EU financial collateral arrangements and re-hypothecation in the shadow of ‘shadow banking’: To further regulate or not?

The purpose of this study is to analyze the shadow banking issues related to financial collaterals in the form of book-entry securities, as defined in EU under the Financial Collateral Directive (Directive 2002/47/EC, as in force), the so-called ‘FCD’. It examines different legal approaches related to the activities of securities reuse or re-hypothecation that financial intermediaries, mainly as collateral takers, conduct in modern markets. Despite its positive aspects, it is beyond any doubt that re-hypothecation poses risks to the markets. The collapse of too large both in number and size entities in recent times that negatively affected investors properties in securities pointed out that the ‘too big to fail’ myth is not rather real. To this end, further measures have to be taken in addressing these risks. The study points out the following as areas on which EU regulation should focus in this respect: (a) Collaterals reuse and re-hypothecation should not be regarded as a pure contractual choice but as a specific service or activity that should be subject to further EU regulation and supervision for its provision by the intermediaries. In achieving this goal, it would be appropriate for a reform of the custody activities to be accelerated for the purposes of distinguishing from a prudential regulatory perspective any ‘non-banking type of safekeeping services’, that is, the custody activities that by definition do not include any securities reuse, from the ‘banking type of safekeeping services’, that is, the custody activities that as banking-like credit intermediation activities may include such a reuse. (b) There should be a clear definition of ‘who owns what’ that should operate as a uniform substantive law rule. This definition should cover the need of proprietary aspects and rights in book-entry securities to be recognized on an EU level regardless of the legal nature of the chains of the securities holding systems and intermediaries involved, that is, regardless of the definition of ‘who holds what’. The ‘who owns what’ definition would be appropriate to be based not on the existing ‘securities account’ approach, as adopted by FCD, which in concept reflects the ‘PRIMA’ (‘Place of the Relevant Intermediary Approach’) principles, but on an approach able to accommodate the ownership and the other proprietary aspects in book-entry securities more accurately from a legal perspective. This approach should take seriously into account the concepts of the ‘law under which the securities are constituted’ as an aspect of the lex societatis rule. In this regard and for the purposes of establishing proprietary rights in book-entry securities, the actual owners (shareholders) should be registered as such in the official registrars of the country of the securities constitution. (c) Furthermore and in terms of addressing the issues of cross-border securities holdings, there should be a clear conflict of laws rule in determining the applicable law for all the proprietary aspects in such securities. This rule should be based on the above ‘who owns what’ substantive law definition. In this regard, the applicable law that should define the proprietary rights in securities should be the law under which the securities are constituted. Therefore, any investor registered, for example as a shareholder, under the registry system applicable in accordance with the law under which the relevant securities are constituted, shall be considered as the owner of the securities regardless of the systems and chains of intermediaries to which the investor entrusted their property in such securities to be held. The study considers all these parameters as of extreme importance in addressing the ‘shadow banking’ issues in the securities and collaterals sector and, to this regard, in achieving a real protection for the markets and the investors in EU.This article was submitted to the Journal on 21 November 2014