Repo, Collateral, Re-use and Legal ownership

[NNath]

Hi @David Harper CFA FRM, In 2 separate questions on Gregory's Question Set there is the idea of legal ownership of the collateral and also if its different in case of re-hypothentication (re-use). I just want to be clear of the legal ownership is transferred or not.

Question 406.2 Option B is true https://forum.bionicturtle.com/threads/p2-t6-406-counterpartyrisk-characteristics.7695/
Legal ownership is transferred.

Question 410.2 Option B is not true https://forum.bionicturtle.com/threads/p2-t6-410-collateral-andrehypothecation.7734/
Legal ownership is not transferred.

Question 325.2 Option B is not true http://forum.bionicturtle.com/threads/p2-t6-325-collateral-toreduct-credit-exposure.7195/
Legal ownership is not transferred.

 

[David Harper CFA FRM]

Hi @NNath That is a keen observation! These are all sourced in Gregory, but question 406.2 explicitly refers to a repurchase agreement ("repo") whereas the other two questions refer to counterparties posting collateral in (private) bilateral derivatives trades. In general, a repo is considered transfer of ownership (i.e., sale). On the other hand, in bilateral derivatives contracts, the posting of collateral can be either via pledge or title transfer. I am not sure Gregory explores the distinction, it seems as if he generally assumes that collateral is pledged; e.g., "5.1.1 Rationale for Collateral Suppose that a netted exposure (sum of all the values of transactions with the counterparty) is large and positive. There is clearly a strong risk if the counterparty is to default. A collateral agreement limits this exposure by specifying that collateral must be posted by one counterparty to the other to support such an exposure. The collateral receiver only becomes the economic owner of the collateral if the collateral giver defaults." --- Gregory, Jon (2012-09-07). Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets (The Wiley Finance Series) (Kindle Locations 1946-1950). John Wiley and Sons. Kindle Edition.

Superficially, then, I would defend the distinction by: repo is a sale/repurchase versus derivatives collateral is (assumed to be) pledged rather than sold.

However, it's not this simple because (i) these meaning of the terms can hinge on legal definitions; e.g., is title ownership? does a pledge give use of the asset?; and (ii) related, jurisdications can vary; eg., US versus Europe. I hope that helps!

 

[nansverma]

Hi David, firstly sorry if I am posting this in the wrong thread. On Page 52 of the Jon Gregory notes, below is mentioned about the segregation. Should the red highlighted line be 'required' instead of 'not required' ?

Segregation: Even if collateral is not rehypothecated, there is a risk that it may not be retrieved in a default scenario. Segregation of collateral is designed to reduce counterparty risk and entails collateral posted being legally protected in the event that the receiving counterparty becomes insolvent. In practice, this can be achieved either through legal rules that ensure the return of any collateral not required (in priority over any bankruptcy rules), or alternatively by a third-party custodian holding the initial margin.

 

[David Harper CFA FRM]

Hi @nansverma No worries, here is fine. Our notes do honor (copy) Gregory as Gregory does write (in the source) "In practice, this can be achieved either through legal rules that ensure the return of any collateral not required (in priority over any bankruptcy rules), or alternatively by a third party custodian holding the initial margin."

And, as I check his errata (see https://cvacentral.com/books/credit-value-adjustment/errata/ ) I do not see a correction for this sentence.

However, to be honest the sentence does not concern me, I simply read it a little differently. If I were going to revise the sentence, I would write something like the following, because the parenthetical phrase provides a clue:

...."either through legal rules that ensure the return of any collateral (to the creditor) which is available for return and has not otherwise been claimed by a secured creditor with higher priority; for example, tax authority."

See what I mean? I think it just means "return of collateral that is not legally required for something else"! ... In bankrupty, secured creditors have priority over unsecured creditors, however, I *believe* it is possible for even segregated collateral to be vulnerable to contest by other secured creditors. That's just my interpretation ... Thanks!

 

[nansverma]

Thanks David.