Regulators take aim at recycled securities The widespread practice of using the same securities over and over again is back under the microscope as global regulators seek to prevent a repeat of the 2008 financial crisis and get more control over sources of credit outside the regular banking system. Brokers and banks routinely recycle the cash and securities handed to them as collateral by large institutional investors. Cash gets reinvested and securities are often pledged out in another transaction, usually in the short-term repurchase or "repo" markets, often via clearing houses. Known as "rehypothecation" when it involves client assets, this serial lending boosts companies" bottom lines and serves to lubricate the markets by making more securities available for trading. "The system of temporary transfers adds liquidity and we think it will be essential to support the growth of demand for collateral," says Kevin McNulty, chief executive of the International Securities Lending Association. But regulators have eyed the practice with suspicion ever since the 2008 collapse of Lehman Brothers. The European arm of the failed US broker actively used rehypothecation to help fund its own activities and its customers have faced a four-year battle to trace and recover their assets. In recent weeks, the global Financial Stability Board has sought to constrain securities lending and repo - selling securities with an agreement to repurchase later - as part of its crackdown on "shadow banking," while global banking and securities regulators are taking aim at the reuse of collateral posted as part of derivatives transactions. European regulators have also sought to limit reuse of collateral posted by investment funds for their derivatives. What we are really dealing with here is throwing a bucket of sand into the machine. If the argument is that the machine was going too fast, there is no question that this will make it go slower. The question, of course, is whether it will stop it altogether," says Simon Gleeson, partner at Clifford Chance. In general, regulators are seeking to limit the number of times a security can be passed on to a new counterparty, with the aim of limiting contagion in case of a firm collapse and also ensuring that investors and traders know exactly whose risk they are exposed to. "The regulators really want to break down the big chains of rehypothecation," says a senior executive at a clearing house who declined to be named. I think they would like to see a slower velocity of collateral moving around the market. Banking regulators point to Lehman as evidence that repeated reuse of securities can fuel credit bubbles, by giving companies a ready source of cash without requiring them to meet capital and liquidity requirements that banks must follow. "Anyone with a securities portfolio can build their own shadow bank by borrowing at call against the securities and then employing the cash in credit assets; that is, borrow short to lend long," says Paul Tucker, deputy governor of the Bank of England. Hypothecation of client assets gives non-banks the wherewithal to fund their business in this way, effectively becoming a non-bank bank. It can make the financial system fragile. Bank-type risks need to come with bank-type regulation, which itself has needed a massive overhaul," he says. The regulators really want to break down the big chains of rehypothecation. I think they would like to see a slower velocity of collateral moving around the market Senior executive at a clearing house Some of these concerns, particularly about the long chains of risk that could build up as the same security is reused, are shared by the market. According to Manmohan Singh, an International Monetary Fund economist, the number of times a security is passed around the system - or "churn" - has fallen from an average of three times before Lehman's 2008 collapse to 2.2 times at the end of 2012. Nevertheless, there is concern about plans for a further clampdown. "Until we know how it's going to be implemented, we can't tell what the impact will be," says David Clark, chairman of the Wholesale Markets Brokers" Association. I think it matters hugely. How you would migrate the right rules for banking markets into shadow banking matters. The International Swaps and Derivatives Association has already warned that margin rules in their current form could increase systemic risk. The financial markets trade body has calculated there could be a shortfall of up to $1tn in initial margin requirements. "Margin policy is in part a balancing act, the aim being to require sufficient collateral to protect systemic resiliency without being too conservative and harming liquidity in important markets," says Stephen O'Connor, chairman of ISDA. Margin requirements on that scale would effectively put a tax on instruments which are helpful to the economy. Mr Clark says rehypothecation did not have a lot to do with the crisis. I think there are bigger things to worry about. The more and more collateral and security and margins, the bigger the drain on global liquidity.