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.
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.”
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.
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.
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.”