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Brussels, 30 March 2001

Proposed Directive on financial collateral arrangements - frequently asked questions(see also IP/01/464)

Why is collateral needed and how is it used?

A collateral arrangement involves one party (collateral giver/debtor) delivering some form of property for example, securities and/or cash to another party (collateral taker/creditor) and agreeing that the creditor may use that property, in the event of a default by the debtor, to satisfy outstanding obligations of the debtor to the creditor. The purpose of collateral is to secure the creditor's claim to assets in case the debtor is unable to fulfil their obligations (i.e. instead of having a simple right to the money, the creditor has access to specified assets of equivalent value, also known as a "right in rem").

Collateral is used throughout the EU to support financial transactions. Market participants use it to manage and reduce their credit risks arising from all kinds of financial transactions, from derivatives to general bank lending. It is also used on the money markets where the participants balance the overall amount of liquidity provided by central banks against transactions amongst themselves that match individual surpluses to shortages of liquidity. There are two main types of collateral arrangement:

  • The classic way of providing collateral is by a "pledge", whereby the debtor provides the creditor with collateral, such as securities. The ownership of the collateral remains with the collateral provider, the debtor, but is usually "blocked" in favour of the creditor (the collateral taker). If the debt is not repaid, the creditor has the right to liquidate the collateral and thereby redeem the debt.

  • Another way of providing collateral is by a "title of transfer" (an example includes repurchase agreements - also known as "repo"), whereby the debtor sells the collateral to the creditor in exchange for the loan. Simultaneously, the parties agree that at a future date, the creditor will sell the collateral back to the debtor for an agreed price (the repurchase price) which typically includes the interest on the loan. If the debtor goes bankrupt, the creditor simply cancels the obligation to sell back the collateral and sets off its value against the remaining debt (known as "netting"). This instrument has been developed in order to avoid cumbersome procedures or uncertainties involved in pledge collateral agreements in some Member States.

What are the legal problems with collateral today?

Each Member State has its own legal traditions. The rules that are applied to collateral transactions therefore vary from one jurisdiction to another. For participants in the EU financial market this means having to adjust to a different set of rules for each Member State in which they do business, which is complex and costly. Such differences are particularly problematic with regards to bankruptcy legislation and perfection requirements, as explained below:

  • Bankruptcy legislation. One of the main purposes of bankruptcy legislation is to ensure that all creditors are treated fairly. According to bankruptcy legislation, a transaction in which a creditor has been "favoured" shortly before the moment when the bankruptcy occurs is normally declared invalid by the liquidator (e.g. where an already existing loan has been secured with collateral shortly before bankruptcy, the liquidator can declare that the offering of collateral was invalid). The purpose of this legislation is the same in each Member State, but there are important differences concerning the definition of whether a transaction favours a creditor and whether it should therefore be invalidated. In some countries, it depends on whether or not the creditor has accepted the collateral in "good faith"; (i.e. he was unaware that the company was about to go bankrupt). In other countries there are objective rules, according to which all such transactions securing old debt can be invalidated if the transaction was carried out in a certain period before the bankruptcy occurred. Such differences make it difficult for market participants to agree on cross-border transactions, because foreign bankruptcy legislation could have an impact on the validity of an agreement with a foreign counterparty. Thus, market participants have to be aware of the whole range of bankruptcy legislation applied throughout the Community.

  • Perfection requirements and liquidation of collateral. There are also rules concerning the procedures a creditor must follow to ensure their right to the collateral in the event of bankruptcy of the debtor (and how to ensure priority over other creditors in accordance with the agreement). These procedures are called "perfection requirements" and exist to ensure that the creditor does not illegally benefit from the collateral and to prevent further use of the collateral by the debtor. But collateral takers today must comply with impractical publicity requirements, sometimes dating back many centuries, to ensure that third parties are aware that the assets being provided as collateral would not be generally available in an insolvency situation. In today's fast-moving securities market the application of these rules can be difficult and inconvenient, but failure to comply can result in the invalidity of the collateral. In addition, the circumstances under which the creditor would be allowed to liquidate the collateral differ substantially from one Member State to another. In some jurisdictions, the collateral can be liquidated immediately, but in others the creditor can be obliged to wait several months.

  • The 'Lex rei sitae' rule and location of securities. Problems can arise in determining the location of collateral under the 'Lex rei sitae' rule, which dates back to Roman law and therefore well before the existence of book-entry securities. According to the 'Lex rei sitae' rule, the applicable law is the law of the jurisdiction in which the collateral is located. However, since securities can be moved around the world like money, crediting and debiting securities accounts within a chain of intermediaries, determining where these book-entry securities are located can be problematic.

These differences in legal frameworks between the Member States have made it necessary for market participants to build up large volumes of information on how to handle collateral within the EU. Resources used in this way could be used much more efficiently if Member States could agree on the creation of a simplified minimum Community regime for the provision of securities and cash as collateral. This Directive proposes such a simplified framework to create legal certainty, built on recognition of techniques currently used in the market to the extent that they are fair and reasonable.

What about consumers - how will they benefit from the proposal?

This proposal is part of a whole package of measures the Financial Services Action Plan (FSAP) full achievement of which will create significant benefits for the economy in general, including consumers (see IP/00/556). As explained recently by the Committee of Wise Men chaired by Baron Alexandre Lamfalussy (see IP/01/215), the creation of a more integrated and cost-efficient financial market the objective of the FSAP - will bring significant benefits for the EU economy as a whole, enhancing the potential for stronger economic growth and therefore also for job creation.

This proposal contains two specific measures which will increase liquidity in the collateral market: First is the proposal for a clear statutory regime regarding agreements permitting the collateral taker to re-use the collateral for their own purposes under pledge structures. Re-use of collateral is already known in a number of Member States as "re-hypothecation" or "re-pledging". Secondly, the proposed Directive would allow for collateral substitution, whereby the collateral provider can withdraw particular securities and replace them with other securities of equivalent value if the collateral agreement so provides. Greater liquidity will lead to more efficient price determination and the resulting reduction in market volatility will enable both large and small investors to buy or sell securities more easily and at a fairer price.

Integrated European financial markets will mean that consumers will be better able to purchase financial services and securities from the best European suppliers of investments, insurance and pension funds, with costs falling and net yields increasing as investment choice widens.

What about SMEs in the financial market?

Although most participants in the wholesale financial market are large companies, the proposal could enhance the opportunities for small and medium sized financial entities because counterparties may be prepared to deal with entities with no, or a low, credit rating if they make a collateral arrangement in which they have confidence. This is also the case for cross-border transactions in the money market in the Economic and Monetary Union, which today is dominated by the biggest financial institutions despite the fact that most of the medium sized institutions are also connected to the TARGET cross-border payment system.

Which conditions would the industry have to fulfil in order to be covered by the Directive?

Market participants have to enter into a straightforward written contract outlining the terms of the collateral arrangement. They also have to comply with the simplified perfection requirements, i.e. the collateral taker has to take possession over the collateral or "block" the collateral on a securities account in order to prevent that the collateral provider makes further use of the collateral.

The proposed Directive would apply directly to any financial institution under prudential supervision, central banks, public authorities and persons other than natural persons whose capital base exceeds €100 million or whose gross assets exceed €1,000 million.

Would this proposal only apply to collateral used in a cross-border context?

No, even though the problems are due mainly to the patchwork of different legislation in the Member States, the aim of the proposed Directive is to create an integrated financial market for collateral in the EU. The Directive therefore has to apply to a collateral arrangement whenever it is subject to the laws of an EU Member State.

When will we enjoy the benefits of this proposal?

According to the Financial Services Action Plan, completion of which is due to be achieved by 2005, the objective is that this proposal be adopted by the Council and Parliament in 2003. However, the benefits of this proposed Directive will be available in practice only once it has been implemented into the legislation of all Member States. If the deadline for adoption is met, implementation should take place during 2004.

With regard to the creation of an integrated EU market the answer is unfortunately not so simple. As stated both in the Wise Men Report (see IP/01/215) and in the Report of the Giovannini Group "EU Repo Markets: Opportunities for Change" in October 1999 (see IP/99/794), the lack of integration is also due to the obstacles in the clearing and settlement systems for securities, different taxation etc. But this proposal is one more building block to help deliver the legal basis for the creation of an efficient internal market in financial services.

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