Financial Collateral Arrangements

• Author: Gulenay Rusen
• Position: Res. Ass. Anadolu University, Law Faculty Eskisehir/Turkey
• Pages: 250-258

Page 250

1. Introduction

Reforms in insolvency law have triggered the significance of collateralisation which can be deemed as a primary risk mitigation technique gaining much importance day by day. Financial institutions carry on cross-border trading without the restrictions of exposure limits by taking and giving collaterals which cover all or part of those credit exposures. (Coiley, 2001) The value of collateral held by the European Central Bank at the beginning of the 2000 was 550 billion US dollars and nearly the 160 billion dollars of this amount was held on cross-border transactions.(Summe, 2001) These gigantic totals well illustrate the importance of collateralisation on financial markets.

Increasing use of securities and collaterals in transactions also brings the legal ambiguity in today's financial markets which are trying to globalise. It should have been noted that without legal certainty an achievement can not be obtained in a complete manner. To solve this legal ambiguity in financial markets, reform movements have been started through out the world from different groups, institutions and communities involving both jurists and practitioners. ¹

The Directive on settlement finality in payment and securities settlement systems (Directive 1998/26/EC of the European Parliament and of the Council of 19 May 1998 on Settlement Finality in Payment and Securities Settlement System [1998] OJ L166/45, hereafter cited as the Settlement Finality Directive) and the Directive on financial collateral arrangements (Directive 2002/47/EC of the European Parliament and of the Council on Financial Collateral Arrangements [2002] OJ L168/43, hereafter cited as the Collateral Directive) were adopted. These two directives are both supplementary legislations for the Directive of the Parliament and of the Council on the reorganisation and winding up of credit institutions dated 4 April 2001(Directive 2001/24/EC of the European Parliament and of the Council on Reorganisation and Winding up of Credit Institutions [2001] OJ L125/15, hereafter cited as the Reorganisation and Winding up Directive). All of these directives are the circles of a chain that aims the proper functioning of the internal financial market in European Union. In this paper, mainly the Collateral Directive will be taken into account as the subject of this paper is collateral arrangements. Firstly, the necessity of a harmonised collateral law and the aims of the Collateral Directive will be handled. Following, the main provisions of the directive will be analysed in details. While analysing in details, the different implementations of the directive in member states will be mentioned. Finally, the conflict of laws clause and the consequences of the directive will be explained.

Page 251

2. Necessity For A Harmonized Collateral Law

Collaterals have became the vital instruments for the modern financial markets as they are used nearly in all types of transactions such as; bank treasury and funding, payment and clearing systems, repurchase agreements, general bank lending and etc (Lober & Klima, 2006). It is stated in the tenth semi-annual survey of the repo market that the EU repo market size is now estimated to be in excess of Euro 5.8 trillion.² Creditors naturally want to obtain enforceable and valid collaterals to reduce their credit risk. In payment and securities settlement system, collateral is the major mechanism to decrease the systemic risk (Lober & Klima, 2006).

Collateral can be in the form of the cash or securities and when it comes to dematerialised securities, the problems start to emerge. In classical "direct holding systems", the owner of a security has direct relationship with the issuer. However, "indirect holding systems" which are very commonly used in nowadays transactions, consist of more then one tier of intermediaries between issuer and investor. As a result of this multiple securities and multiple layers of intermediaries occur. When a problem arises like opening of the insolvency proceedings against one of the parties, it becomes a very sophisticated issue because each state has its own law regarding to above mentioned issues. In addition to this, not only substantive laws of the states vary from each other, but also conflicts of laws approaches vary. (Einhorn & Siehr, 2004) Hence, different national laws may apply to separate parts of the transactions. For instance, assets provided as collateral may situate in one state, debtor's domicile can be in another state, debt can also be governed by a third state. Indirect holding systems make it much more sophisticated as an indirect holding system may consist of a lot of tiers like, international central securities depositories, financial institutions, brokers, individual investors and etc.³

The Finality Settlement Directive and the Collateral Directive have been adopted as a solution for the above mentioned situations that would probably hamper the internal financial market. Although the Finality Settlement Directive constituted a milestone for payment and securities system, it has a rather restricted scope and only covering some types of collateral arrangements. Because of this, a new action was started to create legislation on collateral arrangements that would go beyond the scope of the Finality Settlement Directive, after taking consultations from market experts and national authorities. (The Collateral Directive, recital 2)

3. Financial Collateral Arrangements Directive

3. 1 Main objectives of the Directive

The aim of the directive is to contribute the stability and cost-efficiency of financial market, so that the free movement of capital in the single market will be provided. It also aims to ease the implementation of the common monetary policy. This can be achieved by fostering the efficiency of the cross-border transactions of the European Central Bank and permitting the participants in the money market to balance the comprehensive amount of the liquidity in the market among themselves. (Asgeirsson, 2003/4) The main objectives of the directive are: (Vereecken & Sylvia Kierszenbaum, 2005; Turing, 2007).

· Removing certain obstacles to the efficient use of collateral arrangements by limiting the formalities for the creation or enforcement of the financial collaterals. So that the burdens in the national laws regarding to the form, validity, completion and substance of collateral arrangements would be abolished (Collateral Directive, article 1(2)(a)-(d)),

· Supporting the protection of collateral arrangements from insolvency and reorganization rules,

· The reuse of the collateral is allowed as if collateral takers owned it,

· Recognizing the title transfer of the collateral arrangements and close-out netting structures,

· Enlighten the issue of the applicable law to book-entry securities collateral by stating that the governing law shall be the law of the country where the securities account is maintained.

3.2. Scope

3.2.1. Personal Scope

Parties to agreements on financial collateral arrangements are listed in article 1(2). These parties are; specific financial institutions, namely public sector debt and account management bodies, central banks, multilateral Page 252 development banks, international financial institutions, central counterparties, settlement agents and clearing houses.(Collateral Directive, article 1(2)(a)-(d)) An additional category is also stated in article 1(2)(e) as "persons other than natural persons, including unincorporated firms and partnerships may participate in such arrangements provided that the other party is an institution defined in above articles 1(2)(a) to (d)." However an opt-out clause is stated for Member States so that they may exclude this additional category. (Collateral Directive, article 1(3)) This opt-out clause is the result of the countries which are supporting the need for stable and efficient financial market. (Lober & Klima, 2006)

Implementation of the personal scope of the directive differs between Member States mainly because of this opt-out clause. It is remarkable that except for Austria, all the other Member States have not used a full optout clause somehow. Malta had also decided to exercise this opt-out clause when they first implement the directive on May 1 2004, however they revoked this clause after having consultations with the local financial services industry on the basis that the other persons (including unincorporated firms and partnerships) stated in article 1(2)(e) could not benefit from the advantages of directive such as remedy of appropriation.(Portanier, 2005) An extended implementation is made by Belgium that Belgium has included natural persons, however excepting the title transfer transactions from this extension.(Lober & Klima, 2006)

3.2.2. Material Scope

The Directive only covers the financial collaterals in the form of cash ⁴ or financial instruments ⁵ according to article 1(4). Two types of financial collateral arrangements are defined in article 2(1) (b) and 2(1) (c) and directive applies to both of them. First, one is "title transfer financial collateral...