FIND­ING A BAL­ANCE

Business Day - Business Law and Tax Review - - BUSINESS LAW & TAX REVIEW -

get a re­turn that is equal to or ex­ceeds the con­trac­tual re­turn due to the col­lat­eral giver. The move away from cash is fur­ther il­lus­trated in the se­cu­ri­ties lend­ing mar­ket, with non-cash col­lat­eral now rep­re­sent­ing 60% of col­lat­eral re­ceived by lenders, ac­cord­ing to the ISLA Se­cu­ri­ties Lend­ing Mar­ket Re­port — Septem­ber 2015.

While the year-on-year per­cent­age in­crease may not be con­sid­ered to be sig­nif­i­cant, it is ex­pected that this trend will con­tinue into the fu­ture, with a growth in the de­liv­ery of other se­cu­ri­ties for col­lat­eral, as cash and gov­ern­ment se­cu­ri­ties are used to meet the new reg­u­la­tory liq­uid­ity re­quire­ments. Th­ese find­ings are con­sis­tent with those emerg­ing from the Deloitte 2014-15 in­ves­ti­ga­tion.

The Group of 20 (G-20) man­dates that stan­dard­ised de­riv­a­tives should be cen­trally cleared. The move to­wards the cen­tral clear­ing of all over-the-counter de­riv­a­tives will gen­er­ate a rise in the de­mand for cash, as cen­tral coun­ter­par­ties re­quire cash col­lat­eral to be posted. The bi­lat­eral post­ing of cash col­lat­eral for margin­ing pur­poses will re­sult in more cash be­ing placed with cen­tral coun­ter­par­ties, and thus an over­all re­duc­tion in the level of cash held by en­ti­ties.

While the use of non­cash col­lat­eral may present so­lu­tions in ad­dress­ing the above reg­u­la­tory con­straints, non­cash col­lat­eral gives rise to its own com­plex­i­ties. Th­ese in­clude op­er­a­tional risk aris­ing from the day to day man­age­ment in­clud­ing the val­u­a­tion of col­lat­eral, mon­i­tor­ing of con­cen­tra­tion and wrong way risk, as­sess­ment of el­i­gi­bil­ity cri­te­ria, cal­cu­la­tion of man­u­fac­tured div­i­dends-coupons and track­ing of the un­der­ly­ing col­lat­eral. Fur­ther­more, the use of non­cash col­lat­eral gives rise to tax con­se­quences, val­u­a­tion ad­just­ments and fund­ing re­quire­ments.

To ob­tain recog­ni­tion of the col­lat­eral for reg­u­la­tory pur­poses, an out-and-out ces­sion of the non­cash col­lat­eral is re­quired. Under cur­rent tax­a­tion leg­is­la­tion, such trans­fers could at­tract a tax charge (se­cu­ri­ties trans­fer tax-cap­i­tal gains tax which would neg­a­tively im­pact the pric­ing of th­ese trades. How­ever the re­cent Tax­a­tion Laws Amend­ment Act, pro­mul­gated ear­lier this year, will pro­vide re­lief from such tax should cer­tain con­di­tions be met.

The use of non­cash col­lat­eral gives rise to a num­ber of val­u­a­tion com­plex­i­ties, in par­tic­u­lar fund­ing value ad­just­ments. The lat­ter can be ex­plained as the dif­fer­en­tial be­tween the cost of fi­nanc­ing the trans­ac­tion and the re­turn re­ceived on the trans­ac­tion. Al­though rel­a­tively new, both the global and lo­cal mar­ket are still fa­mil­iaris­ing them­selves with this con­cept and may take some time un­der­stand­ing its ap­pli­ca­tion to non­cash col­lat­eral.

In the short term, this may re­strict the mar­ket’s util­i­sa­tion of non­cash col­lat­eral. Lastly, the re­ceipt of cash col­lat­eral pro­vides fund­ing to the re­ceiver, as such cash is fun­gi­ble and can be used by the re­ceiver to fund the un­der­ly­ing trans­ac­tion. The re­ceipt of non­fun­gi­ble (typ­i­cally viewed as non­cash) col­lat­eral re­quires the re­ceiver to raise ad­di­tional fund­ing to fi­nance the deal and this re­sults in a fund­ing cost to the re­ceiver.

Given the reg­u­la­tory changes be­ing driven by the G-20, the in­creased mar­ket volatil­ity and the struc­tural hold­ing of as­sets within the South African mar­ket, a change to the sta­tus quo in col­lat­eral man­age­ment within the South African financial sec­tor can be ex­pected.

What is clear is that col­lat­eral man­age­ment can no longer be viewed as the rou­tine back of­fice task it once was be­fore the financial cri­sis.

The use of col­lat­eral is a com­mon risk mit­i­ga­tion tech­nique used to re­duce credit risk and serves as a means of sta­bil­is­ing the financial sys­tem

Pic­ture: iS­TOCK

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