Pledge v Outright Transfer of Title in Collateral: how to choose which option is best for you?
With regulatory reform in the banking and finance sector focussing on the need to collateralise and secure exposures, there is renewed interest in collateral agreements. Many different derivatives, securities and financing transactions have collateral mechanisms built into the legal documentation which is used. This article aims to break down the main collateral agreements and give a brief overview of the mechanisms provided for securing the exposures and obligations intrinsic in these transactions:
1. Repo and Securities Lending Transactions:
Repo transactions are commonly documented using a Global Master Repurchase Agreement (‘GMRA’) and involve the selling of securities to a buyer, in exchange for the full purchase price for those securities paid to the seller. The commitment is then for the seller to purchase those securities back from the buyer at a future date at an agreed price. However, during the transaction, the value of the securities vary over time and in order to mitigate against this exposure, the GMRA includes mark-to-market provisions allowing the buyer and seller to mark the repo’d securities and collateral assets to a current market value and seek to call for collateral to cover any exposure.
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Securities lending transactions are usually governed by a Global Master Securities Lending Agreement (‘GMSLA’). This agreement provides for the loan of securities from lender to borrower with the requirement for the borrower to post collateral to the lender in order to secure the loan. At the end of the loan the borrower delivers back the loaned securities to the lender and the lender returns the collateral assets to the borrower. However, the parties may wish to ensure that they track mark-to-market exposure of the loaned assets and the collateral assets during the course of the loan. The GMSLA has margin maintenance provisions embedded into the document which permit the parties to continuously balance the current value of the collateral posted by borrower against the fluctuating value of the loaned securities.
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The collateral provisions in the GMRA and GMSLA both require collateral to be posted outright in title in order to secure this exposure. This means that the recipient of the collateral (transferee) will gain ownership rights to the collateral (including the right to vote, right to receive distributions or dividends or income, and the right of re-hypothecation or use of the collateral). Any income payments which may accrue to collateral assets will be made to the transferee at the time (as they are the legal owner). That being said the GMRA and GMSLA include a contractual obligation on the transferee to pay dividends or income payments over to the poster of collateral assets (transferor). This ensures that the transferor retains the economic benefit of those collateral assets, while giving the transferee the full right of use of the assets.
2. OTC Derivatives Transactions:
The International Swaps and Derivatives Association (ISDA) have published a market standard legal agreement (the ‘ISDA’) for use when over the counter derivatives transactions are entered into. Two different credit support annexes (‘CSAs’) have been published to form part of the ISDA Agreement, if agreed between the parties. These CSAs permit the OTC derivatives parties to mark their derivatives positions to a current market value and seek to collateralise the party who bears any market exposure. The two different types of CSA are:
a) The English Law CSA (outright transfer of title)
This annex allows the parties to mark their OTC derivatives transactions to a current market value on a daily basis and call for collateral if the market has moved against one party causing an exposure. If there is an exposure, certain collateral assets (agreed upfront between the parties) will be delivered outright in title to the exposed party. All ownership rights in those collateral assets are transferred. As with the GMRA and GMSLA, this CSA also includes a contractual obligation on the transferee to reimburse income, dividends or interest on collateral assets to the transferor. This ensures that the transferor of collateral retains the economic benefit of the collateral assets. The transferee however gains the right to use the collateral assets as they please.
b) The New York Law CSA (pledge)
This form of CSA similarly allows the marking to market of the OTC derivatives positions against a current market value, but collateral assets are pledged to secure the exposure. This means that ownership rights do not transfer to the secured party. Although the New York Law CSA (in its original form) permits co-mingling of pledged assets with the secured party’s own assets and also permits the right of re-hypothecation, this structure is often not recognised in common law jurisdictions. So, when using this agreement in South Africa, the right of rehypothecation needs to be disapplied in the CSA schedule and additional drafting needs to be included to ensure that collateral assets to be pledged into a segregated account for the benefit of the secured party. As a pledge arrangement does not involve the ownership rights being transferred to the secured party, income payments will be made to the pledgor (since he retains ownership of the assets and along with it the right to receive income).
When considering the method of providing collateral, it’s important to weigh up the benefits and risks that pledge and outright transfer in title involve. These can be summarised as follows:
An outright transfer of collateral gives the transferee the right of use of the collateral assets (and therefore is not a liquidity restraint), while ensuring that the transferor retains the economic benefit of the asset (by the contractual right to receive distributions, dividends and income on the collateral assets). It is important for the transferor to manage excess collateral held by the transferee. The reason being that if the transferee goes insolvent, the collateral assets will form part of the insolvent party’s estate, and the transferor is at risk of not being able to recover those collateral assets. As such, excess collateral postings becomes a credit risk to the transferor in an outright transfer of title arrangement.
A pledge of collateral ensures that the pledgor does not lose ownership or possession of the pledged collateral. In common law jurisdictions the secured party does not have the right of use of those pledged assets, and the pledged assets must be held in a segregated account for the benefit of the secured party. Income, dividends and distributions will accrue to the legal owner of the assets (being the pledgor). The risk of posting excess collateral is much less under a pledge (especially in common law jurisdictions), due to the fact that the pledged collateral is held in a segregated account, for the benefit of the secured party, and is therefore easily identifiable and not co-mingled with the insolvent party’s estate upon an insolvency.
As an aside, If one considers that initial margin for OTC derivatives, is effectively ‘excess collateral’ as it covers a potential future exposure (rather than an actual exposure), it follows that initial margin should always be pledged, segregated and not used, in order to protect the pledgor against the risks associated with excess collateral mentioned above.
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