|Prime Brokerage Anatomy™|
Reuse — often labeled rehypothecation (the two are legally very different but economically very the same things) — is the right a prime broker has over its client’s custody assets to raise money with them in the market — by selling them, in a nutshell — to offset its lending costs, against an promise to return equivalent assets (which it must go and get, by buying them in the market) when the client wants them back.
Anorak’s corner: The difference between “reuse” and “rehypothecation”
The English law “right of use” is quite straightforward. Under it, contractually, a custodian may transfer a custody asset into its own name absolutely, against an obligation to “return” an “equivalent” asset into custody when the client needs it, so sell it. This converts the “custody” relationship over the assets — one of trustee and beneficiary — into one of indebtedness. Once the reuse transfer has happened, the custodian — now not a custodian, of course — may deal with the asset as it wishes, and whether or not it sells it into the market, but has a liability to return an equivalent asset, and when it does, the custody and security relationship resume over that asset.
So far so good. But now we board our liner at Southampton and head for the New World. Here things are never easy. There is a strain of American jurisprudence that admits of paradox — that revels in it — and rehypothecation is one of its higher tide marks. To “rehypothecate” an asset is to take it and sell it outright without depriving its owner of legal title to the asset. Now of course, to someone brought up munching pithy Latin aphorisms like nemo dat quod non habet for breakfast, as all English lawyers were, that doesn’t make literal sense. U.S. attorneys, I fancy, know it. They will regard you beadily should you ask them to explain it, and will decline to do so. It just is. The best I can do is point to a section on the ICMA website which itself sounds rather baffled:
... the collateral-giver remains the owner but only until the collateral-taker exercises his right of rehypothecation. When this right is exercised, there is a material change in the legal relationship between the parties. The pledge is extinguished and the collateral-giver loses his title to the collateral, which is transferred to the third party to whom the collateral has been rehypothecated. In exchange, the collateral-giver is given a contractual right to the return of the same or similar collateral but this claim is intrinsically unsecured.
That sounds to me, readers, like title-transfer reuse — perhaps only at the point it leaves the custodian’s hands and not before, granting a scintilla of additional protection, but really not much.
It is a fundamental part of a prime brokerage business. This is how a prime broker funds its costs of lending to its Hedge Fund clients, which allows them to gain leverage, buy the assets and conflate alpha with vega: it is not a credit risk mitigation technique (for that see security and margin.
It seems a rather drastic right until you put it in context:
- Usually, the client will only own the custody assets in the first place because its prime broker has lent it the money to buy them. Hedge funds like to buy on margin so they they can (ahem) leverage their alpha.
- Running a prime brokerage business — lending to clients and then holding assets they buy with their loans in custody for them, is an expensive business. If the prime broker can raise finance against those (for example by using them as collateral under a securities financing programme) it can improve its balance sheet position, repay its internal treasury department the funds they made available at eye-watering rates, therefore markedly cheapening their own cost of lending and avoiding custody charges. Both of these mean it can price its loans more attractively to its clients.
There is a world of difference between rehypothecation and agent lending, even though UCITS V threatens (vaguely) to regard them as different varieties of the same thing.
Where you DO see a right of rehypothecation
Prime brokerage arrangements
A prime broker lends its client money to buy assets, and holds those assets in custody, taking security over them as surety for repayment of its loan — a “margin loan”. As custodian, the prime broker has legal title but not beneficial interest in the asset. 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 entirely 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
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) may not rehypothecate those assets for its own account.
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.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, “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.
- 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).
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.
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.
- ↑ Normal hypothecation, by the way, is a term you don’t often see (and which means simply to pledge assets by way of security for a debt).
- ↑ 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.