A good paper on collateral rehypothecation. No need for the spin.

Those interested in the rehypothecation debate should read a paper written by Vincent Maurin of the European University Institute called Re-using the Collateral of Others: A General Equilibrium Model of Rehypothecation (EUI, March 2014). What draws attention is the claim that rehypothecation is unnecessary, that there is a more efficient alternative, and that a ban or restriction on rehypothecation would not have the dire consequences for financial market activity claimed by bankers and some (other) academics.

To quote from the Abstract, ‘I show that an efficient financial structure without re-use rights can substitute for rehypothecation. With such a structure, the economy realises an efficient use of durable assets as collateral and rehypothecation is not warranted to alleviate collateral scarcity issues. This paper thus mitigates claims that the recent set of regulations on collateral management will constrain financial markets by lowering collateral velocity.’ Later, the author dismisses fears that, ‘banning rehypothecation would take a huge toll on collateralised financial markets’.

These are strong claims. Unfortunately, only one page into the paper, it descends into utter confusion about the nature of rehypothecation. Having been involved in the regulatory rebate about collateral re-use in the repo and securities lending market, I have become rather sensitive to the misuse of the term ‘rehypothecation’. As I explain below, these are two very different legal concepts that are at the heart of two distinct regulatory debates. It has not been easy to ensure that the differences are understood by policy-maker and regulators, and some still do not.

As it turns out, the contents of the paper are rather different from what is on label and the contents are very much better. The real conclusion of the paper is that rehypothecation is, in practice, the most cost-effective and efficient way of circulating collateral and lubricating the flow of money around the market. So why not say so? Do academics suffer from having to compete too fiercely for attention in a world overflowing with erudite papers, by latching their wagon onto some passing high-profile regulatory (real world) issue?

Where the paper goes wrong

The author starts by discussing ‘rehypothecation’ in the context of derivatives (referring to the ISDA Margin Survey). But then, he suddenly proposes that rehypothecation is what happens when a buyer sells the collateral he has bought through a reverse repo. This usage of the term ‘rehypothecation’ in the context of repo is technically correct in the US market, because US repo is uniquely based on the conveyance of collateral by pledge and rehypothecation means re-pledging. However, it is legally incorrect to use that term elsewhere, as repo is based on title transfer and a buyer who sells collateral short is merely exercising his bas property rights. It is perhaps significant that the paper was written while the author was at NYU rather than at his home base of the European University Institute.

Rehypothecation outside US repo refers to the right which pledgors can give to pledgees to sell the  collateral conveyed from the former to the latter. Normally, a pledgee cannot seize and use collateral unless and until the pledgor defaults. If a pledgee has a right of rehypothecation and exercises it, the pledge is extinguished and replaced with an unsecured contractual right to the return of equivalent assets. Quite a change! The right of rehypothecation is typically sought by prime brokers from hedge fund clients who have pledged assets to cover exposures on derivatives contracts.

But the incorrect use of the term ‘rehypothecation’ is not a mere storm in a legal teacup. ‘Rehypothecation’ outside the US refers exclusively to the use of pledged client assets by prime brokers in the derivatives space and drags us into the regulatory controversy surrounding Lehman Brothers’ sloppy management of client assets and MF Global’s more fraudulent activities. Thus, the author cites the Canadian prohibition of rehypothecation and similar prohibitions under Dodd-Frank and EMIR on the rehypothecation of collateral against centrally-cleared swaps. It is vital to be clear, repo was not involved in the Lehman and MF Global rehypothecation problems.

But the real issue with the misuse of the term ‘rehypothecation’ comes with the next stage of the author’s thesis, the creation of collateral chains and the assertion that ‘borrowers may be wary of losing access to their re-used asset’. This a risk sometimes echoed by the G-20’s Financial Stability Board (FSB), who grasp of rehypothecation is not always what it should be. Here, repo is often assumed to be a pawn, where precisely the same asset needs to be returned back down the chain. A long chain in these circumstances would indeed potentially pose problems. But in repo, the buyer who shorts collateral is required only to return ‘equivalent’ securities, i.e. economically but not legally identical assets. Given that repo is overwhelmingly about liquid and fungible government securities, this is not often an issue.

Where the paper goes right

The object of the paper is to describe a mathematical model to analyse the trade-off between the benefit of rehypothecation — the recirculation of collateral — and the risk of rehypothecation — the loss of access to one’s assets. The risk is a function of a ‘limited commitment’ on the lender’s side to return the asset.

The main conclusion drawn from the model is that rehypothecation is unnecessary and so the risk of failure to return collateral back along repledging chains could be avoided. Instead of increasing the effective supply of collateral by increasing its velocity of circulation through rehypothecation, it is proposed that the supply could be increased more efficiently by synthesising collateral from other instruments using derivatives such as CDS and securitisation, specifically, ‘tranching’ (using claims on different parts of the same asset as collateral for different non-conflicting events) and ‘pyramiding’ (using an asset as collateral for a loan which is then used as collateral for another loan and so on).

The suggestion is ironic, given that these alternatives to rehypothecation are the sort of financial engineering that was at the root of the 2007 credit crisis. A proposal to move from rehypothecation to tranching and pyramiding would be seen by regulators as sliding from the frying pan into the fire.

But the author does not actually propose more financial engineering. Instead, he asks why rehypothecation has been selected by the market over synthesis. Clearly, synthesis through the use of derivatives and securitisation is not sufficiently cost-effective. In academic terms, the inability to synthesise any instrument from  a combination of others is described as a consequence of the financial market being ‘incomplete’. The standard explanation for incomplete markets is frictions or transactions costs. The suggestion is that rehypothecation has lower frictions or transactions costs, as rehypothecation rights require only the addition of a clause to an existing contract, while other forms of innovation imply drafting whole new contracts.

In addition, the author derives a conclusion from an extension of his model that rehypothecation has economic value in OTC markets with no central clearing by a CCP. In a pure centrally-cleared market (eg where there is a CCP), there is no need for rehypothecation or re-use, as all parties settle directly with the CCP. But in an OTC market with no CCP, intermediaries find themselves short with one counterparty and long with another. Lack of rehypothecation or re-use would constrain the intermediary. The ability to rehypothecate or re-use allows collateral received from one counterparty to be delivered by the intermediary to the other counterparty. This facilitates trading.

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