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DOW JONES     Custodian banks can explodes as soon as Fed will increase their rate (Hedge21)

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Hedge21     posted : 26/05/13   05:58 pm

Because of lake of return in repo, custodian banks are encouraged to take Higher risk .
Thus, for example security lending can become a new level of return and risk.
securities lending refer to the lending of securities by one party to another. The borrower provides the lender with collateral, in the form of cash, government securities, of value equal to or greater than the loaned securities.

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The idea is quite simple. A custody bank lends to broker/dealers and other financial institutions. Once it lends it to them they have the right to sell the securities, by lending or holding them. But custodian banks generally do not know what they do with them. The contract with the borrower puts the obligation on them to return the securities regardless of what they have done with them. But if securities lose collateral should compensate… and sometimes it is not enough…

Currently short term rate is closed to 0 and sometimes negative , in the case of security lending, is it possible for custodian bank to seek better return rate? In this case is it possible that the reverse repo can be corporate bonds, ABS or equities (lower credit quality and certainly less liquid, the interest rate received is higher ) or to get a better return you can either find a different counterparty (higher risk counterparties will pay more), change the collateral type or mix (the more flexibility in collateral and the higher risk collateral will attract higher loan values.). Custodians which lend or rehypothecate their collateral are by nature high risk than others
Basically to reduce a risk of default a custodian bank can choose the type of securities (Governmental bonds, stocks, options, gold…) and the underlying rate .

To reduce again the level of risk, a Haircut (percentage that is subtracted from the market value of an asset that is being used as collateral) is also applied.
For example, United States Treasury bills, which are seen as fairly safe, might have a haircut of 10%, while for stock options, which are seen as highly risky, the haircut might be as high as 30%. In other words, a $1000 treasury bill will be accepted as collateral for a $900 loan, while a $1000 stock option might only allow a $700 loan.
If a counterparty is to default, lenders might find themselves wanting to liquidate collateral into an extremely volatile market with all other Custodies and brokers. *** The problem is that some custodies make the market at least daily to capture price changes and do margin calls to make up any shortfalls.

Now think about the Greek example of the risk free rate or sub primes show that everything is possible even a default of the best quality assets.
And now think about the supreme risk free rate the US T-Bill with currently low interest rate and think to the highest level of stocks valuation ( May 2013).

As soon as the Fed will increase his rate, T-Bill depreciation value will appear and the same time effect in collateral. What is now the future value of these securities?? Do you think that 10% or 20 % of Haircut can be enough to save collateral and custodian banks?

Please review our website & don\' hesitate to ask your question
Hedge21     posted : 26/05/13   05:59 pm

Now have a look on Lehman brother ( was also a custody and a counterparty)

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In case of flash crash there is set process spelled out in the contract with the borrower. We have the right to recall at anytime and the borrower has normal market settlement to return. For example if Canadian equity is purchased it settles in T+3. So if we notify for a recall on T+0 the borrower has T+3 to return the security. If he does not return the security on T+3 then they are in default. Depending on the reason for the default we must either a) give notice of the default and then have the right to sell the collateral or b) if the default is due to bankruptcy we do not need to give notice of default and can start to sell the collateral immediately. A flash crash does not mean there is a default scenario. The haircut is also agreed at the time of the loan and we must adhere to either regulatory or client defined minimums. During a crisis we may increase our haircut to cover the increased volatility. Also as we are marking loans against collateral a flash crash could mean loan values drop and collateral values increase, vice versa or move in the same direction. It depends on the loan and collateral portfolio which will happen
Please review our website & don\' hesitate to ask your question
Hedge21     posted : 26/05/13   06:00 pm


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Now imagine that a security like a T bill or high capitalization stock like Apple lost confidence and is heavy depreciate in few hours until the closing bell what would happen the next day to all custodian banks.

CDS will enter in the game all in the same time, this is the popcorn effect and the same time some custody can lose their collateral

Please review our website & don\' hesitate to ask your question
Hedge21     posted : 26/05/13   06:04 pm


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The following day, Black Tuesday was a day of chaos. Forced to liquidate their stocks because of margin calls, overextended investors flooded the exchange with sell orders. The Dow fell 30 points to close at 230 on that day. The glamour stocks of the age saw their values plummet. Across the two days, the Dow Jones Industrial Average fell 23%.

For instance, for the more liquid category, when the price movement of a security exceeds 10% from the quoted price at the close of the previous market day, quotation is suspended for 15 minutes. After 15 minutes, transactions are resumed. If the price then goes up or down by more than 5%, transactions are again suspended for 15 minutes. The 5% threshold may apply once more before transactions are halted for the rest of the day. When transactions are suspended in the cash market on a given security, due to undue price movement, transactions on the option based on the underlying security are also suspended quotations on the derivative markets are suspended for half an hour or one hour when additional margin deposits are requested.
But do you think that is enough to avoid pop corn effect and some bankrupty like Lehman Brother or Bear Stearns.
List of custodian bank, some of them working with hedge funds and lend or rehypothecate their collateral are by nature high risk than others

• Asia Pacific Banking Investment Group
• Banco de Oro Unibank
• Bank of America
• Bank of China (Hong Kong) Limited[1]
• Bank of Ireland Securities Services
• Bank of New York Mellon
• BBVA Compass
• BNP Paribas Securities Services
• Brown Brothers Harriman
• CIBC Mellon
• Citibank
• Comerica Bank
• Credit Suisse
• Deutsche Bank
• Estrategia Investimentos[2]
• Euroclear
• Fifth Third Bank
• Goldman Sachs
• HDFC Bank
• ICICI Bank
• Japan Trustee Services Bank
• JPMorgan Chase
• Kasbank N.V.[3]
• KeyBank
• Mitsubishi UFJ Trust and Banking Corporation
• Morgan Stanley Smith Barney
• Northern Trust
• PT. Bank Central Asia, Tbk.
• RBC Royal bank of Canada
• Societe Generale Securities Services
• Standard Bank
• Standard Chartered Bank
• State Bank of India
• State Street Bank and Trust Company
• The Kingdom Trust Company[4]
• The Master Trust Bank of Japan
• U.S. Bank
• UniCredit
• Union Bank N.A.
• Wells Fargo Bank

There are plenty of solutions to avoid this crash scenario but do not think that Fed ECB and some countries like UK Ireland Swiss or Luxembourg appreciate it …
In the same time if you are a retail with important asset, it should be a good idea to change for less risky bank

O Ben Yezza
Ex Student in Luxembourg University and New York Stern School of Business

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