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Banking Essentials - Part I

This pathway will walk us through the basics of banks, starting with some of the different types and their main functions, then starting to look at the regulation faced by the banks, both before and after the Global Financial Crisis.

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Tackling the Cost of Living Crisis

In this video, Max discusses the cost-of-living crisis currently enveloping the UK. He examines its impact on households as well as the overall economy.

CSR and Sustainability in Financial Services

In the first video of this two-part video series, Elisa introduces us to sustainability. She begins by looking at the difference between sustainability and corporate social responsibility, two terms that can be easily confused.

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Legal and Security Considerations of Security Loans

Legal and Security Considerations of Security Loans

Richard Comotto

30 years: Money markets

In this video, Richard helps us understand the importance of giving loans by title transfer. He further explains the importance of the term ‘equivalence’ and finishes by explaining when pledged collateral can be used and why it is unpreferred.

In this video, Richard helps us understand the importance of giving loans by title transfer. He further explains the importance of the term ‘equivalence’ and finishes by explaining when pledged collateral can be used and why it is unpreferred.

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Legal and Security Considerations of Security Loans

15 mins 8 secs

Key learning objectives:

  • Understand the importance of giving loans by title transfer

  • Understand the importance of the term ‘equivalence’

  • Outline when pledged collateral could be used and why it is unpreferred

Overview:

Securities loans are distinct from traditional loans in several ways. For one, they are typically made through title transfer, with an equivalent security being returned at maturity. This is similar to the way collateral is handled in securities lending, which is also often done through title transfer or as a pledge. These legal characteristics are designed to ensure that the transaction runs smoothly.

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Summary

Why are loans given by title transfer?

In a securities loan, the lender transfers full legal and beneficial title to the borrower, giving the borrower unencumbered rights of use and access to all the benefits of ownership, such as coupons, dividends, control over corporate actions, and voting rights. This means that the lender must give up all property rights to the loaned securities, and if something goes wrong, they can only pursue a claim for damages against the borrower, rather than reclaiming the security. Without the transfer of legal and beneficial title, the borrower would not have the rights necessary to benefit from ownership or sell the securities short.

Additionally, since the borrower has the right to sell the loaned securities to a third party, the lender must give up the right to the return of the exact same security and instead accept the return of equivalent securities. 

Why do borrowers only have to return an equivalent security at the end of the transaction? 

The term "equivalent" in securities lending refers to the requirement that the borrower returns a security with the same International Securities Identification Number (ISIN) as the loaned security at the end of the loan. This ensures that the transaction involves a full transfer of legal title of the security. This is because, if the lender required the exact same security to be returned, the borrower would be unable to sell the loaned security during the loan and may not be considered the true owner of the security. 

The Global Master Securities Lending Agreement (GMSLA) defines an "equivalent" security as being of the same type, nominal value, description, and amount as the original loan security, which in practice means the same ISIN. 

Can you pledge collateral, rather than transfer it by legal title?

Since 2018, the GMSLA has allowed collateral to be given by pledge as well as by title transfer, but title transfer is still massively preferred. 

Pledging is a common way of providing collateral, where the pledged collateral is placed under the control and possession of the pledgee. However, the ownership of the pledged collateral remains with the pledgor, and the pledgee is not allowed to use the collateral unless there is a default and the pledgor is also entitled to receive the exact same security back at the end of the transaction. 

One major issue is that pledges and other types of "security interests" are subject to the statutory insolvency process if the borrower becomes insolvent. Insolvency law often requires strict formalities, called "perfection requirements," for creating pledges, such as public registration and publicity procedures. These requirements can be lost through technical mistakes, and if an insolvency occurs, insolvency law does not allow insolvency to be used as an event of default, delaying creditors' response to a default. 

Pledges and other security interests are also not effective in so-called quasi-insolvency events like Chapter 11 or administration, in which a borrower seeks temporary protection from creditors while trying to resolve its problems. 

Additionally, insolvency law may impose burdensome or impracticable restrictions on how collateral is liquidated, and insolvency is not a cheap process for creditors. 

Finally, close-out netting is impossible or impracticable with pledged collateral, which is an essential defence for creditors in the case of repos, securities loans, and derivatives.

Pledge collateral, therefore, is intended for a very special case, borrowing from counterparties in countries with a high regulatory risk-weight. Giving collateral to such parties, results in a large regulatory capital charge. A solution to this problem was provided by a change in regulation that was necessary to allow the collateralisation of OTC derivatives under the Basel prudential standards framework. Regulators require each party to place an initial margin in an escrow account established for the benefit of the other party, which can then only be accessed on the default of the counterparty. The collateral are placed in escrow accounts as pledges, which means that, because ownership is retained by the giver of the collateral, it is not taking a risk on the counterparty and so there is no capital charge. 

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Richard Comotto

Richard Comotto

Senior Visiting Fellow at the ICMA Centre at the University of Reading, consultant to the International Capital Market Association (ICMA) and its European Repo and Collateral Council (ERCC). Technical expert to the IMF, Asian Development Bank and Frontclear market development company on money market and repo market development in Asia and Africa.

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