Academics, you re-hypothecate at your risk!

In a blog in May 2015, I tried to explain that, outside the US repo market, it was incorrect to use the term ‘re-hypothecation’ to describe the use of collateral purchased in a repo by its buyer. Such use is usually termed ‘re-use’ but would be better called ‘re-sale’. The crux of the matter is that re-hypothecation is a right to dispose of collateral that can be given to a pledgee by a pledgor but such a gift is at the discretion of the pledgor. In contrast, the re-use of repo collateral is the proprietary right of the buyer of collateral to dispose of that collateral. This fundamental difference arises because pledged collateral remains the property of the pledgor (giver), whereas purchased collateral becomes the property of the buyer (receiver).

Recognising the distinction between re-use and re-hypothecation is important because of the confusion over what happened to the collateral that was re-hypothecated to Lehman Brothers International Europe (LBIE) by its hedge fund clients in 2008 in order to secure margin lending and derivatives exposures. The inability or unwillingness of regulators to distinguish between re-hypothecation and re-use has had serious unintended consequences for the European repo market.

Barking up the wrong tree

But it is not just regulators who have difficulty recognizing or accepting the difference between re-hypothecation and re-use. In an interesting paper on ‘Collateral Reuse as a Direct Funding Mechanism in Repo Markets’ by George Issa and Elvis Jarnecic of the University of Sydney, the authors kindly refer to my blog last year but then summarily dismiss the substance on the grounds that, ‘Although they are technically different…, the terms “collateral reuse” and “rehypothecation” are used interchangeably to refer to the use of posted collateral in a source transaction to secure a separate transaction.’

The authors are in fact correct to say that the terms ‘are used interchangeably’ but that widespread usage is incorrect, as I tried to explain. Their failure to see the difference leads the authors to propose an invalid reason for the decline in the re-use of collateral in the Australian repo during the Great Financial Crisis (GFC).

The authors argue, ‘… the exploratory analysis showed that collateral reuse experienced a fairly sudden and permanent decline at the start of the GFC. This is consistent with the statement that collateral providers increasingly demanded segregation of their collateral during the GFC due to concerns about credit risk and the possibility that their collateral would not be returned…Following the shock to financial intermediaries from late-2007, a larger fraction of collateral providers then demand that their collateral be segregated due to an increase in the risk that collateral cannot be returned when requested. Hence, even though dealers have a greater need to reuse collateral to ease their funding constraint, the segregation constraint leads to an overall sharp decline in the repo rate spread. A likely reason for the subsequent persistence of a low repo rate spread is higher risk aversion – and therefore a higher likelihood of collateral segregation requests – relative to pre-GFC levels: not only is collateral more scarce due to regulatory requirements…but also repo market participants are more concerned about counterparty risk due to continued liquidity pressures in global financial markets… although dealers have a greater demand to rehypothecate during crisis periods, the reuse rate declines dramatically at the start of the GFC, reflecting increased demand by source party repos for collateral segregation.’

By segregation, the authors mean no commingling with the assets of the prime broker and, most importantly, no re-hypothecation.

The problem with this explanation for the decline in re-use is that sellers in a repo cannot control what buyers do or do not do with the collateral. Because legal and beneficial title to the collateral is sold to the buyer, it becomes the buyer’s unencumbered property. That is the very essence of a repo.

There was indeed a demand by clients for collateral to be segregated (and the widespread withdrawal of the permission to re-hypothecate) but this was by hedge fund clients to their prime brokers in respect of collateral pledged under prime brokerage arrangements, where the collateral had been pledged to secure exposures arising from derivatives transactions and margin lending, and where the hedge funds had previously given their prime brokers permission to re-hypothecate. It was not in respect of repo collateral and legally could not have been.

The rest of the paper

However, the mistaken explanation for the decline in re-use in the Australian repo market should not detract from the quality of the research underlying the paper. The authors use a Furfine-type algorithm to detect overnight repos from securities settlement data and compile a transaction time series. They use this time series to test the hypothesis proposed by Infante (2014) and Eren (2014) that repo dealers acting as intermediaries impose a higher haircut on reverse repo than on matched-book repos, ie they pay less cash for collateral through a reverse repo than they receive for that collateral in a matching repo. In this way, collateral re-use provides net funding to intermediating dealers. Importantly, Infante further suggests that the higher haircut imposed on the reverse repo is an incentive on the seller to run in the event of a deterioration in the credit of the dealer. The data compiled by Issa and Jarnecic conclusively rejects this hypothesis!

There may of course be local reasons why haircut spreads are negative in Australia and future studies of other markets may discover positive spreads. But there is an important lesson to be learned: not all repo markets are the same. FRBNY and FSB please take note!

Finally, a point of detail worth noting is that Issa and Jarnecic estimate re-use in the Australian repo market at 3.56%, a similar order of magnitude to the estimate of re-use in the Swiss market by Furher et al (2014).

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