## Collateral Received that is Permitted to be Pledged at Large U.S. Banks

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---

### Introduction and contribution
- Paper focus: role of rehypothecation in augmenting funding and enlarging the measured size of the shadow banking system; implications for large U.S. banks receiving U.K. funding.
- Key claim: the shadow banking system was at least 50 percent larger than previously estimated once rehypothecation/pledged-collateral data are included.
- Empirical approach: use pledged collateral items disclosed in financial statement notes to capture off-balance sheet rehypothecation funding and estimate collateral “churning” from hedge fund — prime broker relationships.

### Rehypothecation: definitions and institutional context
- Rehypothecation: use by a prime broker of client-posted collateral for the prime broker’s own purposes; typically authorized via blanket consent in Customer Account Agreements or Prime Brokerage Agreements.
- Client trade-offs: hedge funds pay less for prime brokerage services if collateral is permitted to be rehypothecated.

### Regulatory regimes and key legal distinctions
- United States:
  - Rule 15c3–3 limits use of customer securities to finance proprietary activities.
  - Under Regulation T, broker-dealer may rehypothecate up to 140 percent of the customer’s debit balance.
  - SIPA / SIPC: Created by the Securities Investor Protection Act (SIPA) of 1970; SIPC’s receipts since 1970 have grossed more than $2 billion from member assessments for investor recovery in broker-dealer insolvencies.
  - SIPA provides procedures and customer protections in broker-dealer insolvencies.
- United Kingdom:
  - No quantitative cap on rehypothecation; an unlimited amount of customer assets can be rehypothecated and there are no customer protection rules akin to U.S. SIPA.
  - Consequence illustrated by Lehman Brothers International Europe (LBIE): certain assets rehypothecated and not held segregated; clients became unsecured creditors; disentangling assets was onerous.
  - LBIE had about 900 prime brokerage clients at the time of its collapse.
- Continental Europe:
  - EU law does not establish a quantitative cap comparable to U.S. SEC Rule 15c3–3; parties may negotiate reuse rights.
  - Litigation (e.g., Dexia, French Supreme Court decision dated 4 May, 2010 referenced) could affect future regimes but outcomes remain uncertain.

### Rehypothecation after Lehman’s bankruptcy
- Market behavior post-Lehman:
  - Prime brokers demanded more cash collateral in place of securities (unless securities were highly liquid and unencumbered).
  - Larger hedge funds increased use of segregated client accounts and other protections (restricting rehypothecation rights, multiple prime brokers, client money protection under U.K. FSA rules).
- Reported decline in rehypothecation among largest seven U.S. broker-dealers:
  - Total collateral received that is permitted to be pledged/rehypothecated declined from about $4.5 trillion (end-2007) to $2.1 trillion (end-2009).
- Example financial-statement disclosure format (used to derive pledged-collateral series):
  - “As of December 2009 and November 2008, the fair value of financial instruments received as collateral by the firm that it was permitted to deliver or repledge was $561 billion and $578 billion, respectively, of which the firm delivered or repledged $392 billion and $445 billion, respectively.”

### Collapse in the shadow banking system (adjusting for rehypothecation)
- Standard measure (Adrian and Shin, 2009): sum of prime dealer repos, financial sector commercial paper and asset-backed commercial paper (red/lower line in Figure 3).
- Augmented measure: add pledged collateral that can be repledged by large banks (green/higher curve in Figure 3).
- Rationale: Flow of Funds (FoF) data capture only on-balance sheet funding and omit off-balance-sheet pledged collateral disclosed in notes/memo items; including pledged collateral reveals substantially larger non-bank funding to banks via rehypothecation.
- Asset-Backed Commercial Paper (ABCP) context: ABCP estimated to have averaged from $0.5–$1 trillion in 2007–2009 and represents conduit liabilities relevant to shadow banking measurement.

### Non-bank funding to U.S. banks via rehypothecation
- Off-balance-sheet pledged collateral received by large banks represented a sizable funding source relative to on-balance-sheet dealer funding (see Figures 2 and 3; numeric series drawn from company reports and IMF staff calculations).
- Box 1 methodology: use pledged collateral disclosures in financial-statement notes to measure collateral received that is permitted to be repledged; these items arise from customer margin loans, securities borrowing, reverse repos, derivative and other transactions, and often include excess collateral originating from non-U.S. jurisdictions like the U.K.

### Churning (velocity) of collateral — evidence and estimates from hedge funds
- Churning definition: re-use of an asset (rehypothecation rounds), which does not occur for on-balance-sheet items but can occur for pledged collateral disclosed simultaneously by multiple entities.
- Hedge fund sector indicators (end-2007, pre-crisis):
  - Total assets under management (AUM) of the global hedge fund industry: about $2 trillion.
  - Assumed average leverage: 2, implying hedge fund industry held roughly $4 trillion of securities on a mark-to-market basis.
  - Market sources: on average, each of the largest 25 hedge funds borrowed about $30–60 billion from their prime brokers (aggregate roughly $1 trillion).
  - Discussions with collateral teams at large banks: about $1 trillion of the market value of securities of the global hedge fund industry was rehypothecated as of end-2007.
- Churning-factor calculation (illustrative, based on disclosures and industry estimates):
  - Total pledgeable collateral appearing in large ten global banks’ financials: $10 trillion.
  - Share attributable to hedge funds prior to the crisis: 40 percent (of $10 trillion).
  - Formula used:
    - Churning factor of collateral = (ɤ ∑ αi) / (∑ βj / 25)  [as defined in source; empirical simplification reported below]
  - Numerical simplification in source:
    - 40% ($10 trillion) / $1 trillion = 4
  - Result: churning factor estimated at 4 (i.e., collateral re-used roughly four times in this illustrative calculation).

### Velocity (or Churning) of Collateral at a Global Level (Box 2)
- Since the U.S. banks rehypothecate “collateral received that can be pledged” with European banks and vice versa, the source of off-balance sheet funding is higher (through the velocity of collateral).
- When U.S. banks data are added together with large European banks with significant relations with the hedge fund industry (Deutsche Bank, UBS, Barclays, Royal Bank of Scotland and Credit Suisse), the total available pledged collateral was over $10 trillion at end-2007.
- Roughly $1 trillion AUM of all hedge funds were rehypothecated and hedge funds contributed about 40 percent of all pledgeable collateral received by the large banks.
- Thus the churning of collateral could have been around a factor of 4 as of end-2007.
- More recently, as of end-2009, the churning factor has also declined in line with the total available pledged collateral.
- The most recent end-2009 financial reports of large European banks (i.e., Deutsche Bank, Credit Suisse, UBS and Barclays) show lower levels of rehypothecation relative to end-2007 (see figure 4).

### Hedge Fund Practices and Legal/Contractual Constraints (Box 2)
- Large hedge funds are “not leaving money on the table” relative to the era before Lehman; unlike smaller and/or equity focused hedge funds, the larger hedge funds will not sign off on unlimited rehypothecation and not borrow.
- Although the U.K. does not have the 140 percent cap on rehypothecation, many large hedge funds are presently using this figure as a benchmark when negotiating/revising their prime brokerage agreements with large banks.
- Discussions with a diverse group of U.K.’s buy side (including small and medium sized hedge funds, institutional investors etc) indicate that the majority are not yet converging to the 140 percent rule.
- Note: the sample of large European banks cited does not account for other banks that are likely to have large prime brokerage business (HSBC, Societe General, BNPParibas, Nomura etc.) and thus the churning factor may be higher (as the denominator, i.e., pledgeable collateral of all hedge funds globally, will remain at $1 trillion).

### Policy Implications
- Following the collapse of Lehman, hedge funds have become more cognizant of the way the client money and asset regime operates in the United Kingdom.
- For some, the United Kingdom provides a platform for higher leveraging (and deleveraging) that is not available in the United States.
- In general, post Lehman, one would expect an increasing tendency for those providing collateral to counterparties to ask for their collateral to be segregated from the counterparty’s assets and to place limits on its further use.
- The U.K. FSA has not yet made any changes on the use (and re-use) of collateral since their LBIE experience that would remove or reduce the asymmetry in the U.K. and the U.S.
- The FSA’s Consultation Paper 10/9 proposes:
  - (a) daily reporting on client money and assets holdings to all prime brokerage clients, and
  - (b) creating a requirement that all prime brokerage agreements will contain a disclosure annex which will highlight relevant definitions and the contractual limit on rehypothecation.

### Suggested Actions / Recommendations
- Supervisors of U.S. banks reporting on a global consolidated basis need to enhance understanding of collateral funding that U.S. banks receive in the United Kingdom and other jurisdictions with unconstrained rehypothecation rights.
- Monitoring off-balance-sheet pledged collateral and the extent of rehypothecation/churning is essential for properly measuring shadow banking activity and assessing systemic funding vulnerabilities.
- Suggested focus areas for regulators:
  - Incorporate pledged-collateral disclosures into systemic funding metrics.
  - Understand cross-border legal asymmetries (e.g., U.K. vs U.S.) that enable higher leveraging via rehypothecation.
  - Track post-crisis shifts from securities collateral to cash collateral and increased use of segregated client accounts.
- Rehypothecation data and the associated churning factor might be considered by major central banks to augment their tools for understanding the shadow banking system and associated liquidity within the global financial system.

*Source: IMF staff analysis from “Collateral Received that is Permitted to be Pledged at Large U.S. Banks” (text and figures as provided in the source content).*

### 1. Collateral Received that is Permitted to be Pledged at Large U.S. Banks ............................6

### 1. Collateral Received that is Permitted to be Pledged at Large U.S. Banks

### Introduction and contribution
- Paper focus: role of rehypothecation in augmenting funding and enlarging the measured size of the shadow banking system; implications for large U.S. banks receiving U.K. funding.
- Key claim: the shadow banking system was at least 50 percent larger than previously estimated once rehypothecation/pledged-collateral data are included.
- Empirical approach: use pledged collateral items disclosed in financial statement notes to capture off-balance sheet rehypothecation funding and estimate collateral “churning” from hedge fund — prime broker relationships.

### Rehypothecation: definitions and institutional context
- Rehypothecation: use by a prime broker of client-posted collateral for the prime broker’s own purposes; typically authorized via blanket consent in Customer Account Agreements or Prime Brokerage Agreements.
- Client trade-offs: hedge funds pay less for prime brokerage services if collateral is permitted to be rehypothecated.

### Regulatory regimes and key legal distinctions
- United States:
  - Rule 15c3–3 limits use of customer securities to finance proprietary activities.
  - Under Regulation T, broker-dealer may rehypothecate up to 140 percent of the customer’s debit balance.
  - SIPA / SIPC: Created by the Securities Investor Protection Act (SIPA) of 1970; SIPC’s receipts since 1970 have grossed more than $2 billion from member assessments for investor recovery in broker-dealer insolvencies.
  - SIPA provides procedures and customer protections in broker-dealer insolvencies.
- United Kingdom:
  - No quantitative cap on rehypothecation; an unlimited amount of customer assets can be rehypothecated and there are no customer protection rules akin to U.S. SIPA.
  - Consequence illustrated by Lehman Brothers International Europe (LBIE): certain assets rehypothecated and not held segregated; clients became unsecured creditors; disentangling assets was onerous.
  - LBIE had about 900 prime brokerage clients at the time of its collapse.
- Continental Europe:
  - EU law does not establish a quantitative cap comparable to U.S. SEC Rule 15c3–3; parties may negotiate reuse rights.
  - Litigation (e.g., Dexia, French Supreme Court decision dated 4 May, 2010 referenced) could affect future regimes but outcomes remain uncertain.

### Rehypothecation after Lehman’s bankruptcy
- Market behavior post-Lehman:
  - Prime brokers demanded more cash collateral in place of securities (unless securities were highly liquid and unencumbered).
  - Larger hedge funds increased use of segregated client accounts and other protections (restricting rehypothecation rights, multiple prime brokers, client money protection under U.K. FSA rules).
- Reported decline in rehypothecation among largest seven U.S. broker-dealers:
  - Total collateral received that is permitted to be pledged/rehypothecated declined from about $4.5 trillion (end-2007) to $2.1 trillion (end-2009).
- Example financial-statement disclosure format (used to derive pledged-collateral series):
  - “As of December 2009 and November 2008, the fair value of financial instruments received as collateral by the firm that it was permitted to deliver or repledge was $561 billion and $578 billion, respectively, of which the firm delivered or repledged $392 billion and $445 billion, respectively.”

### Collapse in the shadow banking system (adjusting for rehypothecation)
- Standard measure (Adrian and Shin, 2009): sum of prime dealer repos, financial sector commercial paper and asset-backed commercial paper (red/lower line in Figure 3).
- Augmented measure: add pledged collateral that can be repledged by large banks (green/higher curve in Figure 3).
- Rationale: Flow of Funds (FoF) data capture only on-balance sheet funding and omit off-balance-sheet pledged collateral disclosed in notes/memo items; including pledged collateral reveals substantially larger non-bank funding to banks via rehypothecation.
- Asset-Backed Commercial Paper (ABCP) context: ABCP estimated to have averaged from $0.5–$1 trillion in 2007–2009 and represents conduit liabilities relevant to shadow banking measurement.

### Non-bank funding to U.S. banks via rehypothecation
- Off-balance-sheet pledged collateral received by large banks represented a sizable funding source relative to on-balance-sheet dealer funding (see Figures 2 and 3; numeric series drawn from company reports and IMF staff calculations).
- Box 1 methodology: use pledged collateral disclosures in financial-statement notes to measure collateral received that is permitted to be repledged; these items arise from customer margin loans, securities borrowing, reverse repos, derivative and other transactions, and often include excess collateral originating from non-U.S. jurisdictions like the U.K.

### Churning (velocity) of collateral — evidence and estimates from hedge funds
- Churning definition: re-use of an asset (rehypothecation rounds), which does not occur for on-balance-sheet items but can occur for pledged collateral disclosed simultaneously by multiple entities.
- Hedge fund sector indicators (end-2007, pre-crisis):
  - Total assets under management (AUM) of the global hedge fund industry: about $2 trillion.
  - Assumed average leverage: 2, implying hedge fund industry held roughly $4 trillion of securities on a mark-to-market basis.
  - Market sources: on average, each of the largest 25 hedge funds borrowed about $30–60 billion from their prime brokers (aggregate roughly $1 trillion).
  - Discussions with collateral teams at large banks: about $1 trillion of the market value of securities of the global hedge fund industry was rehypothecated as of end-2007.
- Churning-factor calculation (illustrative, based on disclosures and industry estimates):
  - Total pledgeable collateral appearing in large ten global banks’ financials: $10 trillion.
  - Share attributable to hedge funds prior to the crisis: 40 percent (of $10 trillion).
  - Formula used:
    - Churning factor of collateral = (ɤ ∑ αi) / (∑ βj / 25)  [as defined in source; empirical simplification reported below]
  - Numerical simplification in source:
    - 40% ($10 trillion) / $1 trillion = 4
  - Result: churning factor estimated at 4 (i.e., collateral re-used roughly four times in this illustrative calculation).

### Implications and supervisory recommendations (conclusions section summary)
- Supervisors of U.S. banks reporting on a global consolidated basis need to enhance understanding of collateral funding that U.S. banks receive in the United Kingdom and other jurisdictions with unconstrained rehypothecation rights.
- Monitoring off-balance-sheet pledged collateral and the extent of rehypothecation/churning is essential for properly measuring shadow banking activity and assessing systemic funding vulnerabilities.
- Suggested focus areas for regulators:
  - Incorporate pledged-collateral disclosures into systemic funding metrics.
  - Understand cross-border legal asymmetries (e.g., U.K. vs U.S.) that enable higher leveraging via rehypothecation.
  - Track post-crisis shifts from securities collateral to cash collateral and increased use of segregated client accounts.

*Source: IMF staff analysis from “Collateral Received that is Permitted to be Pledged at Large U.S. Banks” (text and figures as provided in the source content).*

### Box 2 summarizes the global churning factor from the lens of the hedge fund industry and

### Box 2 summarizes the global churning factor from the lens of the hedge fund industry and

### Velocity (or Churning) of Collateral at a Global Level
- Since the U.S. banks rehypothecate “collateral received that can be pledged” with European banks and vice versa, the source of off-balance sheet funding is higher (through the velocity of collateral).
- When U.S. banks data are added together with large European banks with significant relations with the hedge fund industry (Deutsche Bank, UBS, Barclays, Royal Bank of Scotland and Credit Suisse), the total available pledged collateral was over $10 trillion at end-2007.
- Roughly $1 trillion AUM of all hedge funds were rehypothecated and hedge funds contributed about 40 percent of all pledgeable collateral received by the large banks.
- Thus the churning of collateral could have been around a factor of 4 as of end-2007.
- More recently, as of end-2009, the churning factor has also declined in line with the total available pledged collateral.
- The most recent end-2009 financial reports of large European banks (i.e., Deutsche Bank, Credit Suisse, UBS and Barclays) show lower levels of rehypothecation relative to end-2007 (see figure 4).

### Hedge Fund Practices and Legal/Contractual Constraints
- Large hedge funds are “not leaving money on the table” relative to the era before Lehman; unlike smaller and/or equity focused hedge funds, the larger hedge funds will not sign off on unlimited rehypothecation and not borrow.
- Although the U.K. does not have the 140 percent cap on rehypothecation, many large hedge funds are presently using this figure as a benchmark when negotiating/revising their prime brokerage agreements with large banks.
- Discussions with a diverse group of U.K.’s buy side (including small and medium sized hedge funds, institutional investors etc) indicate that the majority are not yet converging to the 140 percent rule.
- Note: the sample of large European banks cited does not account for other banks that are likely to have large prime brokerage business (HSBC, Societe General, BNPParibas, Nomura etc.) and thus the churning factor may be higher (as the denominator, i.e., pledgeable collateral of all hedge funds globally, will remain at $1 trillion).

### Policy Implications
- Following the collapse of Lehman, hedge funds have become more cognizant of the way the client money and asset regime operates in the United Kingdom.
- For some, the United Kingdom provides a platform for higher leveraging (and deleveraging) that is not available in the United States.
- In general, post Lehman, one would expect an increasing tendency for those providing collateral to counterparties to ask for their collateral to be segregated from the counterparty’s assets and to place limits on its further use.
- The U.K. FSA has not yet made any changes on the use (and re-use) of collateral since their LBIE experience that would remove or reduce the asymmetry in the U.K. and the U.S.
- The FSA’s Consultation Paper 10/9 proposes:
  - (a) daily reporting on client money and assets holdings to all prime brokerage clients, and
  - (b) creating a requirement that all prime brokerage agreements will contain a disclosure annex which will highlight relevant definitions and the contractual limit on rehypothecation.

### Suggested Actions / Recommendations
- Supervisors of large banks that report on a global consolidated basis may need to enhance their understanding of the off-balance sheet funding that these banks receive via rehypothecation from other jurisdictions.
- The asymmetry between U.K. and the U.S. on the use of client’s collateral is an example that highlights the recent policy recommendations to limit leverage and jurisdictional arbitrage (Tucker, 2010).
- The reduction in pledgable collateral received by the large banks (and the associated churning factor) has a direct impact on global liquidity.
- Rehypothecation data and the associated churning factor might be considered by major central banks to augment their tools for understanding the shadow banking system and associated liquidity within the global financial system.

*Source: Box 2 and accompanying text, _wp10172 - Box 2 summarizes the global churning factor from the lens of the hedge fund industry and*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10172.pdf_