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Wall Street’s $4 trillion kitty

August 24, 2009

matthewgoldstein.jpgThe Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There’s nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can’t be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.

Right now, a party to a derivatives contract can request that any collateral be held in an untouchable, segregated account. But most derivatives traders don’t do this because dealers often charge higher fees for keeping cash in segregated accounts.

A measure banning the redeployment of collateral by dealers would not only bring fairer pricing to the derivatives markets but would also eliminate another source of leverage for Wall Street firms.

And here’s another thing a ban on rehypothecation would accomplish: it would make it easier to deal with the fallout from the collapse of a major derivatives dealer.

It has been estimated that Lehman Brothers, before it collapsed in September, redeployed tens of billions in collateral it took in as a derivatives dealer.

Nearly a year later, hedge funds, banks and other financial institutions that entered into derivatives transactions with Lehman are still trying to determine just where the cash they posted as collateral for those trades went. The litigation over those collateral disputes could take years to resolve.

Michael Greenberger, a former director at the Commodity Futures Trading Commission who teaches law at the University of Maryland, says rehypothecation benefits no one but the derivatives dealer. Worse, he says, allowing investment firms to reuse and redeploy collateral only complicates the “unwinding and resolution’ of a collapsed dealer.

The goal of regulatory reform should be to minimize risk and take away any incentive for Wall Street firms to engage in the kind of hanky-panky that brought about the financial crisis. Barring derivatives dealers from redeploying collateral is a good place to start.

Comments

If rehypothecation benefits no one but the derivatives dealer, then why do the dealers’ customers opt for it? Your article concedes that customers can opt out of rehypothecation already. Are you suggesting that customers should just have two choices: don’t trade or pay high fees for putting money in a segregated account? Or do you want to ban the existing practice of charging $ for using segregated accounts? If dealers cannot charge for these accounts, do you really expect that they’re not going to increase spreads or take money out another way? After all, banning these practices industry-wide means that customers can’t go somewhere else if they don’t like the higher fees or spreads.

Posted by Confused | Report as abusive
 

‘Fees’ from segregated escrow accounts = return or handling fees ? If return, interest or dividends or options or derivatives (again) ?

Posted by Hour glass | Report as abusive
 

Hey Goldstein, I see in you author profile it says Communist!, oh, wait thats Columinst…

Posted by Ready | Report as abusive
 

adding wood to the fire. Of course, people’s wood, not banks’ one. Damn system…

Posted by Walter Stucchi | Report as abusive
 

This is what happens when everything is in a “free market”. The market participants are “free” to do what they want. And while buyers are “free” to not do business with a derivatives dealer, the derivatives dealers are “free” to all decide to do this, thus “freely” exercising their power over buyers. That’s all fine in a “free market” economy where gains are “free” to private hands and losses are “free” for the government to socialize.

Posted by Paul | Report as abusive
 

In addition to the above, another concern is whether dealers are able to use its clients funds AGAINST its clients.

In theory the derivative dealers are supposed to be the ‘middle man’ through which the bets on the market are played. Based on my observations of derivative trading, I believe it is possible that major dealers are operating more like a casino with players pitting themselves against the dealers rather than ‘the market’.

President Obama will be doing a lot of people a big favour if he can succeed in preventing funds from being redeployed by the dealers. If he does succeed in doing this then it will be a major achievement of his Presidency albeit that the majority of people are likely to be oblivious to its significance.

Posted by Greg | Report as abusive
 

Not a chance in the world. These are all corporate men. The President the Senate and the rest. They would never enact a reasonable reform like that until after the system has failed and the reinflation measures failed as well. So apparently that’s what needs to happen. The only question is how long.

Posted by Paul Bogdanich | Report as abusive
 

…with the numbers been thrown around, this is petty cash.

Posted by Hour glass | Report as abusive
 

The worst sytem offered to the society by so called cevilized world getting bitten by the same hunter which rule the world, that is called AS YOU SHOW AS YOU SEE.NONE CAN ESCAPE FROM TIME THAT IS RULE OF THE ROAD. FACE IT

 

So on one hand the Fed and the Treasury are trying to get money and credit flowing again by offering unlimited liquidy to the banking system for free, while taking assets off banks, but then in the next breath you’re suggesting snuffing out lending via the repo market, for example, because once collateral is posted, say blue chip shares, against a cash loan, then the trader has to sit on those shares for the life of the swap, say 6-mos to a year.

so it ties up the bank’s balance sheet without producing as much revenue as the trader cannot relend those shares by doing, say, a reverse repo, lending out shares and taking in cash.

so you just end of slowing down the velocity of money and credit in the banking system as well as driving up borrowing costs for firms that have illiquid assets to pledge as collateral in return for cash loans.

do you really think about the consequences of such policies in the real world? or do you think you can make changes so easily without triggering unintended consequences?

rehypothecation indeed. maybe we should ban novation and fungibility of assets, too? ban everything that sounds complicated or that non-specialists, like financial journalists, do not understand.

Posted by MrBill, Eurasia | Report as abusive
 

…this is so complicated, I think even Greenspan and the US Presidents’ Advisors don’t understand it…And we critisize the poor traders and regulators that have to keep track of all of this while upping our stock/share/bond/property investments, health care and pensions ?

Posted by Hour glass | Report as abusive
 

We keep creating layer after layer of new government and complicated rules. Take the commodity market for example. We don’t need a new branch of government to get this back on path. Just change one rule, you can’t take out a contract on Oil or any food commodity unless you plan to take delivery. Do that and let’s see where the prices go. Stop the speculators from driving up the price of energy and food. It’s just wrong.

Posted by billy in avondale | Report as abusive
 

If the creativity and energy that went into devising these Byzantine financial instruments had gone instead to producing something tangible, the US would be in a lot better shape. We need to spend less time fondling each other’s money and more time figuring out ways to revitalize the nation’s manufacturing base. You can’t eat derivatives. You can’t sit on them. You can’t drive them and you can’t take two when you’re sick. You also can’t deny that Wall Street brought the entire world to the brink of complete financial collapse. So don’t cry “free market” every time someone suggests a way to prevent it from happening again. Had your precious “free market” been allowed to work, your entire corrupted industry would have been wiped off the face of the earth.

Posted by Amandus Colver | Report as abusive
 

The only reason you suggest that rehypothication is \’bad\’ is that it makes the trail harder to identify in court cases. If that\’s the best reason you can come up with….

Posted by jefkit | Report as abusive
 

I can tell you this much,I am a CONNECTED young black dude. I supported the cause from day 1 to finalization. I have never been more disappointed in my life. At this point I question wether or not I was COMPLETELY duped by the repubs. If so, good job, I see you in 2016. If not, you should try to take credit, we have never been more F8UKD! If you bother to track this post, feel free to call me so we can talk. Otherwise, wateva!!!!

 

Certainly we want liquiidty in our markets. Certainly we want credit available to help finanace growth. BUT, we also want that growth based on sound economics in doing this. The key to sound economic growth is actual real savings that are used then invested in sound growth opprotunities. Look at the savings rate in the USA for the past 20+ years. It’s the worse by far in the the world among industrialized countries.

Basing growth on derivitives and other “fiat currentcy” approaches leads to the very bubbles that have brought down our country to its knees. Let;s speak truth. Deruvitives is simply a method that enriches the rich and steals from the average American. Bottom line, run away GREED.

Posted by captain moorni | Report as abusive
 

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