Friday 6th May 2016
NEWS TICKER: Moody's says it has downgraded the ratings of Exeltium SAS's €1,000m 15 year floating rate bank term loan (Facility A), €155m 15 year floating rate institutional term loan (Facility B1) and €280m 15 year fixed rate institutional term loan (Facility B2), together, the senior debt, to Baa3, from Baa2. The senior debt matures in June 2030. Moody's has also downgraded the rating of Exeltium's €153m subordinated bonds, the junior bonds, maturing in December 2031 to B3, from Ba3. The outlook on the ratings is stable. The downgrade of the senior debt ratings reflects, says Moody’s, wholesale electricity market price falls in France, resulting in a material risk that Exeltium's customers will opt out of electricity purchases from 2020 to 2024 and a fall in the weighted average credit quality of clients to Baa3, from Baa2 and iii) the weakened credit quality of the put counterparty, a large French industrial rated Ba2 negative that is obliged to purchase 51% of volumes subject to Client opt-out (the Put Option). Moody's has also revised its French wholesale electricity price assumptions downwards, reflecting the current price environment and Moody's assumption that lower prices will be sustained. The industrial logic of the project is significantly weakened in a low electricity price environment. In Moody's revised base case, the rating agency assumes that clients would opt-out of electricity purchases between 2020 and 2024. Over this period, Moody's assumes that just over half of Exeltium's electricity would be sold under the Put Option, with the remainder sold at market rates. - CORPORATE REPORTING - Lufthansa Group says is maintaining its full-year earnings forecast for an adjusted EBIT which is “slightly above” the previous year’s €1.8b, after reducing its operating losses for the first quarter, having introduced substantial cost cuts and despite a decline in revenues. The firm’s adjusted EBIT loss for the three months to the end of March fell by more than two-thirds to €53m ($61m). Revenues fell slightly to €6.9bn because of pricing pressures in the group’s passenger airlines, says chief financial officer Simone Menne. Lufthansa’s passenger airline division improved its adjusted EBIT by €244m and that for Austrian Airlines was up by €23m. However, currency effects, however, dragged on the result at Swiss International Air Lines, where adjusted earnings fell by €28m. However, the firm issued a health warning that its forecast does not take into account any negative effects of possible strike actions and that it does not expect that pricing pressures will ease any time soon. Lufthansa Group turned in a net loss of €8m, compared with a €425m profit last year, but stresses that this included a large benefit from transactions relating to US carrier JetBlue Airways. Taking this into account, it says, the first quarter net result equates to an improvement of €70m. - SOVEREIGN DEBT - THE UK’s DMO says the auction of £2.5bn of 1.5% treasury gilt 2026 says bids worth £4.473bn were received for the offer of which £2.125bn was sold to competitive bidders and £374m sold to gilt edged market makers (GEMMs). An additional amount of the Stock totalling up to £375.000 million will be made available to successful bidders for purchase at the non-competitive allotment price, in accordance with the terms of the information memorandum. Higher priced bids came in at £98.566, providing a yield of 1.653% and the lowest accepts was £98.526, providing a yield of £1/656% - CYBER SECURITY - Global Cyber Alliance, an organisation founded by the New York County District Attorney's Office, the City of London Police and the Center for Internet Security, say they will collaborate with M3AAWG to push the security community to more quickly adopt concrete, quantifiable practices that can reduce online threats. The non-profit GCA has joined the Messaging, Malware and Mobile Anti-Abuse Working Group, which develops anti-abuse best practices based on the proven experience of its members, and M3AAWG has become a GCA partner for the technology sector – ASSET MANAGEMENT JOBS - IFM Investors today announced the appointment of Rich Randall as Global Head of Debt Investments. Mr. Randall takes on this senior leadership role from his prior position as Executive Director of Debt Investments, which he had held since joining IFM Investors in 2013. Randall replaces Robin Miller, who will semi-retire from IFM Investors after a 17-year association with the company. Miller will remain with IFM Investors and will transition to the role of Senior Advisor and Chair of Investment Committee within the organisation. In his new role, Randall will manage IFM Investors’ global debt investment teams and maintain the organization’s global debt investment process and relationships with investors. He will also oversee the sourcing of infrastructure debt opportunities internationally. He will continue to be based in IFM Investors’ New York offices and will report directly to CEO Brett Himbury – ACQUISITIONS - Intercontinental Exchange says it has backed off from its counterbid for the London Stock Exchange. In a statement issued by ICE, chief executive Jeffrey Sprecher says LSEG did not provide enough information to make an informed decision on the value of the merger. "Following due diligence on the information made available, ICE determined that there was insufficient engagement to confirm the potential market and shareholder benefits of a strategic combination. Therefore, ICE has confirmed that it has no current intention to make an offer for LSEG – POLITICAL RISK – Global risk analysts Red24 reports that political parties, including the National Movement for the Organisation of the Country (MONOP) and the Fanmi Lavalas party, held a series of demonstrations in Port-au-Prince, yesterday. The action was launched to show support for the Commission to Evaluate Haiti Elections (CIEVE), a body established to verify the 2015 elections. The latest call to action came amid heightened tensions between the aforementioned political parties and former president Michel Martelly's Parti Haitien Tet Kale (PHTK), which launched general strikes against CIEVE on 2 May. Further opposition party-led demonstrations are expected to continue in the near-term due to the indefinite postponement of the country's 24 April run-off election and issues surrounding the evaluation of the 2015 elections – INDEX TRADING – Investors have not yet leant into the wind as a ruff of mixed data discombobulated markets yet again, with a lacklustre Asian trading session. More pertinently perhaps, investor sentiment is hanging in advance of tomorrow’s US labour market report. Peter O’Flanagan ClearTreasury reports that uncertainty around Brexit has impacted business sentiment in the UK and “if we are seeing this filter through into Q2 data there may well be additional downside for UK data until we have a referendum result. That may not be an end to the uncertainty as the “Out” campaign appears to be gathering some momentum. Depending on what poll you look at, it would appear the “uncertain” portion of the polls is narrowing, and while the position is currently still far too close to call by looking at the polls, bookies are still favouring the ‘In’ campaign with a 75% probability of remaining”. In the Asian trading session meantime, Japanese stock indexes fell to three week lows, and in line with sentiment this year, the yen has touched yet another 18-month high against the dollar, no doubt testing the resolve of the central bank not to act, despite stating that the yen is way over-priced. The Nikkei225 was down 3.11% today. The Hang Seng ended down 0.37%, while the Shanghai Composite rose marginally by 0.23%. The ASX All Ordinaries ended 0.17% higher, though the Kospi fell 0.49% and the FTSE Bursa Malaysia dropped 0.75%. The Straits Times Index (STI) ended 0.53 points or 0.02% lower to 2772.54, taking the year-to-date performance to -3.82%. The top active stocks today were SingTel, which gained 0.53%, DBS, which declined 2.22%, OCBC Bank, which declined 1.06%, UOB, which declined 1.04% and Wilmar Intl, with a 0.57% advance. The FTSE ST Mid Cap Index declined 0.27%, while the FTSE ST Small Cap Index rose 0.01%. OIL PRICES RISE - The story today was oil as prices climbed in the Asian session, with the Brent crude price breaking through $45; wildfires in Canada were behind the rise. Wildfires look to be burning out of control in the Alberta oil sands region of Canada, which mines and ships heavy crude to the US. Oil companies there have reduced operations as non-essential employees are evacuated. Moreover, US oil output fell last week by more than 100,000 barrels a day to 8.83m, its lowest level since September 2014, though inventories continue to rise. US benchmark West Texas Intermediate for delivery next month was up $1.19, or 2.7%, at $44.97 while Brent prices for July supply rose 94 cents to $45.56. The price of oil has rallied recently because of the 400,000 bpd cut in US oil output (IEA data), US dollar weakness and Asian demand optimism. The next OPEC meeting scheduled for June 2nd will likely be another watershed, as all recent meetings have been. One beneficiary of the recent rally in oil prices is Russia, where the ruble has appreciated 14% against the US dollar this year. As well, investor sentiment towards Russia risk is highly influenced by the oil price. Year-to-date the dollar-denominated Russia RDX equity index is up 25%, and that compares with a gain of 6% for the MSCI EM Index and 1% for the S&P 500 Index reports Chris Weafer at macro-advisory.com. Weafer says the current oil price also makes the removal of financial sector sanctions less urgent for 2016 and eases both short-term geo-political and economic pressure on the Kremlin and reduces social stability concerns. “Oil should rise by [the end of the decade] but be less important by mid-next decade. Medium-term, an oil price rally to over US$100 per barrel is perfectly feasible due to the combination of steadily rising Asia demand (in particular) and the lack of investment by the oil majors since late 2014. Longer-term, the age of oil, or the importance of oil, may already be over or significantly in decline. The strong growth in alternative energy and the commitments made as part of the Paris Agreement make that a very high probability”. Gold is still seen under pressure this morning, say Swissquote’s Michael van Dulkin and Augustin Eden in their morning note today, which they attribute as usual to “pre Non-Farms trading (or lack thereof). We’re of the opinion, however, that employment is OK in terms of the US economic picture such that while there will be short term volatility around it, there’s little point giving this print much attention. Better to concentrate on US inflation data which, if it starts rising, could boost Gold (an inflation hedge) much more efficiently. There is, after all, a fair amount of concern that current easy US monetary policy could lead to inflation overshooting the 2% target when it does finally pick up.” In focus today, UK Services PMI (flat).

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Rehypothecation revisited Photograph © Sureshr/Dreamstime.com, supplied March 2013.

Rehypothecation revisited

Tuesday, 19 March 2013
Rehypothecation revisited Under the right circumstances, rehypothecation—leverage derived from the re-use of existing client collateral—can provide brokers with optimised borrowing opportunities, while giving lenders a reduction in transactional costs. If handled improperly, however, the process can easily go awry—and in a pretty big way. How do you ensure you get it right? US Editor, Dave Simons gives us his view. http://www.ftseglobalmarkets.com/media/k2/items/cache/403e40be559614364503454ce1dd5df3_XL.jpg

Under the right circumstances, rehypothecation—leverage derived from the re-use of existing client collateral—can provide brokers with optimised borrowing opportunities, while giving lenders a reduction in transactional costs. If handled improperly, however, the process can easily go awry—and in a pretty big way. How do you ensure you get it right? US Editor, Dave Simons gives us his view.

Five years ago last month I sat down with Kevin Davis inside the Manhattan offices of ill-fated futures brokerage MF Global, as the soon-to-be ex-chief executive officer laid out his plans for the newly launched spin-off of Britain’s Man Group.


Describing the income MF Global’s team pulled in through clearing and execution regardless of which way the markets went, Davis concluded that “any news is good news—whether it’s good, or bad.” Just days later, one of Davis’s minions, Brent Dooley, who worked out of the firm’s Memphis office, went home and, in a single evening, racked up a $141m loss while recklessly trading wheat futures out of his own account, using the Chicago Mercantile Exchange’s (CME’s) order-entry system. By the time our inconveniently scheduled March cover story was out, MF Global’s shares were already off 70%; months later Davis was done, Dooley was on his way to court—and incredibly that was just the beginning.




Two years later the company, now under the direction of Jon Corzine, the former governor of New Jersey, began an estimated $6.3bn wager on the bonds of various indebted European nations as part of an aggressive campaign to restore shareholder value. Still in a weakened state following the Dooley affair, the company never­theless employed various hyper-leveraged strategies that by all accounts included the process known as rehypothecation—off balance-sheet leverage derived from the re-use of existing client collateral.


Totally legit (in the United States, brokerages are allowed to pledge up to 140% of client’s liabilities), rehypothecation nevertheless has its share of pitfalls, including the need for borrowers to post additional margin on a moment’s notice in order to mollify dubious creditors and regulators.


James MalgieriJames Malgieri, head of service delivery and regional management for BNY Mellon’s Global Collateral Services business.Though Corzine’s bet was right on the money—at maturity all of his eurobond picks paid in full—unfortunately he, nor anyone else at MF Global, would be around to claim victory. Kneecapped by a swift succession of credit downgrades and margin calls, MF Global collapsed in October 2011; unable to raise cash fast enough to stay afloat. Along the way an ­estimated $1.6bn in client assets went missing; miraculously, a court ruling finalised just last month paved the way for nearly all of the misappropriated funds to be returned to its rightful owners.


MF Global was hardly the first to give rehypothecation a bad name (that list includes the mother of all meltdowns, Lehman), but in its wake critics have called for a thorough re-examination of rehypothecation regulation. To sceptics, rehypothecation is part of the same freewheeling, risk-taking environment that made it possible for a lone impulsive trader to deal a near-fatal blow to a $1.4bn operation, then allow a seasoned veteran to come in and finish the job.


For starters, under rehypothecation it is possible for pledged collateral to be co-mingled with other assets on the balance sheet. Keeping pledged and non-pledged securities independently domiciled is key to preventing client assets from being re-hypothecated, say reform advocates, who see a need for greater clarity around asset segregation. A likely byproduct of current regulatory efforts, then, will be a true segregation of client collateral, thereby making it more difficult for unwanted rehypothecations to occur.


In the recent Commonfund Institute report Managing Counterparty Risk in an Unstable Financial System, David Belmont, chief risk officer for Wilton, Connecticut-based financial-services firm Commonfund, noted a conspicuous lack of clarity around the types of assets used for rehypothecation. This has fueled demand for increased broker reporting, says Belmont, “including daily reports on where their assets are being held and which have been lent out or re-hypothecated.”


Benefits—and drawbacks
Even so, proponents believe that rehypothecation can still be an attractive proposition for brokers who are keen on optimising borrowing opportunities, as well as lenders seeking a reduction in transactional costs. To avoid the mistakes of the past and maintain the integrity of the re-pledged collateral, rehypothecation requires the presence of transparent, fully automated monitoring systems and operational practices, including the use of segregated accounts.


Judson BakerJudson Baker, product manager for Northern Trust’s asset-servicing division.Under rehypothecation, “if someone is pledging a bond as collateral, the receiver of the collateral may be able to onward pledge that specific bond to satisfy a margin demand from a separate party,” says Judson Baker, product manager for Northern Trust’s asset-servicing division. “They are essentially using the bond as if it were their own to help meet a margin call, as opposed to using their own trading assets for that margin requirement.”


While reducing initial trade costs and related funding transactions, rehypothecation also facilitates increased velocity and liquidity around financing transactions, says Jean-Robert Wilkin, head of collateral management and securities lending products at Clearstream. “ICSD triparty agents [such as] Clearstream have offered collateral re-use for years, in a manner that is very transparent and is based exclusively on the settlement of securities which are subject to transfer of ownership,” says Wilkin. Rather than question the integrity of rehypothe­cation, industry members “should be able to clearly demonstrate its proper usage, including the manner in ­collateral information is reported to all  involved.”


Since cash can be easily segregated from other assets, rehypothecation issues are less likely to arise. Things can become a bit trickier, however, once securities come into the mix. As such, a number of funds remain dead-set against using rehypothecation, due in large part to the inefficiencies involved. “They would simply rather use funds that are more accessible to them,” says Baker.


If recent history is any judge, rehypothecation has the capacity to create more problems than it solves. ­“Rehypothecation requires that you have processes in place that allow you to easily track the whereabouts of that collateral,” says Baker. “And if your exposure to the first party swings to the point that they need to call in the collateral, you then have to then find an acceptable substitute to bring to Firm B in order to return the initial asset. Operationally, that can be a bit tedious.”


Throw in a few extra nuances, and suddenly you’ve got the makings a quasi-serious settlement-risk issue. “For instance, when substituting collateral, some firms will insist that the re-pledged asset be of like value, and require that the asset is in their possession before they agree to release the asset. That’s when things can become operationally painful—particularly if all the right pieces don’t immediately fall into place.”


For lending agents, rehypothecation does increase the amount of securities available for loan purposes, and as such could conceivably create more revenue, concurs Claire Johnson, head of marketing and product for CIBC Mellon. Providing access to higher-quality ­collateral is yet another potential benefit, adds Johnson, particularly at a time when US Federal Reserve asset purchases and sovereign-debt downgrades are making collateral harder to come by.


Claire JohnsonClaire Johnson, head of marketing and product for CIBC Mellon.Nevertheless, CIBC Mellon believes the risks outweigh the benefits, and, in line with Canada’s general regulatory stance, does not rehypothecate collateral within its lending program. “We have taken the position that the prospective risks associated with having to unwind a multi-level series of collateral trades mean potential delays,” notes Johnson, “which could create challenges or even exposures in a rapidly-changing market environment. Operationally, the collateral could be substituted at any time, and on the loan side we would have to recall it. So there are also potential relationship and reputation concerns in terms of lending out clients’ collateral.”


Rehypothecation for Transformation
In contrast, using rehypothecation as part of a broader collateral-transformation strategy, whereby an equity or lower-quality bond is upgraded in order to meet a margin requirement, has been generally well-received within the markets. “Dealers, clearing firms and custodians have all been seriously looking into this area,” says Baker. “At Northern Trust we have a very strong securities-lending arm, and because this process heavily leverages lending operations, we feel it is a natural fit for us. There are a number of ways for us to make this work—we can act as repo agent, serve as the trade counterparty, as well as line up clients who are holding long positions and are willing to pledge assets in return for higher yield.”


Going forward, this will require that banks such as Northern Trust keep a much closer watch on liquidity ratios, as well as the credit on both sides of the trade, all the while carefully ­monitoring counterparty activities. “While it may be a slightly different form of monitoring than we typically undertake, it’s not a new kind of service altogether,” notes Baker. “As a result, we feel we are in a much better position coming into this, compared to those who may be just starting from scratch.”


Recognising the need to corral risk associated with rehypothecation, custody providers have increasingly extolled the virtues of tri-party ­arrangements, using an integrated prime-custody offering to connect prime brokerages with fund-manager clients.


Rather than risk having their assets subjected to rehypothecation in the first place hedge funds have increasingly sought out zero-margin, long-only prime-custody accounts. At present nearly one in two hedge funds with assets under management (AUM) in excess of $1bn maintain prime-custody arrangements, according to a BNY Mellon/Finadium report issued last fall, up sharply from just 15% five years ago.


The bottom line, says James ­Malgieri, head of service delivery and regional management for BNY Mellon’s Global Collateral Services business, is that one cannot rehypothecate collateral without having the consent of the client. “If you buy stocks on margin in the US, you are required to sign a rehypothecation agreement that allows your broker to re-use those securities in order to raise financing,” says Malgieri. “This puts the onus on the lender to ask questions regarding the broker’s intent to rehypothecate, including with whom, what, when and how.”


As many of the problems associated with rehypothecation have been the result of introducing an “outside” third party, using a custodian as collateral agent gives clients the assurance that their assets will at least stay within the program, says Malgieri. “The key feature here is the ability to control the pledged assets—and in this situation, the collateral agent has the ability to bring bona fide transparency to the rehypothecation process. If you look back at some of the defaults that have occurred in situations where the dealer had the right to rehypothecate, very often the clients didn’t actually know where the rehypothecated securities were headed. Again, if a client is willing to post collateral to be re-used, they had better find out why and what the broker is going to do with it.”


With proper transparency in place and the right kinds of questions asked, rehypothecation can achieve its stated goal of providing added efficiency, as well as more favorable lending terms for the client. “And keeping the ­rehypothecation within network is obviously key to this effort,” says Malgieri.”

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