Collateral Loopholes Eyed

Terry Flanagan

Re-hypothecation could be used to circumvent FinReg.

Banks could potentially skirt regulations intended to create greater transparency in derivatives by exploiting loophole in re-hypothecation.

“The Dodd-Frank Act attempts to bring in more transparency to the middle and back office operations involving the mechanics of the clearing and settlement of cash and derivative trades, the movement of cash and collateral, and risk management,” Ron D’Vari, CEO and co-founder of NewOak Capital Advisors, told Markets Media. “It remains to be seen if the new rules avoid re-hypothecation loopholes.”

Re-hypothecation occurs when banks or broker-dealers reuse the collateral posted by clients such as hedge funds to back the broker’s own trades and borrowings.

Prior to the Lehman collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving over $4 trillion worth of funding by re-hypothecation, much of it sourced from the UK where there are no statutory limits governing the reuse of a client’s collateral.

“The U.S. re-hypothecation rules are much stricter than the UK rules,” D’Vari said. “Hence, many prime brokers’ agreement terms allow for a U.S. client’s collateral to be transferred to the prime broker’s UK subsidiaries under a Global Master Securities Lending. This typically shows up under ‘Consent to Loan or Pledge’ provision.”

In the U.K, there is no limit on the amount of a clients assets that can be re-hypothecated, except if the client has negotiated an agreement with their broker that includes a limit or prohibition. In the U.S., re-hypothecation is capped at 140% of a client’s debit balance.

Re-hypothecation can be involved in repurchase agreements , commonly called repos. In a two-party repurchase agreement, one party sells to the other a security at a price with a commitment to buy the security back at a later date for another price.

“The international rules for movements of cash and collateral accounts for brokerage firms are complex,” said D’Vari. ”With the off-balance-sheet accounting for repos, it is usually hard for the regulators to get a really transparent picture of the capital adequacy and liquidity of larger broker dealers.”

Depending on each account’s permission settings, brokerage firms may be able to purchase U.S. treasuries, and in some cases non-U.S. sovereign bonds in their own name using the unencumbered clients’ segregated funds and re-hypothecate them to back their own trades, D’Vari said.

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