Rehypothecation is a practice whereby banks and brokers use, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may benefit from a lower cost of borrowing or a rebate on fees.
In a common scenario of rehypothecation, securities that are posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades.
Key Takeaways
- Rehypothecation occurs when the lender uses its rights to the collateral to engage in its own transactions, often aiming for financial gain.
- Hypothecation happens when a borrower promises the right to an asset as collateral in exchange for funds.
- Rehypothecation promotes leveraging assets, making one’s portfolio riskier but with higher earning potential.
- Consumers can guard against rehypothecation by avoiding trading on margin and not allowing debt holders to transact using their collateral.
- Rehypothecation was prevalent until 2007, but hedge funds became more cautious after the Lehman Brothers collapse and the subsequent credit crunch of 2008-09.
Insight into Rehypothecation
Rehypothecation was a mainstream practice until 2007, but hedge funds became cautious post the Lehman Brothers collapse and the credit crunch of 2008-09. In the United States, rehypothecation by broker-dealers is limited to 140% of the loan amount to a client, under Rule 15c3-3 of the SEC.
Rehypothecation happens when a lender uses an asset, supplied as collateral on a debt by a borrower, to cover its own obligations. This involves leveraging various assets promised as collateral, generating a cycle that can yield significant profits or cause rapid bankruptcies if the strategy fails.
Brokers usually rehypothecate assets as they need temporary capital. Most often, these parties possess illiquid assets yet require cash for operational needs. Clients must be aware that their own assets could be pledged for someone else’s debt, resulting in complex creditor issues where the investor’s shares are no longer in their possession if the custodian defaults. When assets are rehypothecated, the original owner might become an unsecured creditor, unable to reclaim assets during bankruptcy proceedings.
Rehypothecation vs. Hypothecation
Rehypothecation happens if a customer leaves securities with a broker as a deposit, typically in a margin account, and the broker then uses the securities as collateral for their own margin account or a loan.
Hypothecation occurs when a borrower pledges an asset as collateral in exchange for funds. In the housing market, for instance, a borrower utilizes their home as collateral for a mortgage loan. Though borrowers maintain ownership, the lender can seize the asset if payments are not made as agreed. Similar situations occur with vehicle loans and margin accounts supporting other trading activities.
With rehypothecation, the pledged asset is promised to an external institution beyond the borrower’s original intent. For example, if real estate serves as collateral on a mortgage and the lender pledges it to another institution for a loan, the second institution can claim the property if the mortgage lender fails.
Protecting Against Rehypothecation
To protect against rehypothecation:
- Opt for Cash Accounts: Use cash accounts without margin capability, limiting transactions to the cash available, and avoiding margin calls.
- Review Agreements: Carefully examine service agreements to ensure you understand and agree to rehypothecation terms.
- Explicit Restrictions: For unique transactions, explicitly restrict rehypothecation of your collateral in the contract.
Pros and Cons of Rehypothecation
Pros
- Often results in lower borrowing costs.
- Encourages efficient use of capital within markets and institutions.
- Generously boosts profitability when successful.
- Allows risk-seeking investors to leverage capital.
Cons
- May involve non-transparent practices.
- Can disPlease customers who do not wish their assets to be leveraged.
- Increases default risk due to leverage considerations.
- Might lead to the misuse of assets by bad actors.
Exemplifying Rehypothecation
Rehypothecation is commonly practiced in finance, allowing traders and investors access to more liquid assets like capital invested in desired securities. For instance, a trader with 100 shares of Microsoft stock can use them as collateral for a loan to invest in more shares via a margin account. Hypothetically, the trader could continue this cycle, leveraging newly acquired shares as collateral for further loans.
Real-World Example: MF Global
In 2011, MF Global’s bankruptcy showcased rehypothecation when it used client funds as collateral for speculative trades in Eurozone bonds. The $6.3 billion bet resulted in clients scrambling for residual company assets as unsecured creditors, highlighting significant risks despite potential rebates and lower costs.
Legality of Rehypothecation
Rehypothecation remains legal because clients typically agree to terms allowing it when using brokerage or bank services. Depositing shares in a brokerage account or opening a bank account may include fine print authorizing such practices.
Bitcoin Rehypothecation
Bitcoin rehypothecation follows the same principle, leveraging Bitcoin as collateral without owning it. Due to Bitcoin’s volatility, rehypothecation in this context carries increased default risks.
Broker Rehypothecation Limits
In the U.S., the SEC limits rehypothecation to 140% of the loan amount. For example, with $300 collateralizing a $100 loan, up to $140 can be rehypothecated. Other countries may not impose such limits, increasing the risk in those jurisdictions.
Conclusion
Rehypothecation allows banks, brokers, or individuals to finance assets using collateral not owned originally by them. This leveraging cycle can drive profitability but underpins a high risk of default. Consumers can avoid rehypothecation exposure by steering clear of margin accounts and carefully controlling the use of their collateral.
Related Terms: Hypothecation, Margin Account, Collateral, Loan, Broker.
