## _wp0942

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---

### Introduction
- Rehypothecation: collateral posted by a prime brokerage client to their prime broker can be used as collateral by that prime broker for its own purposes.
- Market sources suggest rehypothecation was historically a cheaper way of financing the prime business than turning to the repo market.
- Post-Lehman, rehypothecation is becoming much more limited; while this may reduce counterparty risk, it can aggravate global liquidity risk.

### Rehypothecation in the United States and the United Kingdom
- Legal/regulatory differences:
  - United Kingdom/Europe: rehypothecation can be for an unlimited amount of the customer’s assets; no customer protection rules analogous to U.S. provisions exist.
  - United States: defined customer protection rules exist (Securities Investor Protection Act (SIPA) of 1970 and Rule 15c3–3).
- Rule 15c3–3 (U.S.):
  - Prevents a broker-dealer from using its customers securities to finance its proprietary activities beyond limits.
  - Under Rule 15c3–3, the broker-dealer may use/rehypothecate an amount up to 140 percent of the customer’s debit balance.
  - Example: Assume a customer has $500 in pledged securities and a debit balance of $200, resulting in net equity of $300. The broker-dealer can rehypothecate up to $280 of the customer’s assets (140 percent x $200).
- SIPC and SIPA:
  - Created by SIPA, the Securities Investor Protection Corporation (SIPC) focuses on restoring funds to investors with assets in the hands of bankrupt brokerage firms.
  - Since 1970, SIPC has accumulated almost $2 billion from its members’ assessments available to investors during insolvency.
- Practical implications:
  - Hedge funds may have opted for funding in Europe because leverage is not capped as in the United States via the 140 percent rule.
  - U.K. bankruptcy law does not distinguish between banks and broker-dealers and does not provide SIPA-like protections; disentangling rehypothecated client assets from proprietary assets can be onerous.
- Types of securities and rehypothecation in the U.S.:
  - Rehypothecation is allowed only on margin securities.
  - Fully-paid securities are generally held in the cash account and are not permitted to be rehypothecated.
  - Excess margin securities (market value exceeding 140 percent of the customer’s debit balance) are not permitted to be rehypothecated.
  - Margin securities (customer securities held in a margin account for which the customer has not made full payment) are not subject to the possession and control requirement and can be used by the broker-dealer subject to limitations.

### Rehypothecation After Lehman’s Bankruptcy — Evidence and Measurements
- Observed behavior:
  - Following Lehman’s bankruptcy, prime brokers demanded more cash collateral in place of securities (unless highly liquid).
  - Liquidator PriceWaterhouseCoopers (PWC) confirmed in October 2008 that certain assets provided to Lehman Brothers International Europe (LBIE) were rehypothecated and no longer held for the client on a segregated basis; as a result the client may no longer have a proprietary interest in the assets.
  - Investors increasingly seek segregated client accounts, restrict rehypothecation rights, use multiple prime-brokers, and apply for client money protection under U.K. FSA’s Client Money Rules.
  - Some investors have taken term loans from large banks and swept non-collateral assets into custody accounts.
- Measured decline in rehypothecation from 10Q/10K filings:
  - Since end-2007 the decline in rehypothecation (i.e., total collateral received that can be pledged) by the largest four broker-dealers was $1.774 trillion.
  - The recent 10Qs of the large four (former) investment banks show a reduction of almost $1.8 trillion in ‘collateral received that can be pledged’.
- Collateral Received that can be Pledged — values as presented in source:
  - Column headings: Nov 2005 | Nov 2006 | Nov 2007 | May 2008 | Aug 2008 | Nov 2008
  - Lehman: 528 | 621 | 798 | 518
  - Morgan Stanley: 798 | 942 | 948 | 953 | 877 | 294
  - Goldman Sachs: 629 | 746 | 891 | 869 | 832 | 579
  - Merrill Lynch: 538 | 634 | 855 | 865 | 676 | 327
  - JPMorgan: (see source note 9)
  - Source: 10Q and 10K reports; For Merrill Lynch the column dates are December, June and September instead of November, May, and August.
  - Note: JPMorgan’s recent 10Q and 10K reports show an increase in ‘collateral received that can be pledged’ due to the combined reporting of Bear Stearns and the perception of ‘being close to Fed’ bank.
- Securities lending decline measured for major custodians:
  - The decline in the amount of collateral flowing from securities lending operations of the major custodians from end-2007 to end-September 2008 is about $737 billion.
  - The decline in collateral if measured from March 2008 (the peak) is about $814 billion.
- Securities Lending by Major Custodians (billions of dollars) — values as presented in source:
  - Column headings: Dec 31, 2007 | March 31, 2008 | June 30, 2008 | Dec 31, 2008
  - Bank of NY: $619 | $637 | $567 | $341
  - State Street: $558 | $591 | $550 | $325
  - JPMorgan: $385 | $411 | $362 | $169
  - Total: $1,562 | $1,639 | $1,479 | $825
  - Source: 10Q and 10K reports
- Aggregate liquidity impact:
  - Between the major three global custodian banks there has been a decline of about $750 billion since December 2007 in collateral flowing in the global financial system.
  - The combined reduction—almost $1.8 trillion from large broker-dealers plus about $750 billion from major custodians—implies reduced liquidity of over $2.5 trillion in the United States banking system alone.
- Economic and market effects:
  - Good collateral increasingly becoming scarce in the credit crisis.
  - Reduced rehypothecation raises funding costs for financial institutions that had been able to use client money/collateral.
  - Reduced rehypothecation is positive for reducing counterparty risk in jurisdictions without swift bankruptcy resolution or SIPC-like protections, but negative for market liquidity.
  - Extensive collateralization mitigates counterparty risk but can aggravate funding liquidity risk because counterparties must provide additional collateral at short notice if conditions change.
  - Shortages of high-quality collateral prompted special operations by central banks.
  - Repo market frictions: declining primary dealer repo activity contributes to credit crunch; delivery failures in the repo market increased and allow collateral hoarding at trivial penalties; deleveraging leads to dislocations in the cash bond market (e.g., negative basis).

### Conclusion — Policy-relevant implications and likely scenarios
- Behavioral changes by market participants:
  - Major financial institutions worldwide have increased or created sizable liquidity buffers of high-grade collateral and cash.
  - Hedge funds in the United Kingdom are demanding “segregated accounts” and limiting rehypothecation rights.
- Likely continued trends:
  - The aversion to rehypothecation depicted in the presented tables is likely to continue.
  - Reduced rehypothecation may encourage secured lending like repo, but reduced primary dealer repo activity and delivery failures complicate this channel.
- Possible structural shifts in prime brokerage and custody:
  - Prime business may change in favor of tri-party repo-financing and/or assigned custody.
  - Some clients may move to a U.S. brokerage where SIPA/Rule 15c3–3 protections apply.
- Trade-offs for policymakers and market participants:
  - Reduced rehypothecation lowers counterparty risk but increases funding costs and reduces market liquidity.
  - Jurisdictional insolvency protection (e.g., SIPA/SIPC) influences client exposure and choices of domicile for prime brokerage relationships.

### APPENDIX I. SECURITIES EXCHANGE ACT’S RULE 15C3–3
- Context and crisis-related dynamics:
  - If the financial crisis deepens, there will be an increasing tendency for those providing collateral to counterparties to ask for it to be segregated from the counterparty’s assets and to place limits on its further use.
  - Reduced rehypothecation leads to deleveraging (via the proprietary trading desks of the broker-dealer) that results in further aversion to rehypothecation.
  - Many foreign central banks are not keen on lending U.S. Treasuries in the repo market.
- Rule 15c3–3: three principal requirements:
  - A broker-dealer must maintain possession or control of certain customer securities (all fully paid securities and excess margin customer securities i.e., securities in a customer’s margin account that exceed 140 percent of the margin debit in their account.)
  - As to customer cash, a broker-dealer must deposit the cash or “qualified securities” of like value in a special account known as the “reserve account”. In other words, the broker-dealer is required to segregate all customer cash or money obtained from the use of customer property that has not been used to finance transactions of other customers.
  - As to customer securities that are not required to be in the broker’s control (e.g., those securities posted as required collateral that can be pledged as collateral to third parties), the broker-dealer is subject to limits on the amount it can borrow against such securities.
- Relationship with SIPA:
  - The customer protection rule is designed to work in conjunction with the Federal bankruptcy scheme for broker-dealers created by SIPA.
- Definition: Customer
  - “Customer” includes any person from whom or on whose behalf a broker-dealer holds securities or cash unless specifically excluded.
  - Customer excludes:
    - Subordinated lenders to the broker-dealer;
    - Other brokers or dealers and municipal securities dealers or government securities broker-dealers; and
    - Counterparties to repo and stock lending agreements.
  - A U.S. bank is generally a customer, even if it is affiliated with the broker-dealer. A non-broker-dealer affiliate of the broker-dealer, even a subsidiary, can be a customer.
- Control requirement:
  - The broker-dealer must obtain and maintain physical possession or control of all customer fully-paid and excess margin securities.
  - A good control location is a U.S. bank.
  - Outside the United States, securities can be held at a non-U.S. bank, broker or dealer, depository or clearing agency designated by the SEC.
  - The SEC has permitted service firms affiliated with a foreign investment company that performs various services for the fund to serve as foreign control locations.
  - Control means that the securities are located in an account in the name of the broker-dealer at a clearing corporation, depository or bank, free of any lien.
- Types of securities (classification under the customer protection rule):
  - “Fully-paid securities”, which are generally held in the cash account into which a customer has actually made full payment;
  - “Excess margin securities”, which are that portion of a customer’s margin securities having a market value that exceeds 140 percent of the customer’s debit balance to the broker-dealer;
  - “Margin securities”, which are customer securities held in a margin, or any other Regulation T account for which a customer has not made full payment. Margin securities are not subject to the possession and control requirement, so a broker-dealer can use these securities in its own business, subject to certain limitations; and
  - Non-customer securities (proprietary positions, for example).
- Rehypothecation rights and limits:
  - Fully-paid securities and “excess margin securities” cannot be rehypothecated (they have to be “controlled”).
  - A broker-dealer has the right to rehypothecate customer (margin) securities when the customer pledges those securities to the broker-dealer to support a margin debit.
  - Under Rule 15c3–3, the broker-dealer may use an amount up to 140 percent of the customer’s debit balance.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0942.pdf*

### Section 1

### Deleveraging after Lehman—Evidence from Reduced Rehypothecation

### Introduction
- Rehypothecation: collateral posted by a prime brokerage client (e.g., hedge fund) to their prime broker can be used as collateral by that prime broker for its own purposes.
- Market sources suggest rehypothecation was historically a cheaper way of financing the prime business than turning to the repo market.
- Post-Lehman, rehypothecation is becoming much more limited; while this may reduce counterparty risk, it can aggravate global liquidity risk.

### Rehypothecation in the United States and the United Kingdom
- Legal/regulatory differences:
  - United Kingdom/Europe: rehypothecation can be for an unlimited amount of the customer’s assets; no customer protection rules analogous to U.S. provisions exist.
  - United States: defined customer protection rules exist (Securities Investor Protection Act (SIPA) of 1970 and Rule 15c3–3).
- Rule 15c3–3 (U.S.):
  - Prevents a broker-dealer from using its customers securities to finance its proprietary activities beyond limits.
  - Under Rule 15c3–3, the broker-dealer may use/rehypothecate an amount up to 140 percent of the customer’s debit balance.
  - Example in source: Assume a customer has $500 in pledged securities and a debit balance of $200, resulting in net equity of $300. The broker-dealer can rehypothecate up to $280 of the customer’s assets (140 percent x $200).
- SIPC and SIPA:
  - Created by SIPA, the Securities Investor Protection Corporation (SIPC) focuses on restoring funds to investors with assets in the hands of bankrupt brokerage firms.
  - Since 1970, SIPC has accumulated almost $2 billion from its members’ assessments available to investors during insolvency.
- Practical implications:
  - Hedge funds may have opted for funding in Europe because leverage is not capped as in the United States via the 140 percent rule.
  - U.K. bankruptcy law does not distinguish between banks and broker-dealers and does not provide SIPA-like protections; disentangling rehypothecated client assets from proprietary assets can be onerous.
- Types of securities and rehypothecation in the U.S.:
  - Rehypothecation is allowed only on margin securities.
  - Fully-paid securities are generally held in the cash account and are not permitted to be rehypothecated.
  - Excess margin securities (market value exceeding 140 percent of the customer’s debit balance) are not permitted to be rehypothecated.
  - Margin securities (customer securities held in a margin account for which the customer has not made full payment) are not subject to the possession and control requirement and can be used by the broker-dealer subject to limitations.

### Rehypothecation After Lehman’s Bankruptcy — Evidence and Measurements
- Observed behavior:
  - Following Lehman’s bankruptcy, prime brokers demanded more cash collateral in place of securities (unless highly liquid).
  - Liquidator PriceWaterhouseCoopers (PWC) confirmed in October 2008 that certain assets provided to Lehman Brothers International Europe (LBIE) were rehypothecated and no longer held for the client on a segregated basis; as a result the client may no longer have a proprietary interest in the assets.
  - Investors increasingly seek segregated client accounts, restrict rehypothecation rights, use multiple prime-brokers, and apply for client money protection under U.K. FSA’s Client Money Rules.
  - Some investors have taken term loans from large banks and swept non-collateral assets into custody accounts.
- Measured decline in rehypothecation from 10Q/10K filings:
  - The latest data show that since end-2007 the decline in rehypothecation (i.e., total collateral received that can be pledged) by the largest four broker-dealers was $1.774 trillion.
  - The recent 10Qs of the large four (former) investment banks show a reduction of almost $1.8 trillion in ‘collateral received that can be pledged’.
- Table 1 (Collateral Received that can be Pledged is Decreasing) — values as presented in source:
  - Column headings: Nov 2005 | Nov 2006 | Nov 2007 | May 2008 | Aug 2008 | Nov 2008
  - Lehman: 528 | 621 | 798 | 518
  - Morgan Stanley: 798 | 942 | 948 | 953 | 877 | 294
  - Goldman Sachs: 629 | 746 | 891 | 869 | 832 | 579
  - Merrill Lynch: 538 | 634 | 855 | 865 | 676 | 327
  - JPMorgan: (see source note 9)
  - Source: 10Q and 10K reports; For Merrill Lynch the column dates are December, June and September instead of November, May, and August.
  - Note (from source): JPMorgan’s recent 10Q and 10K reports show an increase in ‘collateral received that can be pledged’ due to the combined reporting of Bear Stearns and the perception of ‘being close to Fed’ bank.
- Securities lending decline measured for major custodians:
  - The decline in the amount of collateral flowing from securities lending operations of the major custodians from end-2007 to end-September 2008 is about $737 billion.
  - The decline in collateral if measured from March 2008 (the peak) is about $814 billion.
- Table 2 (Securities Lending by Major Custodians) — (billions of dollars), values as presented in source:
  - Column headings: Dec 31, 2007 | March 31, 2008 | June 30, 2008 | Dec 31, 2008
  - Bank of NY: $619 | $637 | $567 | $341
  - State Street: $558 | $591 | $550 | $325
  - JPMorgan: $385 | $411 | $362 | $169
  - Total: $1,562 | $1,639 | $1,479 | $825
  - Source: 10Q and 10K reports
- Aggregate liquidity impact:
  - Between the major three global custodian banks there has been a decline of about $750 billion since December 2007 in collateral flowing in the global financial system.
  - The combined reduction—almost $1.8 trillion from large broker-dealers plus about $750 billion from major custodians—implies reduced liquidity of over $2.5 trillion in the United States banking system alone.
- Economic and market effects:
  - Good collateral increasingly becoming scarce in the credit crisis.
  - Reduced rehypothecation raises funding costs for financial institutions that had been able to use client money/collateral.
  - Reduced rehypothecation is positive for reducing counterparty risk in jurisdictions without swift bankruptcy resolution or SIPC-like protections, but negative for market liquidity.
  - Extensive collateralization mitigates counterparty risk but can aggravate funding liquidity risk because counterparties must provide additional collateral at short notice if conditions change.
  - Shortages of high-quality collateral prompted special operations by central banks.
  - Repo market frictions: declining primary dealer repo activity contributes to credit crunch; delivery failures in the repo market increased and allow collateral hoarding at trivial penalties; deleveraging leads to dislocations in the cash bond market (e.g., negative basis).

### Conclusion — Policy-relevant implications and likely scenarios
- Behavioral changes by market participants:
  - Major financial institutions worldwide have increased or created sizable liquidity buffers of high-grade collateral and cash.
  - Hedge funds in the United Kingdom are demanding “segregated accounts” and limiting rehypothecation rights.
- Likely continued trends:
  - The aversion to rehypothecation depicted in the presented tables is likely to continue.
  - Reduced rehypothecation may encourage secured lending like repo, but reduced primary dealer repo activity and delivery failures complicate this channel.
- Possible structural shifts in prime brokerage and custody:
  - Prime business may change in favor of tri-party repo-financing and/or assigned custody.
  - Some clients may move to a U.S. brokerage where SIPA/Rule 15c3–3 protections apply.
- Trade-offs for policymakers and market participants:
  - Reduced rehypothecation lowers counterparty risk but increases funding costs and reduces market liquidity.
  - Jurisdictional insolvency protection (e.g., SIPA/SIPC) influences client exposure and choices of domicile for prime brokerage relationships.

*Source: _wp0942 - Section 1, WP/09/42 (March 2009).*

### Section 2

### APPENDIX I.  SECURITIES EXCHANGE ACT’S RULE 15C3–3

### Context and crisis-related dynamics
- In general, if the financial crisis deepens, there will be an increasing tendency for those providing collateral to counterparties to ask for it to be segregated from the counterparty’s assets and to place limits on its further use.
- Reduced rehypothecation leads to deleveraging (via the proprietary trading desks of the broker-dealer) that results in further aversion to rehypothecation.
- Many foreign central banks are not keen on lending U.S. Treasuries in the repo market.

### Rule 15c3–3: three principal requirements
- A broker-dealer must maintain possession or control of certain customer securities (all fully paid securities and excess margin customer securities i.e., securities in a customer’s margin account that exceed 140 percent of the margin debit in their account.)
- As to customer cash, a broker-dealer must deposit the cash or “qualified securities” of like value in a special account known as the “reserve account”. In other words, the broker-dealer is required to segregate all customer cash or money obtained from the use of customer property that has not been used to finance transactions of other customers.
- As to customer securities that are not required to be in the broker’s control (e.g., those securities posted as required collateral that can be pledged as collateral to third parties), the broker-dealer is subject to limits on the amount it can borrow against such securities.

### Relationship with SIPA
- The customer protection rule is designed to work in conjunction with the Federal bankruptcy scheme for broker-dealers created by SIPA.

### Definition: Customer
- “Customer” includes any person from whom or on whose behalf a broker-dealer holds securities or cash unless specifically excluded.
- Customer excludes:
  - Subordinated lenders to the broker-dealer;
  - Other brokers or dealers and municipal securities dealers or government securities broker-dealers; and
  - Counterparties to repo and stock lending agreements.
- A U.S. bank is generally a customer, even if it is affiliated with the broker-dealer. A non-broker-dealer affiliate of the broker-dealer, even a subsidiary, can be a customer.

### Control requirement
- The broker-dealer must obtain and maintain physical possession or control of all customer fully-paid and excess margin securities.
- A good control location is a U.S. bank.
- Outside the United States, securities can be held at a non-U.S. bank, broker or dealer, depository or clearing agency designated by the SEC.
- The SEC has permitted service firms affiliated with a foreign investment company that performs various services for the fund to serve as foreign control locations.
- Control means that the securities are located in an account in the name of the broker-dealer at a clearing corporation, depository or bank, free of any lien.

### Types of securities (classification under the customer protection rule)
- “Fully-paid securities”, which are generally held in the cash account into which a customer has actually made full payment;
- “Excess margin securities”, which are that portion of a customer’s margin securities having a market value that exceeds 140 percent of the customer’s debit balance to the broker-dealer;
- “Margin securities”, which are customer securities held in a margin, or any other Regulation T account for which a customer has not made full payment. Margin securities are not subject to the possession and control requirement, so a broker-dealer can use these securities in its own business, subject to certain limitations; and
- Non-customer securities (proprietary positions, for example).

### Rehypothecation rights and limits
- Fully-paid securities and “excess margin securities” cannot be rehypothecated (they have to be “controlled”).
- A broker-dealer has the right to rehypothecate customer (margin) securities when the customer pledges those securities to the broker-dealer to support a margin debit.
- Under Rule 15c3–3, the broker-dealer may use an amount up to 140 percent of the customer’s debit balance.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0942.pdf*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0942.pdf_