The profession of banking originated many centuries ago when the “nouveau riches” had spare money whilst traders needed to finance their operations. The middlemen, bankers, took on the risk of lending money that actually belonged to their depositors. Bank loans have since changed from physical bags of coins to electronic messaging but the function of extending credit to corporates (and other banks) is still an important part of the process of wealth creation.

The recent turmoil in the financial markets has served to accentuate the risk of unsecured lending in providing credit to other banking institutions. Repo market participants have been using the technique of collateralised lending since the early 1990s in Europe, when American investment bankers introduced the practice that had started in the early 70s in the US. As international financial markets have blossomed, so have potential risks. Consequently the benefits of additional collateral holdings are becoming clear to a much wider audience. It is not only repo transactions but also securities lending and derivatives trading that needs additional collateral for margin calls.

When the Eurosystem – the ECB and the national central banks of the Member States - was set up policy makers opted for collateralised credit in the form of reverse transactions such as repurchase transactions, promoting the use of a wide range of collateral in order to protect central banks from adverse counterparty risk. Initially, the Eurosystem collateral framework was grandfathering some national specificities to avoid disruptions from existing market practices regarding the use of collateral for the start of the euro currency.

However, in 2004 the Governing Council of the ECB approved the gradual introduction of a Single List for the collateral framework of the Eurosystem to replace the previous two-tier system of eligible collateral. Two major steps were taken; the first, to include a new category of previously ineligible assets (euro-denominated debt instruments, issued by entities established in those Group of Ten countries that are not part of the European Economic Area); and the second, approval of a framework for including non-marketable assets in the form of bank loans from all euro area countries in the Single List of eligible collateral.

Bank loans
The inclusion of bank loans in the Single List took take place according to a time frame which was published on 18 February 2005.

Bank loans will be eligible as collateral for Eurosystem credit operations in all euro area countries from 1 January 2007, when common eligibility criteria and the Eurosystem credit assessment framework (ECAF) will be implemented;

Between 1 January 2007 and 31 December 2011 an intermediate regime will be in place, allowing each Eurosystem national central bank to choose the minimum threshold for the size of loans eligible for collateral purposes and whether a handling fee should be applied;
As from 1 January 2012 a unified regime will be in place for the use of bank loans as collateral with a common minimum threshold of €500,000.

A set of eligibility criteria for loans was agreed upon to be used as of 1 January 2007, in addition to legal requirements relating to the notification of the debtor, banking secrecy, and the mobilisation and realisation of the loans.

These issues have in the past not been treated uniformly in the different national jurisdictions, and legal requirements vary considerably from country to country. Consequently the start of the intermediate period saw National Central Banks implementing individual measures complying with minimum common service requirements ensuring a common Eurosystem level of service for transferring bank loans. The Correspondent Central Banking Model (CCBM) was extended to allow counterparties to use bank loans in a cross-border context.

When discussions with the industry started on the reform to allow banks across the Eurozone to provide bank loans to the Eurosystem a number of meetings were organised by the Eurosystem. These resulted in a decentralised approach to the handling functions for dealing with bank loans as collateral in Eurosystem credit operations, which at the time was the only way to be ready for the launch by January 2007.

There is no doubt that the increased availability of this additional collateral pool enhanced the robustness of the financial market place and improved the stability of the market as a whole.

Indeed, bank loans could initially be used for Central Bank purposes only, but should also have been seen as a way to increase the use of such collateral for secondary market purposes.

At a meeting in 2006, the ECSDA, who had not been involved in the initial consultation, committed to a more in depth analysis of what could be envisaged for the involvement of CSDs in the handling of bank loans. Also at that meeting the industry accepted that the priority should remain starting to accept credit claims (on Jan 1 2007. The Eurosystem went on to implement successfully the necessary tools to use credit claims as collateral for the purpose of central bank collateralisation by this agreed deadline.

Credit claims & CCBM 2
The average use of credit claims in 2006 amounted to four percent of the total outstanding collateralisation of the Eurosystem. In 2007 this average climbed to 12 percent. Although no data is yet available for 2008 there is evidence that banks have increasingly used credit claims in light of the market turmoil since the summer of 2007.

In 2006 Europe was in need of a major re-organisation of the clearing and settlement area to reflect the increased importance of the euro currency zone. In many discussions at the time, at Central Bank level or in the European Commission, frustration by many market participants at the delay in delivering solutions to the Giovannini barriers became apparent. In response to this the ECB Governing Council took the market by surprise and launched the idea of Target 2 Securities (T2S). At the same time the Eurosystem decided to undertake another look at internal solutions for cross-border settlement of securities or rather cross-border collateral management.. Viable, alternative market solutions failed to materialise even in a situation where overall cross-border use of collateral exceeded the domestic use in 2006.

At this time the Cogesi meetings discussed the implementation for a “centralised” system for all securities transactions, through harmonisation of national procedures and conditions for domestic and cross-border use of collateral. This development would also support a secondary market for non-marketable assets and in addition the requirement for repatriation of securities would be abolished.  As a consequence of discussions with market participants the Eurosystem launched an initial consultation on a new project, called CCBM2, in April 2007 – the next phase for Eurosystem collateral management
 
CCBM2 & triparty
Before elaborating on the credit claim secondary market requirements one has to understand the importance of CCBM2 as a catalyst for market changes. Six guiding principles are envisaged for this new central bank initiative:

Centralised IT platform for the Eurosystem central banks collateral management, complying with the decentralisation approach;
Full compatibility with Target 2 and T2S;
Coverage of both domestic and cross-border use of collateral, and all collateralisation legal techniques (pledge and repo);
Handling all eligible collateral ie both securities and credit claims;
Adoption of real time and STP procedures and;
Use of all eligible SSSs and eligible links.

The initial consultation with the markets exposed issues which were not accommodated in the above principles: Use of collateral for purposes other than Eurosystem credit operations (guarantees to CCP, repo market operations); Pooling of collateral provided by entities belonging to a group; Integration with other existing market solutions (ICSDs collateral management systems); Harmonisation of collateralisation procedures; Inclusion of a contingency module dealing with non-euro collateral; Removal of the repatriation requirement.

Recent developments
Support for the work around credit claims seems to have picked up recently. 

A revision of Directive 2002/47/EC on financial collateral arrangements proposed by the Commission was welcomed by the market as it includes an extension of eligible collateral classes to credit claims. There remains a need for clarity regarding the role of credit claims as collateral in interbank transactions.

Discussions with DG Markt and staff of the ECB have highlighted the need to properly reflect on the potential use of credit claims in today’s financial markets. As such the ERC have focused on the eligibility of credit claims not only for collateralisation of central bank credit but equally for the pool of collateral available for interbank transactions. 
It is hoped that discussions in the Council under the French presidency will result in a changed proposal that will be submitted to the European Parliament before the end of 2008.

At a follow up industry meeting hosted by the ERC with both ICSD’s, SWIFT and a representation from the ECB discussions focused on some practical issues that need to be resolved. There is a need for a centralised data base allowing users of credit claims comfort in this cross-border/cross-system environment. The following issues have been identified for action:

The creation of a central database by the industry to ensure the development of a secondary market that needs to be integrated with the central banks databases for "eligible" credit claims.
Credit claims need to be clearly identified.

Instructions related to credit claims should be standardised and exchanged through electronic messages. As SWIFT already started some work in the framework of CCBM2 the same message types could be used for interbank transactions.

The adaptation of standardised legal documentation that would allow the use of the Global Master Repurchase Agreement (GMRA) for repo transactions with credit claims as collateral will form part of the framework.

Some general criteria for quality check should be put together with public disclosure. 

In today’s financial markets, automatisation is key for a successful start of any new product.

The one million dollar (or should I say euro?) question remains ‘when will credit claims materialise as a fully acceptable tool?’ As an optimist I remain confident that the potential of this product will appeal to many in the banking industry. As the ECB pushes for the implementation of CCBM2 that includes the handling of credit claims, already part of the infrastructure work has started in the private industry. Ultimately it is the users (who in this case are also the originators of the product) that will make a move to exploit this, as yet undiscovered, asset class allowing further collateralisation of the markets. Markets have come a long way towards the implementation of Basle 2, the recent turmoil has undeniable exposed the importance of further collateralisation. So what are we waiting for?