Brussels: Rehypothecation caps being reviewed, says top European Commission policymaker
A top policymaker at the European Commission has said rehypothecation is being firmly scrutinised, adding a cap was a possibility although no decision would be made until the implications were fully understood.
“Re-use and rehypothecation is one area in the shadow banking system regulators are looking at. We are seeking to clarify what exactly re-use and rehypothecation are and explain our concerns. The key issue is to identify what is going on in the market and identify whether there should be legal limits on lending securities which a financial institution has taken from a counterparty,” said Patrick Pearson, head of the financial markets infrastructure unit at the European Commission, speaking in Brussels.
Re-use and rehypothecation is viewed as one of the most systemically important aspects of the shadow banking system. “We have seen what happened at Lehman Brothers, while the securities lending operation at AIG dragged the insurer down along with its credit rating,” commented Pearson.
The SEC currently enforces a 140% cap on rehypothecation while Paul Tucker, deputy governor of the Bank of England, proposed a cap of 125%. The SEC is currently revisiting its 140% cap although there is uncertainty about whether the limit will increase or decrease. The G20 and Financial Stability Board are also delving deeper into how rehypothecation works although Pearson said any cap imposed by the European Commission, if at all, would be between 125% and 140%. This would have a major impact, particularly in the UK, which does not have any rehypothecation limits in place. However, a total ban on rehypothecation within the EU is very unlikely.
“A cap is not a decision we shall take lightly. We understand that liquidity is critical and re-use and rehypothecation is the lifeline and life-blood to the market so we are carefully considering the implications. The last thing we want is a squeeze on liquidity so we are reviewing any potential consequences to a cap,” said Pearson. Any cap on rehypothecation could potentially drain liquidity from the market. Such a move would be hard felt in the eurozone, where liquidity is fast drying up.
A cap on rehypothecation would also make it far harder for prime brokers to fund themselves. Prime brokers subsidise their hedge fund clients through rehypothecation and any cap would therefore ramp up costs for hedge funds at a time when their profit margins are thin. This added burden would be on top of the Basel III costs which prime brokers are likely to pass down to their hedge fund clients and end users. Pearson confirmed it was inevitable end users would be hit by any changes.
Another outcome could be the creation of a trade repository which would require financial institutions to disclose where assets were being held, a suggestion mooted by Paul Tucker. “Transparency is critical and a trade repository would not be a bad idea. The question is whether it can be done. Trade repositories have said it is possible but issues remain such as who will get the data, and how it will be used. There could be some unintended consequences,” acknowledged Pearson.
According to the UK Financial Services Authority’s (FSA’s) latest hedge fund survey, 89% of managers have rehypothecation agreements in place with their prime brokers. Alarmingly, a quarter told the FSA they did not know the precise value of their rehypothecated assets despite prime brokers being legally required to provide daily reports to managers identifying the status of their assets and what has been rehypothecated. However, it is highly possible the survey did not account for assets held in custody.
The FSA also said hedge funds on average permitted rehypothecation up to 119% of net indebtedness, although this was questioned by an expert at the time, who said the figure was closer to 140% or even unlimited in some circumstances.