Collateralization and
the EU Collateral landscape: a legal update
Budapest - September 26, 2002
David Suetens
Senior Vice President, Risk Management Wholesale
Tel
+31-20-383-22-08
E-Mail: [email protected]
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Agenda
•What is collateralization - Business perspective
•Identifying collateral law issues in Europe
•Collateral Directive
•Way forward
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Definition of Collateralisation........
a form of credit enhancement where cash
and securities are exchanged against the
value of a derivatives portfolio
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For Example...............
Interest Rate Swap
Cross Currency Swap
- 5 mln (CP owes AAB)
15 mln (AAB owes CP)
Net exposure
10 mln (AAB owes CP)
So CP calls for collateral from AAB
to cover this net exposure of 10 mln
Net Exposure
Counterparty
ABN AMRO
Collateral
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Collateralization
Business Drivers
Creating Business Opportunities
Collateralization
Tool for Risk Management
Revenue Generator
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Collateralization
Collateral as a creator of business opportunities for you...

Market Access
 Larger Transactions & Longer Maturities
 More Volatile Transactions

European Debt Market
- Sovereign to sub-sovereign debt issuance
weaker credits
increased solvency costs for banks
- Growth in corporate debt
– More non-European borrowers issuing in euros

Deeper and More Liquid Derivatives Market
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Collateralization
Collateral as a tool for risk management…credit risk is being transferred
into legal, operational and market risk
 Legal Risk
 Approved Netting Opinions
 Enforceable Collateral Opinions
 Operational Risk
 Trade Matching identifies mis-booking of a trade
 Market Risk
 Reconciliation identifies mis-pricing of a trade
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Risk Management
Impact on credit add-ons
Example 1: Standard 5 Year Interest Rate Swap
PFE
Low
Medium
High
Uncollateralised
6%
8%
15%
Collateralised
0.75%
2%
3%
Low = EURO Medium = USD
High = Emerging markets
Example 2: Standard 5 Year Cross Currency Swap
PFE
Low
Medium
High
Low = EUR
Uncollateralised
30%
55%
108%
Collateralised
3%
5%
10%
Medium = AUD High = Emerging Markets
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Legal and Documentation Requirements
• ISDA 1992 Master Agreement :
•covers the trading relationship
• ISDA Confirmation
•each transaction will be confirmed
•each confirmation will refer to the ISDA Master
• ISDA Credit Support Annex (English Law - Transfer of Title)
• describes the collateralised trading relationship
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Operational Requirements
•
•
•
•
•
Value derivatives portfolio
Value collateral portfolio
Highlight margin call
Notify and agree collateral movement
Settle collateral
Custodian for securities and cash
Manage coupons and interest payments
• Resolve portfolio differences
• Reconcile derivatives portfolio from time to time
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New Basle Capital Framework
“The Committee acknowledges the benefits that can accrue
from the use of credit risk mitigation techniques and the
key role they can play in prudent risk management.
Accordingly, the committee believes it is important that
the capital framework should provide a better
recognition of mitigation techniques.”
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Identifying collateral law issues
• 1999: ECB establishes the European Financial Markets Lawyers
Group, discussing possibilities that would lead to a harmonisation
in EU Financial markets activity, focusing a.o. on collateral.
• 2000: ISDA’s Collateral Law Reform Group publishes a paper ‘The
Need for National Law Reform’
•1999-2000: EU Commission establishes a Forum Group on
Collateral
Conclusion: a complex and fundamental diversity of European
national laws dealing with creditor rights, property, contract and
insolvency laws.
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Creating a Pledge
 Cumbersome and impractical rules for creating, perfecting,
maintaining and enforcing pledge collateral: England, France , Greece,
Ireland, Netherlands, Portugal and Spain1
1: Based on ISDA’s Paper: The Need for National Law Reform Paper
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Use of Pledge
 Legal restrictions on use of pledge collateral: all jurisdictions, except
England, Greece and Ireland (most positive view) 1.
1: Based on ISDA’s Paper: The Need for National Law Reform Paper
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Enforceability of title transfer
 Uncertainty regarding the enforceability of title transfer
collateral:Denmark, Finland, Greece, Italy, Netherlands, Spain,
Luxemburg1
1: Based on ISDA’s Paper: The Need for National Law Reform Paper
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Title transfer versus 3th parties
 Uncertainty regarding the vulnerability of title transfer collateral
arrangements against third parties: Spain, Finland, France, Germany,
Italy, Portugal1
1: Based on ISDA’s Paper: The Need for National Law Reform Paper
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MTM collateral arrangements
 Material risk that top-up collateral may be vulnerable as a preference
during a suspect period: Denmark, France, Greece, Italy and Spain1
1: Based on ISDA’s Paper: The Need for National Law Reform Paper
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Why change collateral laws?
As collateral managers we want ….
 Effective and simple regime for pledge and title transfer
 Simplify creation, perfection and enforcement
 Confirm efficacy of title transfer collateral throughout Europe
 Clarify conflict of laws rules
 Confirm top-up and substitution
 Right of use (‘rehypothecation’)

Part of Financial Services Action Plan
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Collateral Directive:
first Commission’s proposal
 all financial collateral
 pledge and title transfer agreements covered
No recharacterisation for title transfer arrangements
 both provider and taker must be either:-
1. public authority/central bank or
2. financial institution. under prudential supervision or
3. legal person of capital base exceed. EUR 100
million/gross assets exceed.EUR 1000 million)
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Collateral Directive:
first Commission’s proposal
 Limit rules on creation/enforce
 Re-use of pledge?
 Recognition of substitution/top-up
 Recognition of close-out netting
 Recognition of the PRIMA principle (‘place of the
relevant intermediary approach’) - EU (15) and
Hague (53)
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Collateral Directive: issues
 Scope
•the capital/gross assets test?
•apply test to one party only?
•Collateralized business among corporates?
 Result:
•Financial institutions (including a.o. Sicav’s, Insurance
companies)
•Central Banks (including a.o. EIB, IMF, ECB)
•Public Authorities
•Central counterparty or clearing house
•A person other than a natural person, including partnerships,
provided that the other party is one of the above. But: OPT-OUT
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Collateral Directive: issues
 Creation of a pledge/title transfer
•Occurs often through formal acts, such as:
•Filing with an official body
•Registration in a public register
•Advertisement in a journal or newspaper
 Result:
•Creation/validity not to be dependent on a formal act if:
•The financial collateral arrangement provides for
dispossession, ie the provision of the financial collateral
•The provision of collateral must be evidenced in writing
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Collateral Directive: issues
 Realization: if the Collateral Taker cannot realise collateral
quickly, then
• Increased funding cost from re-hedging
• Additional collateral required to cover close out period
•  Increased transaction costs
• Additional risk for Collateral Provider
 Result:
•No restrictions on realization such as:
•Time period
•Official/Court Approval
•Public Auction or other prescribed sale procedure
•Appropriation: only if agreed by the parties in the collateral agreement
and its valuation. BUT: OPT-OUT
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Lifecycle of the directive
The way forward
 13/12/2001: political orientation agreed by ECOFIN
on compromise text under the Belgian presidency
 March till June: Second reading by the European Parliament
 6/06/2002: Voting by European Parliament in a plenary session
 Publication: 27/06/2002
 Implementation: 18 months after publication ,ie 27/12/2003
 Conclusion: focus on local implementations, avoid carve outs,
discuss and convince your legislator of a broad scope
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