Collateralization and the EU Collateral landscape: a legal update

1. Collateralization and the EU Collateral landscape: a legal update Budapest - September 26, 2002David SuetensSenior Vice President, Risk Management WholesaleTel +31-20-383-22-08E-Mail: david.suetens@nl.abnamro.com

2. Agenda • What is collateralization - Business perspective • Identifying collateral law issues in Europe • Collateral Directive • Way forward

3. Definition of Collateralisation........ • a form of credit enhancement where cash and securities are exchanged against the value of a derivatives portfolio

4. For Example............... Interest Rate Swap - 5 mln (CP owes AAB) Cross Currency Swap 15 mln (AAB owes CP) Net exposure 10 mln (AAB owes CP) So CP calls for collateral from AAB to cover this net exposure of 10 mln Net Exposure Counterparty ABN AMRO Collateral

5. CollateralizationBusiness Drivers Collateralization Creating Business Opportunities Tool for Risk Management Revenue Generator

6. Collateralization Collateral as a creator of business opportunities for you... • Market Access • Larger Transactions & Longer Maturities • More Volatile Transactions • European Debt Market • - Sovereign to sub-sovereign debt issuance • weaker credits • increased solvency costs for banks • - Growth in corporate debt • More non-European borrowers issuing in euros • Deeper and More Liquid Derivatives Market

7. Collateralization Collateral as a tool for risk management…credit risk is being transferred into legal, operational and market risk • Legal Risk • Approved Netting Opinions • Enforceable Collateral Opinions • Operational Risk • Trade Matching identifies mis-booking of a trade • Market Risk • Reconciliation identifies mis-pricing of a trade

8. Risk ManagementImpact on credit add-ons Example 1: Standard 5 Year Interest Rate Swap Uncollateralised Collateralised PFE Low 6% 0.75% Medium 8% 2% High 15% 3% Low = EURO Medium = USD High = Emerging markets Example 2: Standard 5 Year Cross Currency Swap Uncollateralised Collateralised PFE Low 30% 3% Medium 55% 5% High 108% 10% Low = EUR Medium = AUD High = Emerging Markets

9. Legal and Documentation Requirements • ISDA 1992 Master Agreement : • covers the trading relationship • ISDA Confirmation • each transaction will be confirmed • each confirmation will refer to the ISDA Master • ISDA Credit Support Annex (English Law - Transfer of Title) • describes the collateralised trading relationship

10. Operational Requirements • Value derivatives portfolio • Value collateral portfolio • Highlight margin call • Notify and agree collateral movement • Settle collateral • Custodian for securities and cash • Manage coupons and interest payments • Resolve portfolio differences • Reconcile derivatives portfolio from time to time

11. New Basle Capital Framework “The Committee acknowledges the benefits that can accrue from the use of credit risk mitigation techniques and the key role they can play in prudent risk management. Accordingly, the committee believes it is important that the capital framework should provide a better recognition of mitigation techniques.”

12. Identifying collateral law issues • 1999: ECB establishes the European Financial Markets Lawyers Group, discussing possibilities that would lead to a harmonisation in EU Financial markets activity, focusing a.o. on collateral. • 2000: ISDA’s Collateral Law Reform Group publishes a paper ‘The Need for National Law Reform’ • 1999-2000: EU Commission establishes a Forum Group on Collateral • Conclusion: a complex and fundamental diversity of European national laws dealing with creditor rights, property, contract and insolvency laws.

13. Creating a Pledge • Cumbersome and impractical rules for creating, perfecting, maintaining and enforcing pledge collateral: England, France , Greece, Ireland, Netherlands, Portugal and Spain1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

14. Use of Pledge • Legal restrictions on use of pledge collateral: all jurisdictions, except England, Greece and Ireland (most positive view) 1. 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

15. Enforceability of title transfer • Uncertainty regarding the enforceability of title transfer collateral:Denmark, Finland, Greece, Italy, Netherlands, Spain, Luxemburg1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

16. Title transfer versus 3th parties • Uncertainty regarding the vulnerability of title transfer collateral arrangements against third parties: Spain, Finland, France, Germany, Italy, Portugal1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

17. MTM collateral arrangements • Material risk that top-up collateral may be vulnerable as a preference during a suspect period: Denmark, France, Greece, Italy and Spain1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

18. Why change collateral laws?As collateral managers we want …. • Effective and simple regime for pledge and title transfer • Simplify creation, perfection and enforcement • Confirm efficacy of title transfer collateral throughout Europe • Clarify conflict of laws rules • Confirm top-up and substitution • Right of use (‘rehypothecation’) • Part of Financial Services Action Plan

19. Collateral Directive:first Commission’s proposal • all financial collateral • pledge and title transfer agreements covered • No recharacterisation for title transfer arrangements • both provider and taker must be either:- • 1. public authority/central bank or • 2. financial institution. under prudential supervision or • 3. legal person of capital base exceed. EUR 100 million/gross assets exceed.EUR1000 million)

20. Collateral Directive:first Commission’s proposal • Limit rules on creation/enforce • Re-use of pledge? • Recognition of substitution/top-up • Recognition of close-out netting • Recognition of the PRIMA principle (‘place of the relevant intermediary approach’) - EU (15) and Hague (53)

21. Collateral Directive: issues • Scope • the capital/gross assets test? • apply test to one party only? • Collateralized business among corporates? • Result: • Financial institutions (including a.o. Sicav’s, Insurance companies) • Central Banks (including a.o. EIB, IMF, ECB) • Public Authorities • Central counterparty or clearing house • A person other than a natural person, including partnerships, provided that the other party is one of the above. But: OPT-OUT

22. Collateral Directive: issues • Creation of a pledge/title transfer • Occurs often through formal acts, such as: • Filing with an official body • Registration in a public register • Advertisement in a journal or newspaper • Result: • Creation/validity not to be dependent on a formal act if: • The financial collateral arrangement provides for dispossession, ie the provision of the financial collateral • The provision of collateral must be evidenced in writing

23. Collateral Directive: issues • Realization: if the Collateral Taker cannot realise collateral quickly, then • Increased funding cost from re-hedging • Additional collateral required to cover close out period •  Increased transaction costs • Additional risk for Collateral Provider • Result: • No restrictions on realization such as: • Time period • Official/Court Approval • Public Auction or other prescribed sale procedure • Appropriation: only if agreed by the parties in the collateral agreement and its valuation. BUT: OPT-OUT

24. Lifecycle of the directiveThe way forward • 13/12/2001: political orientation agreed by ECOFIN on compromise text under the Belgian presidency • March till June: Second reading by the European Parliament • 6/06/2002: Voting by European Parliament in a plenary session • Publication: 27/06/2002 • Implementation: 18 months after publication ,ie 27/12/2003 • Conclusion: focus on local implementations, avoid carve outs, discuss and convince your legislator of a broad scope