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).
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 US 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.
Not relevant under title transfer collateral arrangements
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.[1]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.
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.
Where you see a right of rehypothecation
- Under an 1994 NY CSA — Use of Posted Collateral (VM) under Paragraph 6(c) — it may be switched on or off.
- Under the US market-standard Master Securities Lending Agreement.
- It is a pretty fundamental part of a prime brokerage offering.
Where you don’t see it
- 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
- In your contractual documentation with a UCITS fund:
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[2]) may not rehypothecate those assets for its own account.[3]
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.
See also
References
- ↑ 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.
- ↑ 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.