What do crisis lessons on rehypothecation tell us about collateral management going forward?
Posting collateral is going to be much more widespread under Dodd-Frank and related derivatives markets reform. Therefore, corporate treasurers, not as well versed in dealing with prime brokerage desks – which are rapidly adding derivatives trade processing to their offerings – thus should move up the learning curve quickly if they want to optimize their use of collateral in conjunction with derivatives, securities lending and other business with broker-dealers.
One lesson they should learn is on rehypothecation, or the practice that allows collateral posted with a broker-dealer (typically acting as a prime broker for a hedge fund) to be used again by the broker-dealer as collateral for its own financing in the “shadow-banking” system. If the collateral gets re-pledged too extensively (i.e., over leveraged), it no longer serves its purpose in credit risk mitigation. Smart counterparties will thus ask about their broker-dealers’ rehypothecation polices, negotiate rehypothecation rights and monitor adherence to them.
Little regulatory help
Though such Ponzi-like financing was a huge contributor to the financial crisis it has not yet been subjected to new regulation. While the US has had caps placed on the extent collateral could be re-pledged (up to 140 percent of customer’s debit balance) before the crisis, the UK has no limits. This is why London was the jurisdiction of choice for prime brokerage, until the risks of its less advantageous bankruptcy provisions came to be a real concern. Without further regulatory help, counterparties will need to be extra vigilant to ensure that collateral reuse does not again get abused as a financing tool.
This may be difficult, however. A Financial Times article last Friday, compared it to cotton candy, spinning goodness out of nothing. But like cotton candy, if a little is allowed to go a long way, it may reduce the costs passed on to customers, which is why they may be tempted to discount the risk of granting rehypothecation rights, negotiating caps (e.g., the US limits) or posting collateral without adequate regulatory protection. This is also another reason for derivatives back-offices to migrate to London.
A working paper by the IMF, The (sizable) Role of Rehypothecation in the Shadow Banking System, helps shed light on the practice in the hopes of prompting a regulatory policy response. According to the paper, rehypothecation enabled a shadow-banking finance mechanism totaling some $4.5tn (just amount the seven largest US dealers) pre-Lehman to blossom. Post-Lehman, the market collapsed to $2.1tn.
However, like the rest of the shadow-banking system, the availability of collateral to leverage for financing is building up again. To the extent collateral for derivatives transactions factors in (post-reform), it could rise further. By raising awareness, the paper also can help more market participants learn how to regulate themselves and their counterparties.