1 risk management wholesale collateralization and the eu collateral landscape: a legal update...

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Risk Management Wholesale

Collateralization and

the EU Collateral landscape: a legal update

Budapest - September 26, 2002

David SuetensSenior Vice President, Risk Management WholesaleTel +31-20-383-22-08E-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...............

ABN AMRO

Net Exposure

Collateral

Counterparty

Interest Rate Swap - 5 mln (CP owes AAB)Cross Currency Swap 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

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CollateralizationBusiness Drivers

Collateralization

Creating Business Opportunities

Tool for Risk Management

Revenue Generator

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Market Access

Larger Transactions & Longer Maturities

More Volatile Transactions

European Debt Market

- Sovereign to sub-sovereign debt issuanceweaker creditsincreased solvency costs for banks

- Growth in corporate debt

– More non-European borrowers issuing in euros

Deeper and More Liquid Derivatives Market

Collateralization Collateral as a creator of business opportunities for you...

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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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Example 1: Standard 5 Year Interest Rate Swap

Uncollateralised CollateralisedPFE Low 6% 0.75%

Medium 8% 2%High 15% 3%

Low = EURO Medium = USD High = Emerging marketsExample 2: Standard 5 Year Cross Currency Swap

Uncollateralised CollateralisedPFE Low 30% 3%

Medium 55% 5%High 108% 10%

Low = EUR Medium = AUDHigh = Emerging Markets

Risk ManagementImpact on credit add-ons

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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 cashManage 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.


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Enforceability of title transfer

Uncertainty regarding the enforceability of title transfer

collateral:Denmark, Finland, Greece, Italy, Netherlands, Spain,

Luxemburg1


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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


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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


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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 directiveThe 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

1 risk management wholesale collateralization and the eu collateral landscape: a legal update...

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