Financial Collateral Arrangement

A financial collateral arrangement is an agreement under which one party provides collateral in the form of cash, financial instruments or certain credit claims to secure obligations owed to another party, typically under repos, securities lending, derivatives or central bank operations. The term is defined in the European Union's Financial Collateral Directive (Directive 2002/47/EC), which gives such arrangements a simplified and robust legal treatment across member states.

The directive was designed to make collateral quick to take, easy to enforce and safe from challenge in insolvency, supporting the smooth working of money and capital markets. It covers both title transfer arrangements, such as the standard repurchase agreement and the English-law credit support annex used with derivatives, and security arrangements in which the provider keeps ownership but grants a security interest. The United Kingdom implemented it through the Financial Collateral Arrangements (No. 2) Regulations 2003, which continue to apply.

When you pawn a watch, the pawnbroker holds it until you repay. If you do not, the pawnbroker can sell it without a long court case, because that was the deal. The rules make pawnbroking quick and simple for both sides.

Banks and investors lend each other huge sums every day, backed by cash or bonds instead of watches. A financial collateral arrangement is the legal setup that lets them do this safely. The law says the lender can quickly use or sell the collateral if the borrower fails, and that other creditors or a bankruptcy administrator cannot easily undo the deal.

• Title transfer financial collateral arrangement. The collateral provider transfers full ownership of the collateral to the taker, who must return equivalent assets when the secured obligation is met. Repos, many securities lending agreements and some margin agreements work this way.
• Security financial collateral arrangement. The provider keeps ownership but grants the taker a security interest, such as a pledge or charge, over the collateral, which must be in the taker's possession or under its control.

The directive applies where both parties fall within covered categories, such as public authorities, central banks, financial institutions, central counterparties and, at a member state's option, other companies; individuals are excluded. Eligible collateral is cash, financial instruments and, since a 2009 amendment, credit claims such as bank loans.

• Fewer formalities. Member states may not require registration, notarisation or similar steps as a condition of validity or enforceability.
• Fast enforcement. On an enforcement event, the taker can sell the collateral or, if agreed, appropriate it at a fair value, without prior notice, court approval or a waiting period.
• Close-out netting. Contract terms for close-out netting must be recognised even if insolvency proceedings have started.
• Insolvency protection. Arrangements and top-up collateral provided under them are shielded from certain insolvency rules that could otherwise void them.
• Right of use. Under a security arrangement, the parties can agree that the taker may use the collateral, a form of rehypothecation, subject to returning equivalent assets.

The requirement that collateral under a security arrangement be in the taker's "possession or control" has been the subject of court decisions in England, which have considered how much control over an account the taker must have for the protections to apply. Arrangements also need clear terms on collateral substitution, haircuts, valuation and margin calls. The EU Securities Financing Transactions Regulation adds conditions on the reuse of collateral, including disclosure of risks and prior consent from the provider. In derivatives, regulatory margin rules for non-cleared trades require initial margin to be held on a segregated basis, often through security arrangements with third-party custodians, while variation margin is commonly transferred outright.

The United States reaches a similar result through different laws. The Uniform Commercial Code governs security interests in securities and deposit accounts, with perfection by control, and the Bankruptcy Code contains safe harbours that let counterparties to repos, swaps and securities contracts close out and enforce collateral despite a bankruptcy filing. Internationally, model documents from industry bodies, such as master agreements for repo, securities lending and derivatives, are drafted to fit these regimes, and legal opinions on enforceability in each country support the netting and capital treatment of collateralised exposures. Weak collateral law can increase credit risk and capital costs, which is why the directive is regarded as an important part of the EU's insolvency and market infrastructure framework.

• Directive 2002/47/EC on financial collateral arrangements