Re-hypothecation
Right of use of a collateral (in US Markets)
Guru Raghavan
What is it?
The ability of a prime broker to use client assets posted as collateral to that prime
broker for the prime broker’s own purposes
Rehypothecation –
Business Drivers
- Liquidity
- Securities lending
- Market leveraging
- Revenue generator
- Tool for risk management
- Creating business opportunities
Rehypothecation –
Business Risks
- Regulatory risk
- Legal risk
- Operational risk
- Market risk
What can happen to the
rehypothecated assets
Pledgor (“out of the money” party) financially strong; Secured Party financially
weak.
If Secured Party becomes bankrupt and pledged collateral exceeds termination
payment to Secured Party, Pledgor becomes unsecured creditor of Secured Party for
the excess.
Rehypothecation –
Normally Accepted Securities
Equities,
Government / Corporate Bonds,
Convertible bonds,
ADRs,
Warrants,
ABS / MBS,
Mortgage certificates,
Letters of credit and Cash
Rehypothecation –
Classification of Assets
“Fully-paid securities”, which are generally held in the cash account into which a
customer has actually made full payment;
“Excess margin securities”, which are that portion of a customer’s margin securities
having a market value that exceeds 140 percent of the customer’s debit balance to the
broker-dealer;
Rehypothecation –
Classification of Assets
“Margin securities”, which are customer securities held in a margin, or any other
Regulation T account for which a customer has not made full payment. Margin
securities are not subject to the possession and control requirement, so a broker-dealer
can use these securities in its own business, subject to certain limitations; and
Non-customer securities (proprietary positions, for example).
Rehypothecation –
Guidelines
Fully paid securities and “excess margin securities” cannot be rehypothecated (they
have to be “controlled”). A broker-dealer has the right to rehypothecate (customer)
margin securities when the customer pledges those securities to the broker-dealer to
support a margin debit. Under Rule 15c3–3, the broker-dealer may use an amount up
to 140 percent of the customer’s debit balance
Rehypothecation –
Criteria for Asset Acceptance
Legal certainty
Ability to objectively price or MTM the value
Liquidity
Marketability
Low volatility
Low correlation with the underlying exposure
Rating of the collateral/ issuer of the collateral
Rehypothecation –
Issues to consider in Asset Acceptance
Nature and location of counterparty
Nature and location of collateral
Regulatory issues
Perfection issues
Tax issues
Rehypothecation - Regulatory
Oversight in US and UK
UNITED STATES
FED and SEC oversight
Five day window to settle trades and
negotiate client transfers
SIPA trustee and rules
SIPC compensation schemes
UNITED KINGDOM
BoE and FSA oversight
Administrator with rules
Immediate seizure
- Failure of trades
- Freezing of assets
- Suspension of services
- Absence of information
Uncertain value and timing
Diminishing confidence
Rehypothecation in US and UK
In the UK re hypothecation can be for a an unlimited amount of the customer’s
assets and there are no customer protection rules such as Rule 15 c 3 – 3 in the US.
Rule 15 c3-3 prevents a broker dealer from using its customers securities to finance
its proprietary activities. Under Rule 15 c 3-3 the broker dealer may use / re
hypothecate an amount upto 140 per cent of the customers debit balance (i.e.
borrowing from the broker dealer)
Rehypothecation and SIPA
A defined set of customer protection rules for re hypothecated assets exists in the US
but not in the UK. This difference meant that when Lehman Brothers International
Europe filed for insolvency there was no statutory protection available to those
customers as the UK insolvency regime is not specific to entity type. In the US,
however, the SPIA of 1970 provides for certain procedures that will apply in the
event of the insolvency of a broker dealer
Rehypothecation and SIPC
Created by SIPA, the Securities Investor Protection Corporation is an important part
of the overall system of investor protection in the US. SIPC’s focus is very specific;
restoring funds to investors with assets in the hands of bankrupt and otherwise
financially troubled brokerage firms. Since 1970 SIPC has accumulated almost $2
billion from its members’ assessment that can be used by investor to recover assets
during insolvency
The End