Saso Kraner
LL.M., Columbia Law School, 2015
Where collateral secures a contractual claim, a right in rem is created. This means it is not only enforceable between the parties to the loan agreement, but also against third parties. The purpose of a collateral arrangement is to protect the collateral taker against default risk relating to the collateral giver. In the event of default, the collateral taker can satisfy her claims using the delivered collateral. Collateral is used in different kinds of transactions. This post focuses on its use in financial transactions.
Collateral provided between financial entities is most often in the form of cash or securities (together, “financial collateral”). Acquiring financial collateral is one of the principal ways in which financial entities mitigate credit risk. Over time, special rules developed for financial collateral. One could argue, however, that the development of special rules for financial collateral was not a natural process, and rather, that it was the product of legal change. Before questioning why we treat financial collateral differently from conventional forms of collateral, we have to determine why there was an extension of the privilege of property rights to financial collateral in the first place. This is particularly important as the extension made the value extraction and wealth accumulation from financial collateral possible. And of course, this extension of property rights is still ongoing, and the boundaries of these rights are constantly challenged or expanded—a process which Professor Katharina Pistor terms the “inflation” of property rights.[1]
The International Swaps and Derivatives Association (ISDA) played an important role in the development of the special rules for financial collateral. According to ISDA, legal uncertainty “seriously [impeded] the efficient use of collateral” and limited “the amount of business that could otherwise be done on a collateralised basis.”[2] This concern spurred ISDA to argue for modification or disapplication of rules relating to conventional collateral when determining the rules for financial collateral. Morgan argues that the reason for this lobbying effort was to secure the enforceability of the ISDA Master Agreement under different national laws.[3] Demand for legal change was strong and influence over lawmakers substantial, and as a consequence, in 2002 the Directive on Financial Collateral Arrangements (Directive)[4] was adopted in the European Union. The objective was to create a uniform and standardized EU framework for financial collateral under both security interest and title transfer structures.[5] The Directive also made certain rules relating to insolvency law (for example, close-out netting and top-up collateral rules) inapplicable to financial collateral arrangements.[6] Moreover, it addressed the creation, validity, perfection, and enforceability of an interest in financial collateral under a financial collateral arrangement.[7] Last but not least, it attempted to eliminate the re-characterization risk—the risk that a title transfer arrangement could be re-characterized as a security interest arrangement (pledge).[8]
In Germany the Directive was implemented in 2004 by a single act of the legislature, which amended existing rules and integrated new rules into existing national legislation. Germany has chosen to apply the Directive as a device for dealing with problems that might arise with contracts between certain financial entities using, for example, financial derivatives, involving security being taken over only financial collateral. As an example of this, Germany implicitly refused to implement the right to use—or at least the legislature believed (rightly or wrongly) that it did not have to change anything. Rather the legislature left it to the courts to determine the right of use on a case-by-case basis.
There are good policy reasons for having a legal regime that provides for a more uniform basis for the taking of financial collateral. For example, a harmonized legal regime can set a level playing field for financial entities based across the EU, encouraging them to undertake more transactions, which in turn would lead to increased liquidity in the market. However, as argued by Professor Katharina Pistor, law can also cause the corrosion of the efficacy of system-stabilizing laws and regulations because it creates regulatory pluralism.[9]
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[1] Katharina Pistor, Law and the Financialization of Wealth 4 (Jun. 24, 2014) (unpublished manuscript) (on file with author).
[2] See Int’l Swaps and Derivatives Ass’n, Collateral Arrangements in the European Financial Markets, The Need for National Law Reform 4 (2000).
[3] Glenn Morgan, Market Formation and Governance in International Financial Markets: The Case of OTC Derivatives, 61 Hum. Rel. 637, 637 (2008).
[4] See Parliament and Council Directive 2002/47/EC, On Financial Collateral Arrangements, 2002 O.J. (L 168) 43.
[5] Parliament and Council Directive 2002/47/EC, supra note 4, Preamble ¶ 3.
[6] Id. Preamble ¶ 5.
[7] Id. Preamble ¶ 9.
[8] Id. Preamble ¶ 13.
[9] Katharina Pistor, A Legal Theory of Finance, 41 J. Comp. Econ. 315, 328 (2013).
