What Is Rehypothecation?

Definition & Examples of Rehypothecation

Definition

Rehypothecation is the reuse of collateral from one lending transaction to finance additional loans.

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Definition and Example of Rehypothecation

Rehypothecation happens when a lender re-uses the collateral posted from one loan to take out a new loan. It creates a type of financial derivative and can be dangerous if abused.

Suppose you borrow money and hand over the collateral. The original lender then turns around and borrows money, repledging your collateral. Your lender no longer has ultimate control over the collateral; their lender now does.

Note

This process increases liquidity in the market while also increasing uncertainty. The more assets are re-used in this way, the less clear it is who owns the asset and who has the right to payment if someone in the chain defaults.

Rehypothecation can result in big problems, especially in the case of "regulatory arbitrage," which is the practice of conducting business in a way that takes advantage of more favorable regulations—sometimes in completely different countries. In other words, it lets an institution take advantage of opportunities created by different regulations.

In such a case, a brokerage house could act according to laws in the United Kingdom (UK), as was the case with the insurance company American International Group (AIG). Some of AIG's London traders engaged in risky trades that were ultimately beyond the reach of American regulators, but which nearly brought about the destruction of the company.

Such regulatory arbitrage can effectively remove any or all limits to a number of rehypothecated assets to which it has access. It does that in order to borrow money and fund its own risky trades. When that happens, it can lead to out-of-control rehypothecation, or "hyper-hypothecation."

Many investors and traders don't encounter the topic of rehypothecation in day-to-day conversations, but changes in regulations around its use could lead to devastating consequences in the wrong situation. Be sure you understand rehypothecation and the risks it poses so you can protect your assets.

  • Alternate name: Collateral re-use

How Does Rehypothecation Work?

Before you can understand rehypothecation, you have to understand hypothecation, which involves pledging certain assets as collateral for a debt. Those assets can be seized in the event of a default. This is quite common in lending. For instance, if you buy a home and take out a mortgage, you are entering into a hypothecation agreement. If you don't repay your home loan, your lender can seize your house.

Rehypothecation happens when a lender takes the collateral from that original loan and uses it as collateral for a new debt. This new debt is now a derivative financial product. It's based on the original debt agreement between the borrower and lender.

Note

Rehypothecation is made possible by something known as "Federal Regulation T," part of the Federal Reserve Board regulations that govern credit by brokers and dealers.

Hypothecation

Imagine you have $100,000 worth of Coca-Cola shares in a brokerage account. You have opted for a margin account so you can borrow against your stock, either to make a withdrawal without having to sell shares or to purchase additional investments.

You decide to add $100,000 worth of Procter and Gamble (P&G) to your portfolio. You figure you'll be able to come up with the money over the next three or four months and pay off the margin debt that is created.

After you put in the trade order, your account now consists of $200,000 in assets ($100,000 in Coca-Cola and $100,000 in P&G). You also have a $100,000 margin debt owed to the broker. You will pay interest on the margin loan according to the agreement governing your account.

Your brokerage firm had to come up with that $100,000 in case you wanted to borrow in order to settle the trade when you bought P&G. In exchange, you've pledged 100% of the assets in your brokerage account to back the loan. That is, you and your broker have entered into an arrangement and your shares have been hypothecated. They are the collateral for the debt, and you've given a lien on the shares.

Rehypothecation

Regardless of how the broker funds the loan, there is a good chance that, at some point, it will need working capital—cash it can use to conduct its operations.  For instance, many brokerage houses work out a deal with a clearing agent, such as the Bank of New York Mellon. They have the bank lend them money to clear transactions, with the broker settling up with the bank later, making the whole system more efficient. 

To protect its depositors and shareholders, the bank needs collateral. So, the broker takes the P&G and Coca-Cola shares you pledged to it; then, the broker re-pledges (or rehypothecates) them to Bank of New York Mellon as collateral for its own loan.

Seizing Rehypothecated Assets

Suppose something happens that causes the brokerage house to fail. In such a situation, the Bank of New York Mellon will have first dibs on the collateral. This was reinforced by a series of court rulings since 2012; they put these entities' interests above the interests of clients.

In your case, these entities would seize the shares of Coca-Cola and P&G to repay the money the broker borrowed. That means you could log in to your account and find that some or all of your cash, stocks, and other assets are gone.

Note

In this case, the lost assets would not be protected by Securities Investor Protection Corporation (SIPC) insurance. While partial recovery may be possible through bankruptcy courts, there are no guarantees. The process would take years, and it could be very stressful.

From Account Holder to Creditor

If your rehypothecated assets are seized, you become just another creditor in the bankruptcy case of your brokerage. You have to hope there is enough money recovered during the court cases to reimburse you.

This whole setup is perfectly legal. Under the regulations of the U.S., it should be possible for clients with margin accounts to know that their potential exposure to a rehypothecation disaster is limited. For instance, if you have an account with $100,000 and only $10,000 in margin debt to fund the outright purchase of a long-equity position, you shouldn't be exposed for more than $10,000.

In reality, that's not always possible. Certain restrictions requiring segregation of fully paid client assets in place in the U.S. (following the Great Depression) are not in place in the UK. 

Aggressive brokers can move money through foreign affiliates, subsidiaries, or other parties. It can be done in a way that allows them to effectively remove the limits on rehypothecation. That means it's not just the assets you have borrowed against that could be seized. They can go after all of your assets.

Notable Happenings: MF Global Bankruptcy

MF Global was a major publicly traded financial and commodities broker with billions in assets. It was run by Jon Corzine, who had been the 54th Governor of New Jersey, a U.S. senator, and the CEO of Goldman Sachs.

In 2011, MF Global decided to make a speculative bet by investing $6.2 billion in its own trading account in bonds issued by European sovereign nations, which had been hit hard by the credit crisis. The year before, the company had reported a net worth of roughly $1.5 billion. This meant small changes in the position would result in large fluctuations in book value. 

Combined with a type of off-balance-sheet financing arrangement known as a repurchase agreement, MF Global experienced a huge liquidity disaster due to a confluence of events. This disaster forced the company to come up with large amounts of cash to meet its collateral and other requirements.

Management raided the assets in client accounts, part of which included making a $175 million loan to the firm's subsidiary in the UK to pony up collateral to third-parties (i.e., rehypothecation).

When the whole thing fell apart, and the company was forced to seek bankruptcy protection, clients discovered that the cash and assets in their account—money they thought belonged to them and secured by debts on which they hadn't defaulted—were gone. MF Global's creditors had seized them, including the rehypothecated collateral.

In the end, the clients of MF Global had lost $1.6 billion in assets. Clients revolted and were able to get a sympathetic judge, who ultimately approved a settlement of the bankruptcy estate. That resulted in an initial recovery and return of 93% of customer assets.

Many clients who held out through the multi-year legal process ended up getting 100% of their money back, due in no small part due to the media and political scrutiny. In the meantime, they missed out on one of the strongest bull markets in the past few centuries, with their money tied up in legal fights.

How to Protect Against Rehypothecation

The best way to protect yourself against rehypothecation within an ordinary brokerage account is to refuse to hypothecate your holdings in the first place. Doing that is simple: Don't open a margin account. 

Instead, simply open what is known as a "cash account," or in some places, a "Type 1 account." Some brokerage houses will add margin capability by default unless otherwise specified. Don't allow them to do it.

This will make placing stock trades or other buy or sell orders, including derivatives such as stock options, a bit more inconvenient at times, because you must have sufficient cash levels within the account to cover settlements and any potential liabilities. It is worth putting up with the inconvenience for peace of mind. On top of that, you'll have the comfort of knowing you'll never face a margin call or risk more funds than you have on hand at the moment.

Key Takeaways

  • Rehypothecation is the re-use of previously pledged collateral as the collateral for a new loan.
  • It improves liquidity in the market while also increasing risk to everyone in the chain who touches that piece of collateral.
  • If an asset is rehypothecated many times, it can send shock waves through the market, leaving many without their original investment.
  • The best way to avoid the dangers of rehypothecation is to avoid margin accounts and instead only open cash investment accounts.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Board of Governors of the Federal Reserve System. "The Ins and Outs of Collateral Re-Use."

  2. Cornell Law School. "Managing Regulatory Arbitrage: A Conflict of Laws Approach," Page 65.

  3. Cornell Law School. "Managing Regulatory Arbitrage: A Conflict of Laws Approach," Page 64.

  4. Columbia University. "How Should Financial Markets Be Regulated?" Page 375.

  5. FDIC. "Part 220—Credit by Brokers and Dealers (Regulation T)."

  6. International Monetary Fund. "The (Sizable) Role of Rehypothecation in the Shadow Banking System," Page 1.

  7. Rutgers University, Eagleton Center on the American Governor. "Governor Jon S. Corzine Biography."

  8. Mises Institute. "MF Global's Fractional Reserves."

  9. Commonfund. "Managing Counterparty Risk in an Unstable Financial System," Page 2.

  10. Mark Nestmann. "Your Money Isn’t Safe in any U.S. Financial Institution."

  11. Securities and Exchange Commission. "Investor Bulletin: Understanding Margin Accounts."

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