Weigh up how collateral affects counterparty risk and funding when it is segregated or rehypothecated versus when it is not.
The idea
How collateral is held decides who bears the risk. If it is segregated, held by a custodian in the poster's name and kept apart from the receiver's own assets, it is protected if the receiver defaults, so the poster has no exposure on it. The cost is that the receiver cannot use it, so it loses the funding benefit and may charge for it. If collateral is not segregated and can be rehypothecated (re-used by the receiver), the receiver gains cheaper funding. The poster, however, becomes an unsecured creditor for its return. Any excess of collateral over what the poster owes is exposed to the receiver's default. So over-collateralisation, including initial margin, creates counterparty risk for the poster. Segregation trades lower counterparty risk for higher funding cost.
A practice question
What does rehypothecation of collateral allow the receiver to do, and what risk does it create for the poster?
- Re-use the collateral in its own deals, lowering its funding cost, while the poster has only an unsecured claim for its return - correct
- Hold it in a bankruptcy-remote account, so that the poster is protected if the receiver defaultsWhy not: That describes segregation, the opposite of re-use.
- Substitute it for cash at will, so the poster's exposure to the receiver is removedWhy not: Substitution does not remove the poster's exposure to the receiver.
- Net it against other posters' claims on the receiver, so that the poster's exposure is reduced to zeroWhy not: Pooling and re-use increase the poster's risk; they do not reduce it.
Rehypothecation gives the receiver a funding benefit but moves the collateral into the receiver's estate; the poster ranks as an unsecured creditor for its return if the receiver defaults.
A harder one
A client moves from a credit support annex that allows its dealer to re-use collateral to one that requires segregation. What is the most likely effect on the dealer?
- Its credit exposure to the client rises, since it can no longer use the collateralWhy not: The dealer still holds the collateral; if anything its exposure is unchanged or lower.
- Its funding cost falls, since it no longer has to manage the collateral it receivesWhy not: Losing the right to re-use collateral raises funding cost, not lowers it.
- There is no change, since funding depends only on who is in the moneyWhy not: Whether collateral can be re-used changes the dealer's funding benefit.
- It loses a cheap funding source, so its cost rises and it will typically widen its price - correct
Re-use lets the dealer fund other positions with the client's collateral. Segregation removes that benefit, so the dealer's cost increases and is usually passed on in pricing.
The hardest tier
A fund owes a dealer USD 12 million on a derivative and has posted USD 12 million of variation margin plus USD 8 million of initial margin, 20 in total, none of it segregated and all re-usable. The dealer's one-year default probability is 1.5% and recovery on an unsecured claim is 40%. The expected one-year loss on the fund's exposure to the dealer is closest to:
- USD 180,000Why not: Applies PD and LGD to all 20 posted, though 12 of it is owed against the derivative and nets off.
- USD 120,000Why not: Omits the loss given default, using only 8 x 1.5%.
- USD 72,000 - correct
- USD 48,000Why not: Uses the recovery rate of 40% as the loss rate, 8 x 1.5% x 40%.
The net exposure is the excess collateral, 20 - 12 = 8. Expected loss = 8,000,000 x 1.5% x (1 - 40%) = 72,000. With segregation of the excess, the exposure would be zero.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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