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Why are Financial Instruments Hypothecated?

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Definition of Hypothecation

Hypothecation is where assets, (in this case Bank Guarantees and Standby Letters of Credit) are pledged to a bank or similar financial institution as security for a loan. If the borrower defaults on repayment then the bank will seize the assets or make a claim against a Bank Guarantee or Standby Letter of Credit)

Who Provides Financial Instruments

It is a relatively small group of companies and institutions that provide Bank Guarantees and Standby Letters of Credit. Known as Providers or Provider Groups they are highly sophisticated investors and can be found in most global financial centres. Recognised as Sovereign Wealth Funds, Hedge Funds Family Offices or Private Equity Funds, they all control huge asset portfolios part of which they use to provide financial instruments.

The Purpose for Providing Financial Instruments

The purpose for providing financial instruments is pure profit. As advised under “Who Provides Financial Instruments” the provider groups due to their immense balance sheets control a massive portfolio of assets. As with all prudent investors the portfolio will contain risk assets and conservative or low risk assets.

The low assets like medium-term notes, (MTN’s), or government bonds will be paying a relatively small return. The provider groups will offer these assets as security to their bankers and request them to issue Bank Guarantees or Standby Letters of Credit for Collateral Transfer.

The return these groups get from Collateral Transfer is circa 6%, considerably higher than their low risk assets are paying. Thus, when the two returns are combined these items show a much higher overall return on the providers balance sheet.

Who Receives Financial Instruments

It is well known that the availability credit facilities have receded dramatically over the last decade. Thus, those companies starved of credit facilities will look to Bank Guarantees and Standby Letters of Credit to use as security for credit facilities. These companies will sign a contract with the provider, (a Collateral Transfer Agreement), and will become the beneficiary of these instruments.