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FINANCIAL COLLATERALS
Why does your Bank love ‘em so much and why you shouldn’t
London School of Economics Mid-term assignment by Francesco Sileo
INTRODUCTION
A financial collateral is an instrument used by corporates and financial institutions in order to mitigate the risk 1 in^ their transactions and achieve other benefits. The main goal of this essay is to provide an overview about these benefits and to analyze the main difficulties that such instruments can raise. In section A I’ll provide a brief description of the financial collateral and will focus on its main features compared to traditional security interests; in section B I’ll point out at the major problems that financial collateral generates; in section C I’ll sum up my conclusions.
(^1) Financial collateral risk mitigation is meant to protect the parties not only against “counterparty credit risk” but also against “settlement risk” and “market risk”
A) FINANCIAL COLLATERAL AND TRADITIONAL SECURITY
INTERESTS
A Financial collateral is an agreement which creates an asset-backed position meant to provide risk protection by security interests and quasi- security using financial assests such as cash, investment securities and credit claims 2. It’s an extremely useful tool because reducing credit risk, enables financial institutions to expand their business^3.
The key element that distinguish financial collateral and traditional security interests (both are asset-backed positions linked to an underlying funded position in order to transfer the risk it creates from one party to another) is the presence, in the financial collateral structure, of margining rules, the right of use, the close-out netting and a lithesome enforcement mechanism. These characteristics make the financial collateral a more advantageous instrument compared to security interests for the following reasons:
- Margining (or Marking-to-market) is the practice in which parties agree that the value of the collateral securities will exceed the value of the collateralized obligation and the amount of margin may depend on the quality, liquidity or price volatility of the securities 4. In order to preserve the margin value, specific provisions are included in the agreement, allowing the collateral taker to make a “margin call” requiring the collateral giver to deliver (^2) J. Benjamin: Financial Law (Oxford University Press, 2007) p. 445 (^3) J. Benjamin: Interests in securities (Oxford University Press, 2000) (^4) J. Benjamin: Financial Law (Oxford University Press, 2007) p. 318 – 319
collateral system, this could have only been achieved with Title transfer collateral agreements (quasi security) since under security interests the excercise of such right is incompatible with the “equity of redemption” which entitles the security giver to the return of the particular assets originally delivered 8 (it’s a right in rem)
- Another peculiar attribute of financial collaterals is a rapid and informal enforcement contemplated by the Financial collateral directive (FCD) 9 which allows the collateral taker to realise the collateral provided by sale or appropriation in case of financial instruments or claims and by setting off the amount of cash. In this way, it’s easyer for the collateral taker to enforce his right in case of counterparty default.
The last difference between financial collateral and security interest is the abolition (provided by the FCD and implemented by the FCAR in the UK) of formal requirements for the creation, validity, perfection or enforceability of collateral except for the only requirement of the written form “ad substantiam”. Since security interests require a specific formal pattern 10 , they are burdened by slow and “market-unfriendly” bureaucratic procedures, thus the collateral represent a more attractive solution for corporates and financial instituitions.
(^8) J. Benjamin: Financial Law (Oxford University Press, 2007) p. 462 (^9) Dir. 02/47/CE, art. 4 (^10) these requirements generally involve an act of publicity such as registraion,
notarization or delivery
B) ALL THAT GLITTERS IS NOT GOLD
Up to this point we found that financial collateral are a great way to mitigate the risk, to grant liquidity to the market and to overcome the bureaucratic lenghtinesses of the security interests. Nevertheless such a flexible instrument can create several problems both on a “microeconomic” prospective (Collateral parties risk) and under a “macroeconomic” standpoint (Systemic risk). I’ll discuss them separately:
- The first problem concerning collateral taker’s risk is related to the insolvency of the collateral giver and in particular to certain insolvency provisions that could clash with the margining and substitution practices. Those indeed, traditionally create compatibility problems with provisions such as insolvency displacement rules that invalidate disposition of property taking place after (or closely before) the commencement of insolvency procedures 11. Notwithstanding, the FCD has expressly regulated this conflict, providing the disapplication of certain insolvency provisions 12. Another issue raised by insolvency is related to the right of use because in case of collateral taker insolvency, if he transferred the asset away, the collateral giver would only have a claim, which is a weaker form of protection.
- Right of use involves another issue due to the fact that usually the collateral is held by a custodian, who is entitled to transfer the (^11) That’s because the effect of Margining and Substitution clauses, is that “at
any moment of the transaction, different parts of the collateral pool may have been delivered at different times” [J. Benjamin: Financial Law (Oxford University Press) p. 455] (^12) Dir. 02/47/CE, art. 8. Similar problems can raise with regard to Close-out
netting and the art. 7 of the FCD clear this aspect
C) Conclusions
Collaterals are a remarkable instrument to mitigate the risk, provide liquidity to the market players and thus enhancing the growth of the economy allowing corporates to expand their businesses but they can also cause problems if not properly regulated. The FCD and the FCAR provides some of the answers to those issues but not to all of them, thus a more complete regulatory intervention is in my opinion needed, especially with regard of priority contests and systemic risk issues.
