What’s in a word? Well, in the quasi-legal world of regulation, it can be everything!
For example, in the post-crisis regulatory dialogue over the repo market, the words ‘re-hypothecation’ and ‘re-use’ have been causing endless mischief. This blog proposes that we therefore dispense with those misnomers and import the word ‘re-sale’ as a less ambiguous alternative.
The context of this issue is the use of collateral that has been received from another party. Why, you may ask, should such onwards usage not be called re-hypothecation or re-use?
Outside the US, re-hypothecation should be limited to the onward use of assets which have been received from a client under a pledge (re-hypothecation is the fancy legalese for re-pledging). The right of re-hypothecation is a privilege typically extended by hedge funds to prime brokers on assets pledged from the former to the latter to secure derivatives’ exposures. It allows the prime broker to transfer title to the assets to a third party by means of an outright sale or SFT. When a right of re-use is exercised, the pledge by the hedge fund is extinguished and replaced by an unsecured contractual right to the return of equivalent assets from the prime broker. In return for a right of re-hypothecation, the prime broker offers cheaper funding.
Outside the US, re-hypothecation should be applied only to the onward use of collateral received under a prime broker relationship but never to the onward use of collateral that has been received through a repo. In a non-US repo, collateral is sold outright. In other words, full title is transferred. If the buyer disposes of the collateral to a third party, he is not exercising a right granted by the seller at the latter’s discretion. He is exercising a fundamental right to enjoy his own property. The same is true in non-US securities lending. It is therefore utterly inappropriate to use the word re-hypothecation outside the US. The non-US repo market has tended to prefer the word ‘re-use’ but, as I’ll explain, that is not ideal either.
Unfortunately, many non-US repo market users have latched on to the word re-hypothecation, partly because of its currency among US repo market users and partly because it sounds so much sexier than re-use. And unhelpfully, re-hypothecation is actually the correct word for the onward used of collateral received through repo in the US.
In the US, it is difficult to achieve legal certainty about title transfer (because this requires the parties to demonstrate a transfer of risk on the collateral, which is a problem, because the repurchase commitment in a repo returns this risk to the seller). But pledging is very straightforward in the US. So collateral in a US repo is idiosyncratically transferred under a pledge. Of course, pledges suffer from two key drawbacks. Firstly, the pledgee can typically only dispose of the collateral if the pledgor defaults. This means he cannot use the collateral to refinance himself during the transaction. Secondly, even if the pledgor defaults, the pledgee’s right to dispose of collateral is restricted by the Bankruptcy Code. This imposes a stay on enforcement of collateral rights and unhelpful rules to prevent preferential rights. In the case of US repo, these problems have been overcome by means of the seller giving the buyer a contractual general right of use and through the exemption of repo collateral from the Bankruptcy Code. Given that collateral in US repo is actually pledged, it is appropriate — but only in that market — to describe the onward use of collateral by a buyer as re-hypothecation or re-pledging.
So, outside the US, why not replace re-hypothecation with re-use? The problem is that, in the US, re-use has long been a synonym for re-hypothecation. Moreover, the Financial Stability Board, while accepting that re-hypothecation is not a term applicable to securities financing transactions (SFT) outside the US, have decided to use the word re-use as a generic term for both re-hypothecation and the disposal of collateral received through title transfer. However, they have failed to find a word for ‘non-rehypothecable’ re-use. The result is that, in discussions with the FSB about repo, the concept of re-hypothecation tends to get sucked into the resulting taxonomic vacuum. As a result, it is almost impossible to separate analysis of the re-hypothecation problems at Lehman Brothers (a manifestation of operational risk) from the consideration of whether and to what extent repo contributes to pro-cyclicality and interconnectedness (which are systemic risks). In Europe, regulators have been unable to shake themselves of the belief that repo works through re-hypothecation. This has led them to consider trying to insist banks seek permission to sell securities from those from whom they have repoed (ie bought) them, something which could inadvertently threaten the fundamental right to dispose of one’s own property without interference.
Consequently, if you will forgive my presumption, I am proposing to insert the word ‘re-sale’ into regulatory and market taxonomy to describe the onwards use of collateral received through title transfer. My taxonomy is summarised in the chart below.
Please excuse me now. I have a mass of PowerPoint slides to relabel.