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Account for collateral-related aspects such as funding, rehypothecation and segregation.

FRM® Part II · Credit Risk Measurement and Management · Margin (Collateral) and Settlement · FRM2.CR.17.i

The idea

Funding, rehypothecation and segregation are the practical consequences of how collateral is held. Posting cash or securities has a funding cost: the pledgor earns the overnight collateral rate on cash but funds it at its own cost, and receiving collateral gives the opposite benefit. Rehypothecation means the secured party reuses received collateral for its own obligations. Under a pledge-based CSA it needs a contractual right, while under a title-transfer CSA the recipient owns the assets. If collateral is rehypothecated, the pledgor has only an unsecured claim for equivalent assets if the recipient fails. Segregation, holding the collateral with a third-party custodian, protects the pledgor but removes the reuse and funding benefit. Mandatory initial margin for non-cleared derivatives must be segregated.

Formulas

Annual funding cost of posted cash collateral

Funding cost = C × (rf − rc)

C
the cash collateral posted
rf
the poster's own funding rate
rc
the overnight rate earned on the collateral

Only the spread is a cost, since the poster earns the collateral rate. Rehypothecation lets the receiver capture the opposite benefit; segregation removes it.

A practice question

From the question bank, with the reason each wrong option is wrong.

In collateral management, rehypothecation means:

  1. The secured party reuses collateral it has received, for example by pledging it onward - correct
  2. Collateral is revalued to market each dayWhy not: This describes valuation, not reuse.
  3. The pledgor swaps posted assets for others of equal value at any timeWhy not: This describes substitution.
  4. Posted assets are held in a separate account at a third-party custodianWhy not: This describes segregation.

Rehypothecation lets the receiver reuse collateral, which cuts its funding cost but exposes the pledgor to the receiver's solvency.

A harder one

A bank posts USD 50 million of cash collateral, earning an overnight rate of 4.0%, while its own funding cost is 4.6%. The annual funding cost of this position is closest to:

  1. USD 2.30 millionWhy not: Counts the funding cost but ignores the interest earned on the cash.
  2. USD 0.30 million - correct
  3. USD 2.00 millionWhy not: Counts the interest earned but ignores the funding cost.
  4. USD 4.30 millionWhy not: Adds the two rates instead of taking the difference.

Net carry = 50 x (4.6% - 4.0%) = USD 0.30 million a year of funding cost.

The hardest tier

Initial margin rules require segregation with a third-party custodian and restrict reuse. What is the principal consequence for the receiving dealer?

  1. It keeps the full funding benefit of the margin, because segregation only changes the bookingWhy not: Segregation removes the reuse benefit.
  2. The pledgor loses protection in the dealer's insolvency, because custodian assets form part of the estateWhy not: Reverses the effect; custodian assets are protected from the dealer's insolvency.
  3. Its counterparty exposure rises, because segregated assets give less protectionWhy not: Segregated margin still secures the dealer's claim.
  4. It cannot use the margin to fund itself, so its funding costs and collateral needs rise - correct

Segregation protects the pledgor but removes reuse, so the dealer funds the margin elsewhere and total collateral needs increase.

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