Rehypothecation

What Is Rehypothecation?

Rehypothecation is the practice of a financial firm reusing assets that a client has deposited as collateral for the firm's own purposes. The most common setting is a margin account at a brokerage. When an investor borrows money from the broker to buy securities, the broker usually holds those securities as security for the loan. Many margin agreements allow the broker to take those pledged securities and pledge them again to another party, often to borrow money from a bank to fund its own activities or to cover positions held for other clients.

How It Works

Consider a simplified chain. A client deposits shares with a broker as collateral for a margin loan. The broker then uses those same shares as collateral for its own loan from a bank, or lends them to another customer who wants to borrow them through securities lending. Each step can create a new claim on the same underlying assets, so a single pool of securities can support more total borrowing than the original owners' positions alone would suggest.

The practice is especially common in prime brokerage services, which provide financing, custody, and trade settlement to large institutional clients such as hedge fund managers. Securities regulators typically limit how much client collateral a broker may reuse, and these rules differ from one country to another.

Why It Matters to Investors

Rehypothecation can help markets run smoothly by increasing the supply of collateral and making borrowing and short selling easier to arrange. It also creates risk. If the firm that received the reused collateral runs into financial trouble, a client may have difficulty getting back assets that were passed along to others. Client property can become tangled up in a bankruptcy proceeding, and the failure of Lehman Brothers in 2008 is a widely cited example of how this risk can play out.

Because the practice is usually written into standard account agreements, many investors accept it without much attention. Anyone who uses a margin account can read the terms carefully, including whether rehypothecation is permitted, how far it can go, and how client assets are kept separate. The degree of exposure depends on the firm's policies, the rules that apply where it operates, and the counterparty risk the investor is willing to accept.