Legal and Security Considerations of Security Loans

Why are loans given by title transfer?

In a securities loan, the lender transfers full legal and beneficial title to the borrower, giving the borrower unencumbered rights of use and access to all the benefits of ownership, such as coupons, dividends, control over corporate actions, and voting rights. This means that the lender must give up all property rights to the loaned securities, and if something goes wrong, they can only pursue a claim for damages against the borrower, rather than reclaiming the security. Without the transfer of legal and beneficial title, the borrower would not have the rights necessary to benefit from ownership or sell the securities short.

Additionally, since the borrower has the right to sell the loaned securities to a third party, the lender must give up the right to the return of the exact same security and instead accept the return of equivalent securities. 

Why do borrowers only have to return an equivalent security at the end of the transaction? 

The term "equivalent" in securities lending refers to the requirement that the borrower returns a security with the same International Securities Identification Number (ISIN) as the loaned security at the end of the loan. This ensures that the transaction involves a full transfer of legal title of the security. This is because, if the lender required the exact same security to be returned, the borrower would be unable to sell the loaned security during the loan and may not be considered the true owner of the security. 

The Global Master Securities Lending Agreement (GMSLA) defines an "equivalent" security as being of the same type, nominal value, description, and amount as the original loan security, which in practice means the same ISIN. 

Can you pledge collateral, rather than transfer it by legal title?

Since 2018, the GMSLA has allowed collateral to be given by pledge as well as by title transfer, but title transfer is still massively preferred. 

Pledging is a common way of providing collateral, where the pledged collateral is placed under the control and possession of the pledgee. However, the ownership of the pledged collateral remains with the pledgor, and the pledgee is not allowed to use the collateral unless there is a default and the pledgor is also entitled to receive the exact same security back at the end of the transaction. 

One major issue is that pledges and other types of "security interests" are subject to the statutory insolvency process if the borrower becomes insolvent. Insolvency law often requires strict formalities, called "perfection requirements," for creating pledges, such as public registration and publicity procedures. These requirements can be lost through technical mistakes, and if an insolvency occurs, insolvency law does not allow insolvency to be used as an event of default, delaying creditors' response to a default. 

Pledges and other security interests are also not effective in so-called quasi-insolvency events like Chapter 11 or administration, in which a borrower seeks temporary protection from creditors while trying to resolve its problems. 

Additionally, insolvency law may impose burdensome or impracticable restrictions on how collateral is liquidated, and insolvency is not a cheap process for creditors. 

Finally, close-out netting is impossible or impracticable with pledged collateral, which is an essential defence for creditors in the case of repos, securities loans, and derivatives.

Pledge collateral, therefore, is intended for a very special case, borrowing from counterparties in countries with a high regulatory risk-weight. Giving collateral to such parties, results in a large regulatory capital charge. A solution to this problem was provided by a change in regulation that was necessary to allow the collateralisation of OTC derivatives under the Basel prudential standards framework. Regulators require each party to place an initial margin in an escrow account established for the benefit of the other party, which can then only be accessed on the default of the counterparty. The collateral are placed in escrow accounts as pledges, which means that, because ownership is retained by the giver of the collateral, it is not taking a risk on the counterparty and so there is no capital charge.