Rehypothecation
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A word about credit risk mitigation
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Compare with title transfer and reuse.
Often used in place of the better term “reuse”, rehypothecation is a New York law means of achieving reuse of pledged assets. It is not strictly accurate when applied to title transfer collateral arrangements as the collateral taker in that case owns the asset absolutely, and does not therefore need a right to “rehypothecate” it.
Rehypothecation, or “rehypo”, is an important part of margin lending: more important than ordinary hypothecation, a term you don’t often see (and which as far as I know simply means to pledge assets by way of security for a debt).
Economically, to “rehypothecate” an asset you have been pledged is to take full legal and beneficial title to it, against an obligation to return an equivalent, fungible asset at a later date. This means you can sell the asset in the market, thereby realising funds with it, or use it as collateral in a market transaction elsewhere.
Legal beagles will be fascinated, while no one else will care, that in a New York law “rehypothecation” construct, the pledgor retains title to the rehypothecated asset at all times, even when it is sold outright in the market, whereas in an English law “re-use” construct, title to the asset passes outright to the person re-using it, and is replaced by a debt obligation to return an equivalent asset. Economically the two constructs are the same; it is just that the NY one makes no logical sense at all, while the English one makes perfect sense. Don’t @ me Americans: you know this is true.
Assets a counterparty posts you as collateral — especially as variation margin — are meant to be credit support for the amount that counterparty would owe you (your “exposure”) if you closed out the transaction today — the replacement value of the transaction, so to say.
This is all fine from a credit perspective, but there is a funding angle, too. That exposure is rather like indebtedness — it is as if you have lent your counterparty that money. If you are a prime broker, you probably have lent your counterparty that money. This is money your treasury department will gleefully, usuriously, charge you for using.
Now if only you could use these assets as collateral you owe someone else, or convert them into cash to repay your treasury department — like you could if that collateral was title-transferred to you — wouldn’t that be a fine thing? Well, as long as the collateral is only pledged to you, you can’t: it isn’t your asset to sell.
But this is exactly what rehypothecation allows you to do. But at a cost: the pledgor, who used to own the asset and could reclaim it in your insolvency (on settling its outstanding indebtedness to you) now becomes your unsecured creditor for the return of the “equivalent” asset. If you go bust, the pledgor must file a claim like all other creditors for the net value of the asset. This is why the pledgor will be grateful for the effects of close-out netting.
Where you DO see a right of rehypothecation
Prime brokerage arrangements
In a prime brokerage arrangement, the prime broker has financed the purchase of a client’s asset, and it holds that asset in custody, with security over it as surety for repayment of the amount it lent the client to buy it in the first place. As custodian, the prime broker has legal title but not beneficial interest in the asset. So it is rather as if the client had “pledged” the asset under a New York law CSA to the prime broker. therefore the term rehypothecation, to describe the process whereby the prime broker takes that asset and sells it to defray the cost of financing it, with a contingent obligation to redeliver something identical back on request, is not an outrageous distortion of the facts of what is happening.
New York law-style credit support arrangements
For the specific provision in the 2016 NY Law VM CSA, and tart commentary thereon, see: Use of Posted Collateral (VM)
Rehypothecation achieves the chimaerical effect of allowing the recipient of pledged collateral — i.e., collateral the holder doesn’t own, but simply possesses with a security interest — to sell that collateral outright to a third party, on condition that it remains liable the original pledgor to return an identical (“fungible”) asset at the conclusion of the pledge.
Challenging, you would think, because “nemo dat quod non habet” — you can’t give someone else title to something you don’t yourself own. But somehow, under New York law, one manages it. It is part of the Uniform Commercial Code. Once pledged collateral has been rehypothecated, to this correspondent’s best guess it is exactly as it would be had the pledgor transferred by outright title transfer in the first place: The pledgor has full credit risk to the pledgee for the return of an equivalent collateral asset.
The English law equivalent in a prime brokerage arrangement is to interpose an intermediate step, in which the pledgee may take title outright title to the pledged asset itself, whence habet, and accordingly aliquis dat it outright to a third person.
US market-standard Master Securities Lending Agreement
The collateral leg of a Master Securities Lending Agreement is a pledge which generally has a right of rehypothecation, allowing the collateral holder to reuse the collateral in the market. Like the 2016 NY Law VM CSA this ebntirely defeats the point of creating a pledge structure, but who are we, with our decidedly movable force of namby-pamby logic, to quibble with the quite irresistible force of the US market practice?
Where you don’t see it
2018 Pledge GMSLA
Under a pledge GMSLA used for agent lending. Because, like, why would you? The whole point is to immobilise collateral and keep it out of the lender’s bankruptcy estate
UCITS funds
Financial instruments held in custody for a UCITS V fund must be segregated, clearly identifiable in the custodian’s books and records as belonging to the UCITS and critically the depositary (or its delegate[1]) may not rehypothecate those assets for its own account.[2]
A UCITS can “re-use” assets for its own account on certain conditions, such as that the re-use benefits the UCITS and is in the interests of unit-holders is covered by high quality, liquid collateral under a title transfer collateral arrangement, equal at least to the market value of the reused assets plus a premium. This prohibits PB-style re-hypothecation (which is of course allowed under AIFMD structures but allows UCITS to engage in securities lending.
Title transfer collateral arrangements generally
Under a title transfer collateral arrangement (as opposed to a pledge) the collateral a lady receives is hers to do with as she pleases, as long as she returns something “equivalent” when the time it right.[3]If she receives a security interest over collateral then, unless she has a separate right of use over the asset, she cannot sell it — it not being hers to sell — but must return the self-same thing.
Voting rights and rehypothecation
The question will arise from time to time,[4] “if we have rehypothecated an asset pledged to us and there is a corporate action or a shareholder vote on it, then who gets to exercise it?”
To answer this question there are two distinct relationships to consider:
- Issuer and shareholder: Between the security issuer and the holder for the time being of its securities;
- Pledgor and rehypothecator: between you and the counterparty who pledged the security to you, which you then rehypothecated.
They play out quite differently.
As far as the issuer is concerned, whoever is the beneficial owner of the security from time to time has the vote. It cares not one whit for private dealings between prime brokers and their clients, nor why their securities have changed hands, much less how; only that they have. Rehypothecation is of no concern to the issuer: it must listen to the beneficial holder’s vote, be that the original pledgor (if not rehypothecated at all) the pledgee (if rehypothecated but not yet kicked into the market) or whoever winds up with the security on the record date (once the pledgee has kicked it into the market). So that’s how the issuer will look at it.
Pledgor and rehypothecator
As between the pledgor and pledgee there is a subtler relatiopnship the issuer will not see:
- In custody: as long as the share is in custody, the pledgor, as beneficial owner as the vote.
- In the depot: If the pledgee rehypothecates, the pledgor loses the absolute right to vote the share, because it doesn’t own it any more, but nor does the pledgor gain the right to vote the share, because everyone’s expectation is that it will deliver the share outright into the market as soon as it has rehypothecated it.[5]
- In the market: Once it is in the market, the security is beyond pledgor’s or pledgee’s control. The holder for the time being, whoever she may be, can vote with it as she wishes (though in some common use-cases for rehypothecated shares, by convention will not).[6]
Now just let’s say the pledgee has rehypothecated the asset out of custody but for some reason hasn’t yet got round to kicking it out into the market. Here it holds the share in its open depot, beneficially for itself. From the issuer’s perspective, the pledgee may vote. The issuer will listen to no-one else. But from the pledgee’s contractual perspective, it shouldn’t vote, except as directed by the pledgor. It should treat the share as if it were still in custody, because it can. This may be a stroke of fortune for the pledgor, but from the pledgee’s perspective rehypothecation is a funding optimisation tool, not some right to play with residual optionality on the shares themselves. If the pledgor can effect a vote on its client’s behalf, it should. If the pledgor is disinclined to vote, nor should the pledgor (this may seem a rather holier-than-thou attitude but candidly, it just aligns you in the right place. Bonum ovum esse; don’t take advantage of situations like this; it will only lead to trouble in the end.
Bottom line
Top tip for pledgors: If you want to vote your securities, tell your pledgee to box them out so they are not available for rehypothecation.
See also
References
- ↑ If it has delegated the custody function, like.
- ↑ ESMA opinion on the subject. See also UCITS V Art. 22(7). Good note on it also from Matheson here.
- ↑ If someone tells you they wish to rehypothecate collateral they’ve taken under a title transfer collateral arrangement, quickly find a sleeve you can laugh up.
- ↑ Usually it will arise because the same person, who has been working in the client services team processing corporate actions for twenty years, keeps asking it)
- ↑ There’s no point rehypothecating a security if you don’t want to transfer it into the market. You may hold a quantity in inventory as a buffer, but this should really be a transient state of affairs: the expectation is that everything you rehypothecate goes out the door. If you don’t need to send it out the door, leave it in custody.
- ↑ For example, a, agent lender will not typically vote shares it holds as collateral for stock loans. A lot of these shares are rehypothecated.