SFTR – Collateral Reuse (rehypothecation)

SFTR – Collateral Reuse (rehypothecation)

 Collateral Reuse – PILLAR III

Reuse of collateral provides liquidity and enables counterparties to reduce funding costs. However, it tends to create complex collateral chains between traditional banking and shadow banking, giving rise to financial stability risks… Reuse should take place only with the express knowledge and consent of the providing counterparty.

SFTR[I]

 

Principle sources:

  1. SFTR Article 15
  2. SFTR Recitals 21-25
  3. Information Statement in accordance with Article 15 of the Securities Financing Transactions Reg ulation; ICMA; 13.05.2016
  4. MiFID II Article 16(10)
  5. MiFID II Delegated Act 7.4.16 Recitals 6-9
  6. MiFID II Delegated Act 7.4.16 Articles 5(4),(5), 6
  7. MiFID II Delegated Act 25.4.16 Article 63(2)
  8. Money Market Funds Regulation Article 14

 

Quick Read: SFTR establishes minimum standards which are ‘without prejudice to stricter sectoral legislation’, including ‘national law’. Collateral reuse can only occur when providing counterparty has been informed in writing.

Note link with MiFID II – no Title Transfer Collateral Arrangements (TTCA) allowed with retail clients.[ii] ‘Firms should be allowed to use TTCA with non-retail client only if they demonstrate the appropriateness of TTCA in relation to that client and disclose the risks involved as well as the effect of the TTCA on his assets. Firms should have a documented process of their use TTCA.’[iii]

Also note link with MMF Regulation. Non-cash collateral received under a repo agreement should not be sold, re-invested or pledged or otherwise transferred without prior consent.[iv]

What is reuse?

  • There is a subtle difference between re-hypothecation and reuse. Re-hypothecation means re-pledging.
  • Recall that European Repos are governed by the GMRA 2011 which obliges both counterparties to settle disputes under English law.
  • Under English law, in a pledge the legal title of the goods remains with the pledgor (creditor). The pledgee takes possession but not legal title of the goods.
  • Under the GMRA 2011, absolute title is passed to the collateral-taker (lender) who is thus free to dispose of the collateral however he wishes – including reusing it.
  • ‘reuse’ means the use by a receiving counterparty, in its own name and on its own account or on the account of another counterparty…of financial instruments received under a collateral arrangement (e.g. transfer of title or exercise of a right of use in accordance with Article 5 of Directive 2002/47/EC) but not including the liquidation of a financial instrument in the event of default of the providing counterparty;[v]
  • SFTR reuse laws now circumscribe this English law propriety right.

In summary, it is more accurate to use the word reuse rather than re-hypothecate.

When Legal Force?

  • As of 13 July 2016, including for collateral arrangements existing on that date.[vi]

Penalties for infringement

  • €15 000 000 or, in the Member States whose currency is not the euro, the corresponding value in the national currency on 12 January 2016, or up to 10% of the total annual turnover of the legal person according to the last available accounts approved by the management body for infringements of Article 15.[vii]

Reuse restrictions

  • Counterparties can only reuse financial instruments received as collateral if:
    • the receiving counterparty duly informs the providing counterparty in writing of the risks and consequences that may be involved in one of the following:
      • granting consent to a right of use of collateral provided under a security collateral arrangement in accordance with Article 5 of Directive 2002/47/EC;
      • concluding a title transfer collateral arrangement;
    • the providing counterparty has granted its prior express consent, as evidenced by a signature, in writing or in a legally equivalent manner, of the providing counterparty to a security collateral arrangement, the terms of which provide a right of use in accordance with Article 5 of Directive 2002/47/EC, or has expressly agreed to provide collateral by way of a title transfer collateral arrangement.
  • SFTR sets minimum requirements for pillar III. ‘[T]his Regulation should be without prejudice to any rule under Union law or national law restricting the ability of counterparties to engage in reuse of financial instruments that are provided as collateral by counterparties or persons other than counterparties.’[viii]

 

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[i] SFTR Recital 21, 22

[ii] MiFID II Article 16(10)

[iii] MiFID II Delegated Act 7.4.16 Recital 5

[iv] MMF Regulation Article 14

[iv]SFTR Article 3(12)

[vi] SFTR Article 2(d)

[vii] SFTR Article 22(4)(g)(ii)

[viii] SFTR Recital 24