An article in Bloomberg BusinessWeek, “EU Weighs Curbs on Banks’ Use of Client Assets as Collateral” by Jim Brunsden last week, discussed a move that could have some serious ramifications for repo.
In a nutshell, the article said “The European Commission is weighing whether firms should have to obtain formal consent from their clients before being allowed to reuse assets to back other trades, according to a document obtained by Bloomberg News. The consent would be enshrined in a “contractual agreement” between the parties.”
This could be interpreted any number of ways, but the risk is that it will squash re-hypothecation. Now we all know the saga of Lehman (Europe) and how collateral that was lent out kind of just went poof. The rise of Prime Custodians to hold excess collateral does a lot to address the problem but not solve it completely – a client has to be proactive to get this set up. Over-collateralization is still generally considered unsecured risk should the bank providing the financing goes belly up. The bigger the haircut, the bigger the exposure.
So what about this idea of requiring formal consent to reuse assets? Opting out of reuse will mean the cash lender no longer can use the asset to generate liquidity. Where will they get the cash to fund the deal? If the answer is unsecured markets, the next question is “at what cost”? That borrowing – if it even available given the paucity of unsecured inter-bank trading – will be mighty expensive. We think the option to disallow reuse will come with a high cost attached. Should the EU adopt it, it will be rarely used.
If reuse is limited more broadly, perhaps in connection with a clampdown on shadow banking, then all hell will break loose. We can imagine a misguided effort to cut down on collateral chains by squeezing re-hypothecation. But when it results in dead money on one side and liquidity squeezes on the other, it will expose the folly. And as the article in the WSJ that we wrote about earlier in the week (“The WSJ misses the mark with recent article on repo and shadow banking”) said, re-hypothecation does create credit and limiting credit creation mechanics might not be a great idea. But did that stop anyone before?
Collateral chains can get unwieldy. When Lehman went bust, repo desks had to go out and buy back paper they had repo’ed the dealer, sell paper they had reversed in and enter into replacement financing trades. The less liquid paper was a horror show and we’ve heard stories of it taking weeks to unwind (what had now morphed into) cash positions — with losses for everyone. But on the more liquid paper, the buy-ins and replacements were were simpler to execute. We hope that shadow banking regulations, if they come down to preventing re-hypothecation, take all this into consideration.
A link to the Bloomberg article is here.
A link to our post about the WSJ article is here.