Variation margin: deep history Pt 1

In the worlds before Monkey, primal chaos reigned.Heaven sought order — butThe phoenix can fly only when its feathers are grown.The four worlds formed again and yet againAs endless aeons wheeled and passed.Time and the pure essences of heaven,The moisture of the Earth, the powers of the sun and the moonAll worked upon a certain rock, old as creation, and it becameMagically fertile.That first egg was named, “Thought”.Tathagata Buddha, the Father Buddha, said:“With our thoughts we make the world.”Elemental forces caused the egg to hatch.From it then came a stone monkey.The nature of Monkey was —Irrepressible.

— David Weir, Monkey 1978

As JC starts to overhaul the CSA Owners’ manuals I thought it might be nice to take a step back and look at the deep background to collateral as we glom it today. The road is long, and it has its roots in custom and practice in the industrial revolution. There is deep mythology in play, too. I know this because I made it up myself.

I was prompted to embark on this by the question:

“Why is collateral pledged under New York law CSAs while it is title transferred under English Law ones?”

Like so many of the mystic principles of the law, younglings are told this at an impressionable age, expected to absorb it, take it as read, and thereafter not ask impertinent questions about it.

JC’s dismal career trajectory might have something to do with asking questions that were impertinent — or stupid — in the supervising partner’s eyes there is little difference. In any case, I asked myself this question and — well you know me, readers — I went and fell right down a rabbit hole, didn’t I?

So here is the JC’s deep backgrounder on collateral, security and the role they play in mitigating credit risk and financing costs of lending and financing in modern markets, and why English law variation margin arrangements tend to be by title transfer, and New York ones by pledge.

Where the fossil record is incomplete — or I can’t be bothered looking into it — I have followed the time-tested JC tactic of making it up out of whole cloth. This is my truth. Buckle in!

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Security & collateral. Credit & funding

This is a story about two pairs of concepts: “security” vs. “collateral” and “credit” vs. “funding”. These pairs relate to the business of lending and subtly different, financing. In their way, they help to distinguish between “lending” and “financing”. “Lending” and “financing” is another pair of conjoined, but independent, concepts. It is profound, and resists frontal assault. We can attack it through these proxies.

Security vs. collateral

The first pair is “security” and “collateral”. Herewith the first JC invention: a clean distinction between them. For the purposes of this essay, and perhaps only for the purposes of this essay:

Security is an immaterial legal right—a mortgage, charge, lien, an equitable interest.

Collateral is physical possession of a material thing—an asset, delivered to a creditor’s order for safekeeping.

You may not find it in Black’s Law Dictionary, but it is a practical distinction. Lawyers tend to use the concepts interchangeably: they fulfil similar roles when it comes to mitigating credit risk, but as we will see, not when it comes to funding.

Mainly, lawyers understand credit risk better than they do funding, because credit is the risk something might in the future go wrong, and that is a commercial lawyer’s main preoccupation. But funding is no less — nay, in the round, more — important. But we will get to that.

Now, there are collateral arrangements, security arrangements, and those that are both. I wanted to highlight a term here that captures either legal theoretical interests, whether or not also involving possession, and title transfer collateral interests that necessarily do but, as best as I can tell, there isn’t one.

I thought it might be “encumbrance”, but that implies a security interest, as does “surety”. I tried “posted”, but that conveys the transfer of possession. The commodities people have a concept of “performance assurance”, but that is too wide. Might this be a rare justification for and/or?

I thought that was annoying for a moment but, maybe it is the point. Collateral and security are quite distinct things. They can be, but (in the UK at least) are not often seen in the same room together.

You can have a security interest without any collateral (e.g., an assignment by way of security over contractual rights) and you can have a collateral arrangement without a formal security interest (e.g., a title transfer credit support arrangement). And you can have both. The classic case is the lien.

TL;DR: Security depends on legal magic to work. Collateral doesn’t.

So, that is the first pair of concepts. Security: immaterial rights. Collateral: stuff.

Credit vs. funding

The second pair is “credit risk” and “funding”.

Credit

From early in our careers we learn that, when it comes to handing money over to strangers, credit risk is a lender’s most obvious concern. Even lawyers understand it instinctively: will the borrowers be able repay? What are my weapons if they cannot?

Where a lender has collateral, there is little fuss. She holds it. She can sell it, claim what’s owed and give whatever’s left back. Other creditors can squabble over that to their hearts’ content. Our heroic lender is away, Scot-free.

Where the lender has only security, she is still okay: she can jump the unsecured creditors in the queue and seize secured assets — whereupon they become like collateral, so she can sell them and account for the profits — but to do that she must take formal legal steps, which require a court’s help and are easy to muff up. There is always the risk of challenge by other creditors.

If we invert the old saw Security is one tenth of the law. Possession, is the rest.

Another difference between security and collateral is who has the use of the assets in the mean time?

The lender holds collateral assets. The borrower gives them up at the outset.

The borrower holds secured assets. The borrower keeps possession, but is restricted in what it can do. The lender has no right to intervene unless and until it is entitled to “enforce” its security. But this is an action of last resort, taken only with heavy heart and when all hope is lost. Everyone — borrower and lender alike — is fervent in their hope they this day never comes.

Usually, it never does: a bankruptcy is a remote possibility: a “tail event”. it happens rarely. But it is catastrophic when it does. Security arrangements where the borrower gets to keep its asset are therefore contingencies: forms of insurance a lender puts in place to guard against extreme events. Collateral arrangements, where the borrower collateralises day one, are not.

Another difference — a corollary to the above — is the depth of credit mitigation. The “credit value” of identified collateral is inherently limited to its liquidation value: once it is gone, it is gone. Hence, collateralised obligations tend to be subject to a haircut, regularly “marked to market” and exchanged to ensure there is always a buffer to cover the debt after liquidation. By contrast, a security right against a person is usually unlimited, to the value of the debt, against the person who grants it. You can pursue the guarantor to bankruptcy, if need be, to recover a beneficiary’s debt.

On the other hand, “enforcing” against collateral is dead easy: you just sell it. No particular ceremony, though you must be carefully to achieve a fair price in the market. The more liquid your collateral, the easier that is to monitor. But enforcing security interests is elaborate, involves lawyers, courts and frequently bankruptcy administrators.

So credit is the assessment of a borrower’s likelihood of repay her debt. “Credit risk mitigation” is anything a lender does to improve that likelihood in the event of the borrower’s failure. Security interests and collateral arrangements both mitigate credit risk.

Funding

Funding is the business of finding the money with which a lender makes a loan in the first place. Lending institutions need reliable funding sources: those may be their own customer deposits, separate banking facilities, or medium term note and commercial paper programmes and the bank’s repo and securities lending arrangements, whereby it “lends out” its inventory of securities held for investment, as hedges and as collateral in connection with its customer trading business.

This unglamorous but important business — making sure there is enough money available to lend, and at good rates, to whoever wants to borrow — falls to the bank’s treasury department. Wherever it comes from, money — “funding” — comes at the cost of the interest the bank must pay on it. A bank will do whatever it can to reduce its “cost of funding” and broaden its sources of funding.

A day one cost

Unlike credit risks, funding costs are remote contingency that everyone hopes will never happen. They are a fundamental input cost to the business of providing loans. Optimising funding costs can dramatically boost a bank’s overall performance. Getting it wrong can, in rare cases, be catastrophic — the classic example is Silicon Valley Bank — but in any case, managing funding is not a “once in a blue moon”, tail-risk sort of thing. It matters on every loan on every day.

The imperatives of funding optimisation, therefore, have quite different implications for the kind of security or collateral involved.

Though collateral and security interests both address the credit risk, only possessory collateral is any use in managing its funding costs.

Security ⇒ credit.Collateral ⇒ funding.

Formal security arrangements like charges, mortgages, debentures and informal ones like liens give the lender confidence it will be repaid, but they don’t help fund lender. Having confidence your debt will be repaid does not raise the money needed to lend it in the first place.

It seems obvious and usually, would go without saying: the reason borrowers come to banks is because they need money and don’t have it.

Some borrowers do have non-cash assets they do not for the time being need. Especially financial counterparties like investment funds. They tend to be flush with portfolios of investment securities that they have bought and from which they expect to earn a return. That return is a function of time, and while that time passes, those investment securities are just loafing about not really doing anything. A resourceful treasury manager will try to use these securities as collateral. She will deliver these, bodily, to her lender in return for a more competitive loan rate. The lender can afford a more competitive loan rate because that collateral is a potential source of funding.

The lender can monetise the collateral by selling it or onwards “re-pledging” it into the market to generate the money needed for the loan, on condition that it will buy it back, or unwind the pledge, when the loan has been repaid and the borrower wants its collateral returned.

We can see that financial instruments pledged as collateral with this freedom to “reuse” them do help fund the lender’s loan portfolio.

The history of financial collateral is, essentially, a shift from arrangements providing only credit protection to arrangements providing both credit protection and funding optimisation. This required the development of technology to support it. It is, in a way, the history of securities financing.

It starts a long way back, before the dawn of the Age of Swaps. We will go there, next time.

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