In the regulatory debate about shadow banking, and in particular repo, there has been much confusion about the legal terminology of collateral, some of it threatening to have substantive policy consequences. This blog is a basic primer on the difference between ‘re-use’ and ‘re-hypothecation’ of collateral.
Outside the US, a repo works by means of the transfer of the legal title to a piece of collateral from the seller to the buyer. As the collateral becomes the unencumbered property of the buyer, he is entitled to do with the collateral what he wishes. He can pledge it, sell it, repo it out or just sit on it. If the buyer does dispose of the collateral, by the end of the repo, he has to acquire the same or similar (equivalent) collateral in order to return to the seller, but this does not constrain what he can do with the original collateral. The proprietary rights of the buyer are commonly referred to as his right of ‘re-use’. As we will see, this is not an ideal term but it has stuck. What is essential is to recognise that the buyer’s right of re-use is a fundamental property right. He is in the same legal position as anyone else who has bought an asset.
So, what is ‘re-hypothecation’?
As the ‘hypothecation’ bit of the name suggests, ‘re-hypothecation’ is a right related to a security interest attached to an asset. Specifically, re-hypothecation is a right which a pledgor can give, at his discretion, to a pledgee to re-use the collateral. In the US, the term ‘re-pledge’ is used as a synonym for re-hypothecation (unfortunately, so is ‘re-use’). Generally, pledgees can only dispose of collateral if the pledgor defaults. Until the pledgee exercises a right of re-hypothecation, legal title to the collateral remains with the pledgor, who continues to be entitled to the return of the original property. But as soon as the right of re-hypothecation is exercised, the pledge disappears and the pledgor’s property rights are replaced by a contractual right to the return of the same or similar (equivalent) assets. If the pledgee defaults, the pledgor becomes a mere unsecured creditor (and in most jurisdictions, will have lost his client asset protection rights).
A pledgee who is given a right of re-hypothecation can exercise his right and dispose of the collateral by means of sale or repo. However, the sale or repo are independent transactions and not part of the re-hypothecation. Re-hypothecation has nothing to do with repo — outside the US.
In practice, rights of re-hypothecation are typically given by hedge funds to prime brokers on assets in the fund’s segregated custody account, where they will be subject to a pledge in favour of the prime broker. Such rights are given in return for custodial and other services, in particular, sub-LIBOR financing. Re-hypothecation became an issue in the wake of the failures of Lehman Brothers International Europe and MF Global. Client assets were not returned promptly or in full. These problems were largely due to poor communications with clients, giving rise to disagreements as to the extent to which rights of re-hypothecation had been given, and inadequate systems and controls at the prime broker, leading to uncertainty as to which client assets had been re-hypothecated.
How has the term ‘re-hypothecation’ come to be associated with repo.
The reason is US repo. Under the law of New York, which is the predominant jurisdiction in the US, the transfer of title to collateral is not legally robust. In the event of a repo seller becoming insolvent, there is a material risk that the rights of the buyer to liquidate collateral could be successfully challenged in court. Consequently, the transfer of collateral in the US takes the form of the seller giving the buyer (1) a pledge, in which the collateral is transferred into the control of the buyer or his agent, and (2) the right to re-use the collateral at any time during the term of the repo, in other words, a right of re-hypothecation. The right of re-use of the pledged collateral (reinforced by an exemption under the US Bankruptcy Code from the automatic stay of enforcement that otherwise prevents a creditor from immediately liquidating collateral in the event of a borrower’s insolvency) gives US repo the same legal effect as a transfer of title of collateral.
So, it is perfectly legitimate to use the term ‘re-hypothecation’ for US repo. Is there a problem in extending the use of that term to other repo markets? This is what has happened as regulators, co-ordinating under the Financial Stability Board (FSB), have sought to ensure global consistency in regulation. Numerous regulatory papers have carelessly used the term re-hypothecation in general descriptions of repo.
The danger is two-fold. Firstly, there is the risk that the specific problems with re-hypothecation of client assets at Lehman and MF Global could taint general perceptions of repo and attract unnecessary new regulation. Secondly, as re-hypothecation is a discretionary right, there is no objection in principle to its regulation (this is already happening in respect of derivatives collateral). In contrast, attempts to regulate proprietary rights to collateral would interfere with basic property rights and therefore have profound legal implications.
English courts, the UK Financial Conduct Authority (FCA) and ISDA have steered away from the use, or advised against the use, of the term ‘re-hypothecation’. After some false starts, the European Banking Authority (EBA) has grasped the difference. Other regulators and market commentators have yet to follow suit.
 The EBA has stated ‘Re-hypothecation refers to the right of financial intermediaries to sell, pledge, invest or perform transactions with client assets they hold; and it allows prime brokers and other financial intermediaries to obtain funding using their client collateral… Collateral re-use usually covers a broader context, where securities delivered in one transaction are used to collateralise another transaction, including the ability to reuse collateral through change in (temporary) ownership. Yet, the terms re-hypothecation and re-use of securities are often used interchangeably…’
However, the ability to distinguish between ‘re-use’ and ‘re-hypothecation’ is still not universal with the EBA. In its July 2013 consultation paper on asset encumbrance, it is stated that re-use and re-hypothecation do not have distinct legal interpretations!