Have you considered Strate’s triparty collateral platform to optimise non-cash collateral and minimise tax, credit and operational risk?
Recent amendments to the “collateral arrangement” exemption in the Securities Transfer Tax Act provide a compelling reason to re-evaluate your collateral management strategies.
Strate is South Africa’s principal central securities depository (CSD), responsible for the safekeeping of the legal, digital record of securities ownership. In partnership with Clearstream (part of the Deutsche Börse group), Strate provides an internationally renowned triparty collateral platform that integrates with, and leverages off, our core CSD function, to facilitate the automated, seamless, and traceable movement of non-cash collateral based on client-defined rules. In this way, we aim to mobilise under-utilised securities, reducing the demand for cash as collateral, which increases the availability of liquidity in a portfolio as cash liquidity buffers are not consumed by collateral arrangements. It also enhances portfolio performance as extensive cash buffers are not required.
Triparty collateral platforms are well established globally and critical to the functioning of international markets, connecting and creating an ecosystem of central and commercial banks and buy-side clients to optimally manage the cost of capital, liquidity and collateral optimisation needs.
The most recent amendments to the “collateral arrangement” exemption in the Securities Transfer Tax (STT) Act provide a compelling reason for South African market participants to re-evaluate their collateral management strategies.
A brief history of “collateral arrangements”
Prior to the introduction of the “collateral arrangement” exemption in the STT Act in January 2016, South African financial market participants were restricted to either providing cash collateral via an outright transfer in title, or providing non-cash collateral via a pledge. This was limiting for a collateral receiver, as pledged collateral could not be re-used by the collateral receiver (or the collateral giver). As the common law considered securities as personal rights, they could only be granted under a pledge when given as collateral.
Section 38 of the Financial Markets Act of 2012 introduced the concept of an out-and-out cession of securities. Out-and-out cession permits the transfer of ownership of securities to the collateral receiver, along with the consequent right of use. The tax treatment of the out-and-out cession of securities was not addressed at the time, and, under the STT Act, this meant that STT and Capital Gains Tax (CGT) would be applied against every out-and-out cession of non-cash collateral, making it economically unviable.
To counter this, the “collateral arrangement” exemption was introduced as an amendment to the STT Act in January 2016 to provide conditions upon which non-cash collateral could be transferred via an out-and-out cession and benefit from an exemption to STT and CGT. The market welcomed the introduction of this exemption and immediately adopted it.
Further changes have been made since 2016, including the extension of the 12-month period for the return of equivalent non-cash collateral to 24-months, broadening the definition of “identical share/security” to cater for specified corporate events, and including listed South African government bonds as allowable collateral.
The amendments that came into effect on 1 January 2023 require market participants to urgently revisit their collateral arrangements. Prior to 1 January 2023, non-cash collateral receivers could re-use collateral they received in any way they wanted to, subject to them being able to return equivalent securities to the collateral giver within a 24-month period. If this was done, and if the other requirements of the “collateral arrangement” were met, then no tax consequences would apply to either the initial transfer or return of the collateral securities.
The 2023 amendments to the “collateral arrangement” exemption introduce restrictions on the re-use of collateral securities that are received. The defined, allowable cases where the re-use of securities will continue to benefit from tax exemptions are now limited to:
- A further collateral arrangement
- A repurchase agreement entered into with the South African Reserve Bank (SARB) as contemplated in section 10(1)(j) of the South African Reserve Bank Act
- Complying with Regulation 28 of the Pension Funds Act, or
- Securing overnight cash placement to comply with the Basel III Supervisory Framework for measuring and controlling large exposures (LEX)
The above allowable cases are referred to as the “permitted purpose”.
If collateral securities are re-used by the collateral receiver for any purpose other than the permitted purpose, then the tax exemptions will not apply. Per the Binding General Ruling (BGR) issued by the South African Revenue Service (SARS) in November 2022, the collateral giver, through no fault of its own, may also be liable to pay tax on the initial, qualifying (exempt) transfer of the collateral securities if the collateral receiver uses such securities other than for a permitted purpose.
Since a collateral giver has no control over how the collateral receiver decides to re-use collateral securities, but may suffer adverse tax consequences as a result of these actions, there is an understandable reluctance to continue to provide non-cash collateral via an out- and-out cession without seeking indemnification from the collateral receiver.
Should such an indemnity not be forthcoming, the collateral giver may revert to providing collateral via a pledge. This will be limiting for the collateral receiver as a pledge does not permit any right of use – and it would be a regression for the market.
Out-and-out cessions of collateral were introduced and permitted with the intention of reducing “transaction costs and market pricing because of the ability to rehypothecate collateral and reduce tax costs and making South Africa more attractive as an investment destination” (Explanatory Memorandum on the Taxation Laws Amendment Bill, 2015).
Limited by the inability to rehypothecate pledged assets, the collateral receiver may insist on only receiving cash collateral, potentially increasing the cost for the collateral giver, and having a negative impact on liquidity on the broader market.
How Strate’s triparty collateral platform supports and enables compliance with the “collateral arrangement” requirements
Strate’s world-class collateral platform connects collateral givers and receivers in an efficient, automated and robust way. The service leverages our core function of maintaining the legal, digital record of ownership as a CSD, as well as our core settlement and asset servicing capabilities. This enables us to facilitate the traceable re-use of securities as collateral, if permitted, and supports a transition away from manual oversight and management of collateral to automated, rules-based processes that can be managed by exception.
In line with the allowable re-use cases, our platform allows for the monitoring of re-use in a further collateral arrangement, as well as for securing overnight cash placements for LEX purposes. The SARB is currently working on a triparty collateral project, and we will be able to support repurchase agreements with the SARB should they join our collateral ecosystem.
It is this ability to both trace and manage re-use (if required) that will enable collateral givers and receivers to most easily comply with the requirements pertaining to their use of non- cash collateral within the permitted purpose. When using our service, collateral givers will firstly elect whether they are providing collateral through a pledge or an out-and-out cession. If pledge is elected, securities are flagged in favour of the collateral receiver and the pledge is perfected at the level of the CSD. If out-and-out cession is elected, the collateral giver must also choose whether to permit or restrict re-use.
If re-use is permitted, the collateral securities may only be re-used in a transaction with another counterparty that is also a client of the triparty collateral service. This creates a secure collateral ecosystem where the movement of securities can be traced throughout the lifecycle, in order to provide the automated services required for substitution, optimisation or mark-to-market purposes, as well as managing the tax consequences.
Another option is for the collateral giver to elect out-and-out cession and restrict re-use. While not used at present, market participants may want to consider this as a compromise. This will give the collateral giver peace of mind from a tax risk perspective and will provide the collateral receiver with immediate access to collateral and netting processes should there be an event of default. It would not be possible to manage this scenario outside of the controls provided by a platform such as ours.
Most importantly, under all circumstances within our triparty collateral platform, the right to sell securities remains with the collateral giver as the beneficial owner of the securities.
Optimising capital and balance sheet management, while minimising credit and operational risk
By connecting collateral givers and receivers through our platform, we enhance efficiencies through the automated, rules-based selection, allocation, optimisation and substitution of collateral in accordance with the collateral receiver’s pre-defined eligibility, while maintaining the integrity of the collateral giver’s allocation priorities. In this way, a collateral receiver can expect to always receive eligible collateral, while the collateral giver can prioritise what they consider to be cheapest-to-deliver, thereby ensuring greater retention of high-quality assets and contributing to better capital management.
Collateral allocated by our platform is evaluated and reconciled daily, ensuring that all exposures are optimally covered, while eligibility and sufficiency of collateral for both giver and receiver are monitored in near-real time. The risks of over- or under-collateralisation are managed and reduced, as are concerns about holding unqualified collateral.
We provide automated monitoring of adherence to a range of criteria, including haircuts, concentration limits, credit ratings, issuer ratings, price age and volatility, average traded volume, as well as industry sector or specific ISIN exclusions, thereby ensuring that the risk associated with holding securities as collateral will always be within the parameters defined by each client.
The use and demand for cash as collateral is minimised, allowing it to be directed to the real economy to promote investment and growth, while the vision of collateral fluidity, mobility and optimisation can be operationalised on a market-wide basis, leading to better pricing and risk reduction. In this way, we can develop and grow the South African capital markets, ultimately leading to sustained economic growth to the benefit of all.
For more information, please contact Farzana Khan, Head of Collateral Services: FarzanaK@strate.co.za
