Rehypothecation is the practice where banks and brokers use assets posted as collateral by their clients to secure their own borrowing and trading activities.
Detailed explanation
When a client opens a margin account and borrows funds to purchase securities, the broker requires the client to pledge those securities as collateral. In rehypothecation, the broker takes these specific securities and pledges them again to a third party, such as a clearing bank. The broker uses the client collateral to secure its own loan, which provides the broker with liquidity to fund daily operations and proprietary trading.
The rules governing this practice vary by jurisdiction. In the United States, regulations limit rehypothecation to 140 percent of the client’s debit balance. This means a US broker can only repledge a portion of the collateral. In the United Kingdom, there is no statutory limit on rehypothecation. Brokers operating under UK law can rehypothecate 100 percent of a client’s assets if the prime brokerage agreement permits it. This difference leads many large institutional funds to heavily scrutinize the jurisdiction where they hold their assets.
Rehypothecation creates counterparty risk for the client. If the broker defaults on its loan to the third-party bank, the bank has the right to seize the pledged assets. The client loses direct access to their securities. The client is then treated as a general unsecured creditor in the broker’s insolvency proceedings. The client must attempt to recover the value of their assets through the bankruptcy process, which often results in partial or total loss.
Example
Assume you, as an Elephant investor, hold 1,000 shares of a peanut supply company in a margin account. You borrow funds from your broker, Savannah Brokerage, to purchase additional stock. You pledge your 1,000 shares as collateral for this margin loan.
Savannah Brokerage then needs cash to finance its own business operations. The broker takes your 1,000 shares and pledges them to a large investment bank to secure a corporate loan. The shares are now rehypothecated. If Savannah Brokerage goes bankrupt and defaults on its corporate loan, the investment bank retains your shares to cover the broker’s debt. You lose your shares and must enter the bankruptcy process to try and reclaim your lost value from the liquidated assets of Savannah Brokerage.