Cedel Bank, the Luxembourg-based clearing organization, has unveiled the Global Credit Support Service (GCSS), a new legal structure for holding and transferring collateral interests in securities. Designed to cover all credit exposures, GCSS will be particularly useful for counterparties to swaps who may wish to have their transactions collateralized on a regular mark-to-market basis.
Neither English nor New York law provides a completely fail-safe system for holding or transferring a security interest across international borders. If, in a derivatives transaction, party A goes bust, counterparty B cannot be certain that A's receivers will give B's security interest in the collateral provided by A (in another jurisdiction) priority over A's other creditors. However, Luxembourg law recognizes the concept of the
fiduciaire (fiduciary). A fiduciary has legal title to the collateral which it holds. If collateral provided by A for B's benefit were held by a fiduciary, then A's receivers would be powerless to stop the fiduciary, as legal owner of the collateral, from transferring it to B. It is this feature of Luxembourg law which Cedel Bank is exploiting, in addition to sophisticated law on book-entry securities custody and settlement. To understand the significance of this, it is worth examining the way on-exchange derivatives trading occurs. The clearing house imposes margin requirements on its members. It analyzes each member's positions and arrives at a net margin requirement that will protect the clearing house if that member defaults.
The clearing house has no direct links with members' customers. The members do have that contact: they protect themselves against the risk of a customer defaulting by over-margining - that is, requiring more margin from the customer than is due to the clearing house.
While the clearing house nets the member's positions, the member often requires a level of margin from each customer which assumes only some or no other offsetting positions exists. Greater collateral is required by the member, especially if it is providing a credit line to a customer to fund the customer's margin obligations. If the member obtains a bank guarantee or a pledge of securities from the customer, this reduces the capital the member is required to put up by the regulators. But the problem with the collateral is that part of what is pledged are the market positions themselves. But these are intangibles and English law has difficulty applying a charge (the instrument through which security is taken) to intangibles, although the US Uniform Commercial Code (UCC) provides for registration of such a security interest.
The weakness in English law was recognized and addressed 10 years ago in the Companies Act 1985, but only for the benefit of clearing houses and exchanges. "That's why LIFFE and the London Clearing House were protected against Baring's collapse," explains Eric Bettleheim, who practises English and New York law as a partner at Mayer, Brown & Platt and also specializes in derivatives. It was a committee chaired by him that was instrumental in pushing through the 1985 amendment.
Off-exchange swaps trading relies on netting under master agreements. The four types of credit-support annex - New York UCC, English charge, English set-off and transfer, and Japanese loan and pledge - recently published by the International Swaps and Derivatives Association, provide for collateral to secure the netted obligations. Each party is otherwise dependent solely on the ex-change of cash flows under the transaction. A credit-support annex allows the parties to agree at what point the collateral kicks in - for instance, when the mark-to-market swap falls below a given value or when a party loses its current credit rating. But the credit-support annex is only as good as the underlying legal systems that impinge on it. Hence the significance of Cedel Bank's innovation with its new legal structure.
Cedel Bank is not offering itself as a clearing house for swaps but as an agent for holding and managing swaps collateral. It will shuttle the collateral back and forth between parties to reflect their res-pective positions, leaving them free to carry on swaps trading under their existing agreements. For instance, A enters into a fiduciary agreement with Cedel Bank and a bilateral credit-support agreement with B. Under the fiduciary agreement, Cedel Bank takes legal ownership of the assets pledged by A and records B's interest in the assets in its books. Under a separate fiduciary agreement with B, Cedel Bank agrees to transfer the assets to B on B's instruction. Neither A nor its receiver can interfere with B's right of enforcement should A default.
"The parties don't report their trades, just the aggregated value of each swaps master agreement," says Kathleen Tyson-Quah, senior corporate counsel at Cedel Bank, "nor does the system need standard valuations. The parties enter their own valuations and set out, in the bilateral agreement, the degree of tolerance allowed. So, for example, they may provide for splitting the difference if their valuations are up to 5% apart. We value the collateral daily and move securities and cash between them accordingly."
The difference between this and an on-exchange clearing house is that, as Tyson-Quah says, "a clearing house is only as strong as its weakest member, whereas GCSS need not limit participation. The use of the fiduciary structure overcomes most concerns about cross-border perfection of pledges of securities collateral".
Work on overcoming these problems continues. Important revisions to the UCC are pending in key US states such as New York and California. This month the Capital Markets Forum of the International Bar Association, which brings together some of the leading lawyers in the field, will publish a detailed discussion paper by Randall Guynn, a partner at Davis Polk & Wardwell. The paper covers the need for the international harmonization of securities ownership, transfer and pledging laws.
Arguing that the legal uncertainty surrounding collateral held by custodians increases the cost of capital and reduces the value of the securities held, Guynn upholds Luxembourg law and the revised UCC as models that other jurisdictions could implement. "Investors and secured creditors who hold interests in securities through intermediaries [need] to be certain, once the governing law has been ascertained, that they have a distinct package of rights that cannot be successfully attacked by adverse claimants."