Repo is not a pledge
The word “pledge” is often applied to repo. This mislabelling is common in emerging repo markets but also in the US and among European regulators, while it is institutionalised in China in that country’s so-called “pledged repo” market. But lending and borrowing against pledged collateral --- “secured loans” --- is very distinct from lending and borrowing through repo.
The key distinction is that a pledge only transfers the control and possession of collateral but not legal title. All that the cash lender in a secured loan receives is a limited property right --- a “security interest” --- which is merely the right to dispose of the collateral but conditional upon a default by the cash borrower. In contrast, the buyer in a “true” repo sells collateral to the seller (with a commitment to repurchase the same type of asset in the future). This gives the buyer control and possession but also legal title to the collateral. And that means that the buyer has the unfettered right to dispose of the collateral from the moment it is delivered.
As a consequence of what does or does not happen to ownership, there is an enormous difference between the reliability of collateral that has been pledged and collateral that has been given by title transfer. Repo was invented to circumvent the problems of collateralisation by pledging. To apply the word pledge to repo is therefore to miss the whole point about repo (if not about secured loans).
The first key problem with a loan secured by pledge is that a default by the cash borrower will drag the pledged collateral into the statutory insolvency process. That process is primarily designed to address personal and commercial bankruptcy. As such, it is intended to ensure fairness among creditors of equal ranking by avoiding fraudulent or preferential claims made on the assets of the insolvent, including collateral given by that party. While this process is going on, and it is rarely a quick process, claims against the insolvent are subject to a stay of enforcement.
But protection against fraud and preference is not the priority of wholesale market participants, who are well able to protect their own interests against such risks. What wholesale market participants need is speed. This means the ability to rapidly crystallise large-scale market risk-driven exposures arising from repo, securities lending and derivatives with an insolvent counterparty. And that means stepping out of the statutory insolvency process and applying the contractual right of “close-out netting” (that is, ability to terminate contracts, accelerate obligations and liquidate collateral).
Avoiding the statutory insolvency process is made possible by title transfer to give the buyer the unfettered right to dispose of the collateral.[1] Close-out netting allows a massive number of potentially volatile transaction exposures to be collapsed into a much smaller and therefore more manageable net exposure. However, close-out netting is typically restricted to mutual obligations, something created by reciprocal transactions like repo, which are intended to be treated as single financial relationships. Pledges, on the other hand, are standalone obligations and, being proprietary interests, cannot be netted against monetary claims.[2]
The second key problem with secured loans is that the cash lender has no automatic right to dispose of the collateral during the term of the loan. While he can ask the cash borrower for the right to “rehypothecate” the collateral, the cash borrower is under no obligation to agree. The lack of a right of re-use means secured loans cannot mitigate the liquidity risk of the lender (by enabling the collateral to be used to arrange refinancing with a third party). Nor can secured loans play no role in supporting the liquidity of the securities market by providing a means for dealers to borrow and lend securities.
So, why is the name repo so often applied to secured loans? One reason is egregious ignorance (regulators). The second is what might diplomatically be called expediency. Where it is not possible to do repo, commercial pressure may encourage everyone (including regulators) to ignore the inconvenient truth, in the hope that nothing will go wrong. The inability to do true repo is down to legal obstacles to collateralisation by title transfer and close-out netting against an insolvent counterparty (this is the case in China and other emerging markets). It may also be that true repo is held back by the lack of a securities settlement system to transfer ownership (the case in some frontier markets). However, the explanation is more complicated in the case of the US.
In the US, in 1984, a court re-characterised a repo as a disguised secured loan and, ever since, there has been a concern that a court might do so once again. To avoid this risk, Congress provided a “safe harbour” for “securities contracts” --- including repo --- by exempting them from the main provisions of the Bankruptcy Code, notably from the automatic stay of enforcement. But it did so in an odd way. Rather than define a repo as a sale of collateral, Congress decided to level up the protection of secured loans by securities intermediaries. This was done by deeming securities interests such as pledges to be immediately perfected. An intermediary holding pledged collateral therefore has the same right to possess, enjoy and alienate that collateral as if it had been transferred by sale.
But let’s be clear, that does not mean US repo actually transfers collateral by pledge. SIFMA’s MRA (older cousin of the ICMA GMRA) states that the intention of the parties is to transfer title to collateral. It’s just that there is a fall-back provision. If a court again disagrees that a repo is a sale of collateral, the parties will be able to rely on the safe harbour provisions of the Bankruptcy Code to protect their collateral rights. In addition, the MRA provides a general contractual right of re-use of collateral to resolve the other key drawback to pledged collateral.
[1] And title transfer makes cross-border repo much easier as it avoids the idiosyncrasies of different insolvencies regimes.
[2] A contractual approach to managing transactions with an insolvent counterparty also avoids blunt tools like enforcement of collateral by sale, allowing flexible valuation procedures to be applied to illiquid collateral.