Sunday 1st February 2015
NEWS TICKER FRIDAY, JANUARY 30TH: Morningstar has moved the Morningstar Analyst Rating™ of the Fidelity Japan fund to Neutral. The fund was previously Under Review due to a change in management. Prior to being placed Under Review, the fund was rated Neutral. Management of the fund has passed to Hiroyuki Ito - a proven Japanese equity manager, says Morningstar. Ito recently joined Fidelity from Goldman Sachs, where he successfully ran a Japanese equity fund which was positively rated by Morningstar. “At Fidelity, the manager is backed by a large and reasonably experienced analyst team, who enjoy excellent access to senior company management. While we value Mr Ito’s long experience, we are mindful that he may need some further time to establish effective working relationships with the large team of analysts and develop a suitable way of utilising this valuable resource,” says the Morningstar release - The Federal Deposit Insurance Corporation (FDIC) today released a list of orders of administrative enforcement actions taken against banks and individuals in December. No administrative hearings are scheduled for February 2015. The FDIC issued a total of 53 orders and one notice. The orders included: five consent orders; 13 removal and prohibition orders; 11 section 19 orders; 15 civil money penalty; nine orders terminating consent orders and cease and desist orders; and one notice. More details are available on its website - Moody's Investors Service has completed a performance review of the UK non-conforming Residential Mortgage Backed Securities (RMBS) portfolio. The review shows that the performance of the portfolio has improved as a result of domestic recovery, increasing house prices and continued low interest-rates. Post-2009, the low interest rate environment has benefitted non-conforming borrowers, a market segment resilient to the moderate interest rate rise. Moody's also notes that UK non-conforming RMBS exposure to interest-only (IO) loans has recently diminished as the majority of such loans repaid or refinanced ahead of their maturity date - The London office of Deutsche Bank is being investigated by the Financial Conduct Authority (FCA), according to The Times newspaper. Allegedly, the bank has been placed under ‘enhanced supervision’ by the FCA amid concerns about governance and regulatory controls at the bank. The enhanced supervision order was taken out some months ago, says the report, however it has only just been made public - According to Reuters, London Stock Exchange Group will put Russell Investments on the block next month, after purchasing it last year. LSE reportedly wants $1.4bn - Legg Mason, Inc. has reported net income of $77m for Q3 fiscal 2014, compared with $4.9m in the previous quarter, and net income of $81.7m over the period. In the prior quarter, Legg Mason completed a debt refinancing that resulted in a $107.1m pre-tax charge. Adjusted income for Q3 fiscal was $113.1m compared to $40.6m in the previous quarter and $124.6m in Q3 fiscal. For the current quarter, operating revenues were $719.0m, up 2% from $703.9m in the prior quarter, and were relatively flat compared to $720.1m in Q3 fiscal. Operating expenses were $599.6m, up 5% from $573.5m in the prior quarter, and were relatively flat compared to $598.4min Q3 of fiscal 2014. Assets under management were $709.1bn as the end of December, up 4% from $679.5bn as of December 31, 2013. The Legg Mason board of directors says it has approved a new share repurchase authorisation for up to $1bn of common stock and declared a quarterly cash dividend on its common stock in the amount of $0.16 per share. - The EUR faces a couple of major releases today, says Clear Treasury LLP, and while the single currency has traded higher through the week, the prospect of €60bn per month in QE will likely keep the euro at a low ebb. The bigger picture hasn’t changed, yesterday’s run of German data was worse than expected with year on year inflation declining to -.5% (EU harmonised level). Despite the weak reading the EUR was unperturbed - The Singapore Exchange (SGX) is providing more information to companies and investors in a new comprehensive disclosure guide. Companies wanting clarity on specific principles and guidelines on corporate governance can look to the guide, which has been laid out in a question-and-answer format. SGX said listed companies are encouraged to include the new disclosure guide in their annual reports and comply with the 2012 Code of Corporate Governance, and will have to explain any deviations in their reporting collateral. - Cordea Savills on behalf of its European Commercial Fund has sold Camomile Court, 23 Camomile Street, London for £47.97mto a French pension fund, which has entrusted a real estate mandate to AXA Real Estate. The European Commercial Fund completed its initial investment phase in 2014 at total investment volume of more than €750m invested in 20 properties. Active Asset Management in order to secure a stable distribution of circa 5% a year. which has been achieved since inception of the fund is the main focus of the Fund Management now. Gerhard Lehner, head of portfolio management, Germany, at Cordea Savills says “With the sale of this property the fund is realising a value gain of more than 40%. This is the fruit of active Asset Management but does also anticipate future rental growth perspectives. For the reinvestment of the returned equity we have already identified suitable core office properties.” Meantime, Kiran Patel, chief investment officer at Cordea Savills adds: “The sale of Camomile Court adds to the £370m portfolio disposal early in the year. Together with a number of other asset sales, our total UK transaction activity since January stands at £450m. At this stage of the cycle, we believe there is merit in banking performance and taking advantage of some of the strong demand for assets in the market.” - US bourses closed higher last night thanks to much stronger Jobless Claims data (14yr low) which outweighed mixed earnings results. Overnight, Asian bourses taken positive lead from US, even as Bank of Japan data shows that inflation is still falling, consumption in shrinking and manufacturing output is just under expectations. According to Michael van Dulken at Accendo Markets, “Japan’s Nikkei [has been] helped by existing stimulus and weaker JPY. In Australia, the ASX higher as the AUD weakened following producer price inflation adding to expectations of an interest rate cut by the RBA, following other central banks recently reacting to low inflation. Chinese shares down again ahead of a manufacturing report.” - Natixis has just announced the closing of the debt financing for Seabras-1, a new subsea fiber optic cable system between the commercial and financial centers of Brazil and the United States. The global amount of debt at approximately $270m was provided on a fully-underwritten basis by Natixis -
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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