A word about credit risk mitigation
A legal security interest — a type of bailment, if we’re getting technical — created by transferring possession of an asset by way of security for a an obligation, with the intention to create that security interest. It is the act of pledging, not the document evidencing the pledge, that matters.
The pledgee takes a “special” proprietary legal interest in the assets, though, but does not take legal title to them. The key factor is possession. This makes a pledge kind of awkward where the debtor wants to carry on holding or using the asset — in that case, a floating charge or an assignment by way of security is better — but you do see it (as for example in the 1995 ISDA CSD (English law) — though that document is far less popular than the non-pledge 1994 ISDA CSA (NY law), which is a straight out title transfer collateral arrangement.)
Preferred means of delivering collateral vary in different markets. If you had to generalise, you would say our American friends, west across the big ditch, prefer pledge mechanics; British and commonwealth types tend to favour title transfer.
The big difference between 1994 New York law CSAs and English law CSAs: title transfer and pledge
This feels as good a time as any to raise the great subject of title transfer and pledge. Under a 1994 New York law CSA one transfers Credit Support by means of pledge. Under a English law CSA one transfers Credit Support by means to title transfer.
What is the difference? Well, in a Nutshell™:
Title transfer under a English law CSA
Under a “title transfer collateral arrangement” when a party provides collateral it transfers it to the other party outright and absolutely: it gives it, free of all reversionary interests, to the Transferee.
- Securities delivered to Transferee become the Transferee’s property absolutely
- Transferee does not hold them in custody for the Transferor;
- Transferee has only an obligation to redeliver an equivalent security.
- Therefore no CASS or custody question arises at any point - the Transferor gives up all legal claims to the asset.
- Nor does it make any sense to talk about the Transferee’s right to reuse or rehypothecate the asset. It owns the asset outright: by definition it can do what it wants with it; the Transferor can’t stop it.
Pledge under a 1994 New York law CSA (and a English law CSD)
Examples: The 1994 New York law CSAs and the English law CSD are security financial collateral arrangements in that the Pledgor creates a security interest over the document in favour of the Secured Party, but retains beneficial ownership of the assets.
- The Pledgor delivers the assets to the Secured Party to hold in custody, subject to the security interest, for the Pledgor. The Pledgor retains title to the assets.
- Secured Party holds the assets subject to a security interest securing its payment obligation under the related transaction.
- The custody arrangement only exists while Secured Party holds the security, not before.
- Under the 1994 New York law CSAs the Secured Party may nonetheless be entitled to sell the pledged asset absolutely, under a process known as rehypothecation. Don’t laugh. The JC thinks this converts the pledge into a title transfer collateral arrangement — at least at the point of rehypothecation. If so, it makes you wonder why, you know, all the fuss with security interests.
“Transaction” versus “Credit Support Document” complicated affair.
You are going to love this. Strap yourselves in. Are you ready?
- English law CSAs are Transactions but are not Credit Support Documents.
- 1994 New York law CSAs not Transactions, and, explicitly, are Credit Support Documents, though you should not (according to the user’s guide) describe the parties to one as “Credit Support Providers”.
- English law CSDs (including the 2018 English law IM CSD) are not Transactions and, explicitly, are Credit Support Documents.
This means the Events of Default for failure to pay under an English law CSA — being a Transaction, a failure to pay under it is a Section 5(a)(i) Failure to Pay or Deliver — are different from those applying to New York law CSAs and English law CSDs (being Credit Support Documents, a failure to pay under these is a Section 5(a)(iii) Credit Support Default).
Because ownership transfers absolutely, the Transferee doesn’t have to do anything to enforce its collateral. It already owns it outright. Indeed, to the contrary, should the Exposure that the collateral supports disappear, the Transferor will be the creditor of the Transferee. It is as it it were a Transaction under the ISDA where the mark-to-market exposure had flipped around. Indeed, a English law CSA is a “Transaction” under the ISDA Master Agreement — it is an integral part of the ISDA Master Agreement itself, and it is the proverbial schoolboy error to label a English law CSA as a “Credit Support Document”. It is not a Credit Support Document. From the point of view of the ISDA architecture it is the Confirmation for a Transaction.
But the 1994 New York law CSAs are not Transactions, for the same reason: title doesn’t change hands. They are old fashioned security arrangements. Therefore they 'are Credit Support Documents in the labyrinthine logic of ISDA’s crack drafting squad™. This all no doubt must have seen an excellently complex thing for the little gnomes in ISDA’s crack drafting squad™when they were devising the idea of the CSA back in the early nineties. Nowadays, it just seems silly. But here we are, folks.
- Luxembourg pledge
- Account control agreement
- Tri-party collateral arrangement
- This doesn't stop triparty agents requiring title transfer providers to grant their counterparties a right of reuse.