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This question follows up my answer and the related comment to this post and in general relates to counterparty risk.

When you buy a financial asset, this asset goes in your account at your custodian bank.

So assume you bought some Swiss Government bond and that your custodian is, say, JP Morgan. What happens if JP Morgan goes bankrupt like Lehman Brothers?

Are you sure to keep your bond? Are you sure to lose it?

The underlying question is: to the Swiss government, who is the bond holder? You, or the bank?

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The short answer is that it depends ;-) The long answer is complicated because it is a complicated topic. Disclaimers:

  • I am not a lawyer (feel free to comment if I have overlooked anything)
  • I believe the information below to be fairly standard, but
  • counterparty risk is eventually driven by contracts and has to be envisaged on a case by case basis

Cash is a counterparty risk

Imagine that you are a fund and your assets are held at a prime broker (PB). Your cash balances will typically be comingled with other clients' cash balances on the PB balance sheet. In case of a bankrupcy, this cash will form part of the liquidation process and you will rank as one of the PB's general creditors (= you will probably not recoup all of your cash, if at all - and even if you do, it will take time).

One way to mitigate that risk is to invest the cash in securities, which are not comingled with the bank's assets. Unless...

Some of your other assets might be at risk too: rehypothecation

A typical prime brokerage agreement would also include a rehypothecation clause under which the PB has the right to use your assets, in other words to transfer some of your assets from your account to their account.

The main purpose of rehypothecation is to enable the PB to finance the cost of providing your fund with leverage: the PB will typically use those securities as collateral to raise some cash which they can then lend to you, which in turn enables you to leverage your portfolio.

In your case, if the Swiss bonds you just bought are part of the assets that have been used by your PB, and your PB goes bankrupt, those bonds will represent a potential loss - unless you can net them with liabilities that you owe to your PB (i.e. assuming there is a master netting agreement, which there generally is).

The amount that the PB can rehypothecate is generally a function of how much indebtedness you have with them. The PB will then use some of your assets, for an amount up to x% of that indebtedness. How the indebtedness is calculated and how x is determined depends on various factors (x = 140% seems to be standard).

How to mitigate the risk?

There are various ways to mitigate the counterparty risk, such as:

  • Negotiation! Getting better terms on the rehypothecation side helps. If counterparty risk in an absolute concern, you can even negotiate to completely remove the possibility that your PB use your assets. But they will charge you more to offset that financing loss
  • Reducing your indebtedness (think resetting OTC derivatives transactions for example)
  • If you are in a situation where your PB can't rehypothecate your assets because you don't have any indebtedness, buying government bonds instead of holding cash will reduce your risk - that is the typical situation where buying securities with negative yields can make sense
  • Using cash protection schemes, such as the FSA Client Money Rules, which enable you to diversify the banks at which your cash is held
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    $\begingroup$ One thing we've done to hedge some counter-party risk is to buy deeply out-of-the-money puts against our PB (through a third-party broker, of course). One of our senior partners did this against his PB before it went under in the 2008 crisis, which worked-out well for him in the end. $\endgroup$
    – chrisaycock
    Sep 28, 2012 at 11:21
  • $\begingroup$ @chrisaycock "through a third-party broker" ;-) It sounds like an expensive hedge though. $\endgroup$
    – assylias
    Sep 28, 2012 at 11:23
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    $\begingroup$ Hence the deep OTM. These were "death puts" whose premium, at the time, implied the PB would go under once in a hundred years. That seemed like a bargain to our partner regardless of the hedging prospect. $\endgroup$
    – chrisaycock
    Sep 28, 2012 at 11:25

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