeup of government money market funds, allocations to repo can exceed more than 75% of total holdings. And it’s not really a surprise, given the shortage of Treasury bills, that rates at the Fed’s RRP are 50 basis points higher than a one-week Treasury bill. Due to this dynamic, overall portfolio positioning has shortened with weighted average maturities falling sharply across complexes, some dropping more than 30% over the last two months.

Discussions continue around how comfortable the Fed is with this high utilization rate, although language in the most recent Federal Open Market Committee (FOMC) minutes suggests that the facility is operating as expected. In addition to previous adjustments to counterparty eligibility and utilization limits, the minutes noted that “if ON RRP usage continued to rise, it may be appropriate at some point to consider further lifting the per-counterparty limit.” At least in the short term, this suggests that balances are likely to remain high, and the Fed will stand by and be prepared to increase access for counterparties as needed. Over the longer term though, the expectation is that utilization will begin to fall as Treasury supply increases in the second half of the year, money market yields continue to move higher and monetary policy (hopefully) shifts less rapidly. When that inflection point will actually happen is anyone’s guess. Therefore, the tit for tat between traders and data points looks to continue in the near term.