In a new research report, Finadium investigates the rules for collateral segregation in the United States and the United Kingdom, including the UK’s application of European Union laws on collateral. These are complex issues that have been made more confusing by the multiple rules and regulations at play in major trading markets.
As more focus comes on the protection of client assets, and separate accounts to protect investors from the potential of counterparty default, investors and their service providers must pay closer attention than ever to the rules behind collateral segregation.
A central reason for collateral segregation has been to facilitate, protect or manage the risk of rehypothecation. This long-established practice in financial markets permits brokers to use client assets as their own subject only to an obligation to return them when contractually due. Brokers use rehypothecated assets for any purpose, including making loans to other clients or further rehypothecating assets to other counterparties. Whether segregation of customer accounts at a broker is effective in risk control is questionable.
The Lehman litigation in the United States and United Kingdom reflected very different approaches to client protection: mutualized risk vs individual contract protection. Remedial legislation, including Dodd-Frank, the Alternative Investment Fund Managers Directive and the Financial Collateral Directive have established new rules and a new direction for collateral arrangements. Uncertainties still remain, particularly where financial regulators have informally adopted guidelines based on pre-financial crisis collateralization practices. For investors and managers, this changing area of law and regulations requires the exercise of due diligence and prudence. For brokers and custodians, there are new challenges in adapting to a changing business environment.
This report should be read by all financial market participants, including asset owners, brokers, custodians, technology firms and regulators, seeking to understand how their organizations should best respond to the market, operational and legal challenges presented by collateral segregation and rehypothecation rules today.
For more information and the Table of Contents, please visit the Finadium website.