The Commonfund Institute has posted a new paper by David Belmont on the management of counterparty risk in the wake of MF Global, Peregrine, and the near implosion of the Knight Capital Group. Much of the paper involves a familiar though satisfyingly complex word: rehypothecation.
Belmont proposes a counterparty risk strategy that stands on three legs: scrutiny; diversification; and vigilance as to the aforesaid practice of rehypothecation.
Scrutinize and Diversify
Start with the simple matter of which counterparties (especially banks and brokers) are selected. Belmont proposes that fund managers should consider:
- The reputation, experience, etc. of a potential counterparty;
- The regulatory environment in which the potential counterparty operates;
- The stability of the terms on which it is willing to enter into a relationship; and
- Its ability to provide the appropriate level of service in connection with the fund’s business needs.
Questions concerning the level of service in particular may involve an inquiry into efficient and timely processing, reporting, clearing, and settlement, and the competence of staff, inclusive of those who prepare books and records.
There are limits to how much an outsider can know about a counterparty’s ongoing creditworthiness, though. Belmont sees this as a key takeaway of the fall of MF Global. To protect against such cases, it is also critical to diversify counterparty risks. Managers have taken this idea to heart of late, to the extent that few funds are launched without having at least two prime brokerage relationships in place. Another way of diversifying counterparty risks is to take some of the traditional counter-party functions inside the house. A fund with sufficient scale might for example build proprietary clearing and settlement systems.
It is that third leg of this counterparty risk management survey that involves rehypothecation, that is, the reuse by banks and brokerages of the assets that have been entrusted to them as collateral, such as the lending of securities held for this reason for the use of short sellers.
One of the issues this practice creates for a fund is that, even if the fund is dealing with a very creditworthy broker, that broker in turn may be lending out its assets to a third party that isn’t – and there is no transparency as to that third party recipient. Another (though related) issue is the “unclear priority of counterparty claim status in transactions … with an insolvent entity.”
Under the Securities Exchange Act in the U.S., there are limits on the practice of rehypothecation. A broker can only rehypothecate assets up to 140 percent of the value of the client’s liability that said broker.
Intriguingly, in the U.K. there are no such statutory limits. Some agreements between U.S. brokers and their clients allow for assets to be transferred to a U.K. subsidiary of that broker, in order to take advantage of the anything-goes rule there.
At any rate, funds do not have to submit meekly to whatever contracts their brokers offer. Belmont suggests funds try to amend their Credit Support Annex or Broker Agreements to prohibit or limit their collateral. They might also seek to restrict the use of the practice to brokers that maintain a specified credit rating. Belmont observes, though, that this “would have had no effect in the Lehman Brothers case since Lehman maintained its credit rating right up until the collapse.”
Risk management, like other good things, does not come for free. Any negotiated restriction may result in a higher funding charge from the broker affected.
Belmont is aware, of course, that counterparty risk is never the only consideration in the choice of a broker. Sometimes trade-offs have to be made. But when commercial considerations dictate the choice of a broker whose contract terms are less than optimal from a risk management point of view, the trade-off should be an explicit calculation, a careful cost-benefit analysis.
Belmont also discusses related collateral management issues: for example, the sweeping of excess equity.
A fund manager should have enough excess value (“equity”) in its account with the broker to cover expected day to day changes in the required margin. But it doesn’t want to have excess equity there, something that may occur as a result of profit accumulation, dividends and interest payments, or the liquidation of positions. Thus, managers should be “sweeping up” excess equity regularly.
This is easier said than done. Given the unpredictability of margin requirements, how much of the equity is the excess that should be swept? Belmont discusses two of the evolving models that bear on this issue and that seek to reduce the operational complexity it might otherwise create.