Scope of Re-hypothecation Regulation (Report of Workshops (3))
Kazutoshi Sugimura *, Masaru Itatani, Masaki Bessho (Bank of Japan)
Research LAB No.17-E-3, March 15, 2017
Keywords: Re-hypothecation; Regulation
JEL Classification: G19, G28, G33, K19, K22, K23
Contact: email@example.com (Masaru Itatani)
- Currently the Ministry of Finance.
The margin requirements for non-cleared over-the-counter ("OTC") derivatives transactions are introduced in 2016 (pursuant to an international agreement by the G20 to reduce systemic risk from OTC derivatives) and restrict the re-hypothecation of initial margin collateral. While this restriction is introduced in order to protect client assets, there has been a concern that such restriction may have a negative impact on market liquidity. The Report of the Workshops on "Contemporary Financial Transactions and Their Regulatory Treatment" (2016) (the "Report") analyzes the appropriate scope of regulation in relation to the re-hypothecation of initial margin collateral. Japan implements this regulation in a manner compatible with the international agreement, and introduces a new trust scheme concept, which allows for the segregated management of collateral assets. The Report also analyzes the potential for the trust scheme, which could provide room for the re-hypothecation of securities and hence, mitigate the unintended negative impact on market liquidity, while ensuring harmonization with the international agreement.
The experience from the recent financial crisis has led to a global call for restricting re-hypothecation. For example, as a general rule, under the margin requirements for non-centrally cleared over-the-counter derivatives transactions, securities and cash transferred from clients as "initial margin collateral" may not be re-hypothecated by recipient financial institutions.
Some market participants have voiced their concerns that excessive restriction of re-hypothecation may cause a shortage of assets used as collateral and therefore affect their market liquidity. Other market participants, while recognizing the fact that the shadow banking system has relied heavily on re-hypothecation, point to the need to be cautious when implementing this regulation as they are concerned that the global financing environment may be affected if less collateral is available for re-hypothecation. As such, it may be desirable to limit the restrictions on re-hypothecation in non-cleared OTC derivatives transactions to the extent deemed necessary and reasonable in light of its purpose.
Intent and purpose of re-hypothecation regulation
Why does re-hypothecation have to be regulated? The Financial Stability Board ("FSB") has stated that the "re-hypothecation of client assets (by recipient financial institutions) can create financial stability risks, especially if clients are uncertain about the extent to which their assets have been re-hypothecated, or about treatment in the event of (the financial institution's) bankruptcy." In relation to the shadow banking system, one notable risk is that "re-hypothecation can replace ownership of securities with a contractual claim on a financial institution to return equivalent securities, with ownership of the re-hypothecated securities transferring to this institution."
Based on these background facts, the re-hypothecation of initial margin collateral is restricted under the margin requirements applicable to non-cleared OTC derivatives transactions (which is to be introduced jointly by authorities in each country).
Margin requirements in Japan
Japan's margin requirements for non-cleared OTC derivatives transactions are consistent with those of the international agreement reached among authorities. Under Japan's margin requirements, "Financial instruments business operators" and "registered financial institutions" (together, the "Regulated Financial Entities") may neither post initial margin collateral they receive from their clients as collateral to others nor lend it out.
A major characteristic of Japan's margin requirements is to require management of initial margin collateral through the "creation of a trust or similar methods." Specifically, Regulated Financial Entities are required to create a trust under which clients are beneficiaries and Regulated Financial Entities who receive initial margin collateral are settlors (the "Trust Scheme"). Initial margin collateral, which becomes a trust asset, is to be returned to clients when there is a "collective liquidation or similar" event with respect to the settlor.
Why is the Trust Scheme introduced? The intent and purpose of these requirements are to impose a "no re-hypothecation" obligation on Regulated Financial Entities, while ensuring each party is able to close-out in the event of the other party's default through the application of the Act on Collective Liquidation of Specified Financial Transactions Conducted by Financial Institutions, etc. (Act No. 108 of 1998) (the "Collective Liquidation Act", which is known as the Netting Act of Japan) to non-cleared OTC derivatives transactions.
The Collective Liquidation Act affords a non-defaulting party the right to "close-out" or "liquidate" eligible financial transactions upon the other party's default, thereby exempting that party's right to such transactions from the operation of normal bankruptcy procedure.
Since collateralization which does not involve a transfer of title (for example, pursuant to a pledge (Shichi-Ken)) is understood to fall outside the scope of the Collective Liquidation Act, parties may use the legal form "deposits for consumption (Shouhi-Kitaku)" or "loans for consumption (Shouhi-Taishaku)" in order to apply that Act to their transaction.
However, it should be noted that those who post collateral using such legal forms are denied priority over claims remaining after liquidation as "deposits for consumption" or "loans for consumption" involve a transfer of title to collateral. In other words, collateral posting party's claims to demand restitution for the excess amount of collateral are uncollateralized. Therefore, creation of a trust should be employed to segregate collateral from the settlor's bankruptcy estate.
Scope of regulation
As mentioned above, there is a concern that regulation on re-hypothecation may affect market liquidity. Do Japan's margin requirements properly address this concern?
Under Japan's margin requirements, as a general rule, Regulated Financial Entities may neither post initial margin collateral they receive from their clients as collateral to others nor lend it out. However, in the event that cash is posted as initial margin collateral, it may be used or lent out as long as this is implemented in a safe manner and is ancillary to the management of initial margin collateral under a trust or similar method.
However, whether assets posted as initial margin collateral are cash or securities does not seem to be important when deciding whether to allow for re-hypothecation. In other words, to the extent that it is remote from the bankruptcy of a recipient regulated financial entity through the creation of a trust, clients do not necessarily bear credit risk against the regulated financial entity. Therefore, as long as the value of the trust assets is maintained in its entirety, the Trust Scheme can be deemed to accord clients priority with respect to their trust assets, whether cash or securities, in the bankruptcy of a regulated financial entity.
If this is the case, under the Trust Scheme, it may also be possible to allow for the re-hypothecation of initial margin collateral even when securities are posted as collateral. This approach takes account of market liquidity as long as it is sufficiently consistent with the international agreement.
It should also be noted that the current Japanese regulation restricting the re-hypothecation of collateral securities is quite understandable, given the high degree of respect accorded to the international agreement which restricts re-hypothecation of initial margin collateral as a general rule.
Japan's margin requirements do not allow for the re-hypothecation of securities posted as initial margin collateral. However, market participants have raised a concern that the restriction of re-hypothecation may affect market liquidity. This article suggests that, under the Trust Scheme, re-hypothecation of such securities would not frustrate the intent and purpose of the regulation.
- Report of Workshops on "Contemporary Financial Transactions and Their Regulatory Treatment" (2016), to be included in Kin'yu Kenkyu (Monetary and Economic Studies), Institute for Monetary and Economic Studies, Bank of Japan (forthcoming 2017) (in Japanese).
The views expressed herein are those of the authors and do not necessarily reflect those of the Bank of Japan.