Re-hypothecation Right of use of a collateral (in US Markets)

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Re-hypothecationRight of use of a collateral (in
US Markets)
Guru Raghavan
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What is it?

• The ability of a prime broker to use client
  assets posted as collateral to that prime broker
  for the prime brokers own purposes

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Rehypothecation Business Drivers

• - Liquidity
• - Securities lending
• - Market leveraging
• - Revenue generator
• - Tool for risk management
• - Creating business opportunities

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Rehypothecation Business Risks

• - Regulatory risk
• - Legal risk
• - Operational risk
• - Market risk

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What can happen to the rehypothecated assets

• Pledgor (out of the money party) financially
  strong Secured Party financially weak.
• If Secured Party becomes bankrupt and pledged
  collateral exceeds termination payment to Secured
  Party, Pledgor becomes unsecured creditor of
  Secured Party for the excess.

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Rehypothecation Normally Accepted Securities

• Equities,
• Government / Corporate Bonds,
• Convertible bonds,
• ADRs,
• Warrants,
• ABS / MBS,
• Mortgage certificates,
• Letters of credit and Cash

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Rehypothecation Classification of Assets

• Fully-paid securities, which are generally held
  in the cash account into which a customer has
  actually made full payment
• Excess margin securities, which are that
  portion of a customers margin securities having
  a market value that exceeds 140 percent of the
  customers debit balance to the broker-dealer

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Rehypothecation Classification of Assets

• Margin securities, which are customer
  securities held in a margin, or any other
  Regulation T account for which a customer has not
  made full payment. Margin securities are not
  subject to the possession and control
  requirement, so a broker-dealer can use these
  securities in its own business, subject to
  certain limitations and
• Non-customer securities (proprietary positions,
  for example).

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Rehypothecation Guidelines

• Fully paid securities and excess margin
  securities cannot be rehypothecated (they have
  to be controlled). A broker-dealer has the
  right to rehypothecate (customer) margin
  securities when the customer pledges those
  securities to the broker-dealer to support a
  margin debit. Under Rule 15c33, the
  broker-dealer may use an amount up to 140 percent
  of the customers debit balance

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Rehypothecation Criteria for Asset Acceptance

• Legal certainty
• Ability to objectively price or MTM the value
• Liquidity
• Marketability
• Low volatility
• Low correlation with the underlying exposure
• Rating of the collateral/ issuer of the
  collateral

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Rehypothecation Issues to consider in Asset
Acceptance

• Nature and location of counterparty
• Nature and location of collateral
• Regulatory issues
• Perfection issues
• Tax issues

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Rehypothecation - Regulatory Oversight in US and
UK
UNITED STATES UNITED KINGDOM
FED and SEC oversight Five day window to settle trades and negotiate client transfers SIPA trustee and rules SIPC compensation schemes BoE and FSA oversight Administrator with rules Immediate seizure - Failure of trades - Freezing of assets - Suspension of services - Absence of information Uncertain value and timing Diminishing confidence
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Rehypothecation in US and UK

• In the UK re hypothecation can be for a an
  unlimited amount of the customers assets and
  there are no customer protection rules such as
  Rule 15 c 3 3 in the US. Rule 15 c3-3 prevents
  a broker dealer from using its customers
  securities to finance its proprietary activities.
  Under Rule 15 c 3-3 the broker dealer may use /
  re hypothecate an amount upto 140 per cent of the
  customers debit balance (i.e. borrowing from the
  broker dealer)

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Rehypothecation and SIPA

• A defined set of customer protection rules for re
  hypothecated assets exists in the US but not in
  the UK. This difference meant that when Lehman
  Brothers International Europe filed for
  insolvency there was no statutory protection
  available to those customers as the UK
  insolvency regime is not specific to entity type.
  In the US, however, the SPIA of 1970 provides for
  certain procedures that will apply in the event
  of the insolvency of a broker dealer

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Rehypothecation and SIPC

• Created by SIPA, the Securities Investor
  Protection Corporation is an important part of
  the overall system of investor protection in the
  US. SIPCs focus is very specific restoring
  funds to investors with assets in the hands of
  bankrupt and otherwise financially troubled
  brokerage firms. Since 1970 SIPC has accumulated
  almost 2 billion from its members assessment
  that can be used by investor to recover assets
  during insolvency

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• The End