This blog post was originally published on TabbFORUM.
For many sell-side capital markets participants, collateral management has emerged as the most profound business requirement of 2013. For the buy-side, and depending on the final rules and participants’ functional capabilities, collateral optimization may be one of the most prolific revenue opportunities presented in years.
This opportunity is apparent because while global regulatory mandates are changing (or have changed), certain customer asset protection and segregation requirements explicitly allow counterparties to contractually control the velocity and impact of their pledged collateral. This is significant because contractual control over collateral may transcend to cost reductions for collateral pledgers as well as enhanced revenue channels for those who conduct lending, facilitation, prime and transaction services.
Taken together, collateral optimization and collateral management are different opportunities viewed through the same lens. The greatest challenge of mutualizing the instant opportunity is the ability to conduct proper and perpetual cost-benefit analysis that appropriately weighs the buy-side collateral management levers with the sell-side regulatory-driven constraints. In other words, collateral optimization is a function of measuring and contemplating whether hypothecation, control and related waivers are worth the implicit costs.
What is Hypothecation?
Hypothecation refers to the pledging of collateral to secure an obligation. For example, hypothecation occurs when a hedge fund pledges and posts eligible collateral to its prime broker to secure a trading portfolio, with or without rights to borrow against these secured assets.
Beyond the direct collateral posting and collection phase (hypothecation), comes the potential for a subsequent re-use of the pledged assets. This process is known as rehypothecation, and refers to the re-use or re-pledging of the subject collateral. There are practical implications of rehypothecation that include both risks and benefits.
Rehypothecation Benefits and Risks
On the benefit side, participants share economic incentives to enter into facilitation, prime and transaction services that permit the commingling and rehypothecation of posted collateral. This contemplates additional revenue opportunities for the prime broker by leveraging the client’s pre-pledged collateral assets for the purpose of backing the broker’s own trades and/or borrowing activities. In turn, the pledger benefits through reduced capital or transaction costs, and likely more economically favorable borrowing or transaction terms.
Therefore rehypothecation has good business justification, but the benefits are not without certain risks. For instance, rehypothecation necessarily involves the commingling of client assets because in order to leverage the assets, a service provider, for instance a prime broker, must have a security interest in and a contractual right to re-pledge.
In addition to the pledger’s waiver of certain rights, namely commingling and subordination, rehypothecation includes other risks including a potential default, insolvency, or the inability to return the pledged assets based on systemic risks within the rehypothecation chain. As a result of this balancing, visibility of all relevant collateral should be managed through a collateral optimization engine and be capable of reconciling the cost benefit paradigm in addition to the requisite inventory, valuation and collaboration functions.
The Rules Create the Potential Opportunity
On its face, hypothecation rules as they relate to swaps and security-based swaps have become more prescriptive through the enactment of the Dodd-Frank Act (DFA). Generally the DFA rules have either banned or significantly impaired rehypothecation by: (i) requiring customer account segregation, (ii) mandating disclosure and invocation of collateral rights; and (iii) mandating explicit limits on rehypothecation and/or investment.
For example, the Securities Exchange Commission’s (SEC’s) rule 18a-4, which applies to security-based swap dealers (with 15c3-3 applicable to broker-dealers), stipulates that a security-based swap entity’s non-covered entity counterparties’ can elect to have collateral segregated at an independent third party custodian, or alternatively, waive the right to collateral segregation altogether. Waiver also presumes a subordination agreement which relinquishes some or all priority claims and contemporaneously avoids a capital charge onto the security-based swap entity. Without these contractual waivers, the security-based swap entity may be disincentivized to provide certain collateral transformation or preferential lending arrangements – so each participant should appropriately and independently analyze its position.
Regarding cleared swaps, legal segregation with operational commingling (LSOC) generally prohibits a futures commission merchant (FCM) from permitting a lien on cleared swaps customer collateral that it holds. The prohibition would logistically restrict the FCM’s ability to rehypothecate the customer’s collateral. However, on October 17, 2012, the Commodity Futures Trading Commission (CFTC) provided interpretive guidance that explicitly allows a cleared swaps customer to grant a lien, or be induced to grant a lien or security interest in its pledge collateral. This is significant as the regulators have guided the marketplace with generalized restrictions, yet have contemplated the foreseeable circumstances where market participants utilize technology automation to analyze the cost benefit of collateral optimization on a case-by-case or counterparty basis.
Both instances of regulatory action by the SEC and CFTC seemingly endorse a “right to contract” perspective that allows and even encourages participants to independently model rehypothecation risks and benefits by using automation.
Automation is the Key to Survival
Ultimately, it is necessary for all participants considering rehypothecation, or any aspect of collateral waiver, as part of an underlying collateral management or optimization strategy to consolidate automation across business lines and asset classes. This accomplishes a true cost-benefit justification. Both buy-side and sell-side firms are moving toward automating collateral pools and portfolios, trade reconciliation, and valuation; including real-time liquidity monitoring and account segregation as distinct opportunities.