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.

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