Definition
Rehypothecation is a practice in the financial industry where a bank or broker reuses the assets, often collateral, that have been posted by clients to back their own trades and borrowing. In simpler terms, it’s the reuse of collateral provided by another party. This practice provides leverage for financial institutions but can also present significant risks.
Phonetic
The phonetics of the word “Rehypothecation” is: ree-hypo-theka-shun
Key Takeaways
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- Definition and Use: Rehypothecation is a practice in finance where a broker reuses the assets – typically collateral pledged by clients – for their own purposes, like securing their own loans. This can involve leveraging the same assets many times over, helping to boost liquidity and earnings.
- Risks and Controversies: Rehypothecation carries substantial risk, mainly due to the fact that brokers may overestimate the value of their assets and face potential insolvency during a market downturn. It also played a significant role in the 2008 financial crisis, sparking many regulatory debates globally.
- Regulations: Given its risk, rehypothecation is heavily regulated, especially post-2008. Different jurisdictions have different rules with the US placing a cap on the rehypothecation while European Union regulations are more lenient, and a broker can rehypothecate without limit. Hence, customers must be aware of how their collateral could be rehypothecated, depending on legal jurisdiction.
Importance
Rehypothecation is a crucial concept in finance because it refers to the practice where banks and brokers use, for their purposes, assets that have been posted as collateral by their clients. This can boost efficiency and liquidity in the financial markets because financial institutions can use these assets to secure other transactions, drive their lending activities, or fund their operations. However, it also introduces systemic risk into the financial system, given the interdependent chain of obligations it creates. If one party fails to meet its obligations, it can lead to a domino effect of defaults. Hence, while rehypothecation can help optimize market operations, it should be managed with careful risk assessment.
Explanation
Rehypothecation serves a significant purpose in financial markets by offering a tool for leveraging investments and maximizing the potential of financial resources. It essentially means the utilization of collateral provided by one party, by a counterparty (such as a bank or broker) for its own financial gain. Frequently used in securities lending and prime brokerage accounts, rehypothecation facilitates greater liquidity in the market, aiding businesses and corporations to obtain needed capital for expansion, investing or for other financial purposes.However, it doesn’t come without its risks as it may contribute to systemic financial problems in event of a market downturn. The entire system requires an inherent level of trust since physical assets are not tangibly passed between parties. Despite the intricacies and potential hazards involved, rehypothecation is essential to our financial system. Without it, investment and growth opportunities may be severely limited as the pool of available resources would be significantly reduced. Thus, rehypothecation ultimately serves as an irreplaceable mechanism that fuels economic expansion and growth.
Examples
1. Securities Lending: This is the most common form of rehypothecation in the financial industry. An investor may lend their securities to a brokerage firm, which then uses these securities as collateral to secure a loan. The brokerage firm may loan these securities to another client who needs them for short selling purposes. In this scenario, the original securities have been rehypothecated from the initial investor to the brokerage firm, and then to the borrower for short selling.2. Margin Accounts: In a margin account, an investor borrows funds from a brokerage firm for trading. The securities and cash in the investor’s account serve as collateral for the loan. The brokerage firm may subsequently rehypothecate these securities by using them to back its loans from the bank. 3. Hedge Fund Industry: A hedge fund may deposit its securities with a prime broker. The broker then has the right to lend these securities to its other clients or use them as collateral to secure its borrowing. This is another example of rehypothecation. In some cases, multiple layers of rehypothecation may occur, further convoluting tracking of the ultimate ownership of the securities.
Frequently Asked Questions(FAQ)
What is rehypothecation?
Rehypothecation is a practice performed by financial institutions where they reuse, repledge or reallocate collateral pledged by their clients in the same or another transaction. This means that rather than holding onto the collateral, the financial institution can use it for its own purposes.
Is rehypothecation legal?
Yes, rehypothecation is legal and commonly practiced in many countries. However, there are usually rule sets and requirements that govern how much of a client’s collateral can be rehypothecated.
What is the limitation in terms of rehypothecating assets?
The limitation depends on the jurisdiction of the transaction. For instance, in the United States, the SEC has set a limit where only 140% of the client’s debit balance can be rehypothecated. In the UK and other parts of Europe, there’s no such limit in place.
What are the risks involved with rehypothecation?
The major risk associated with rehypothecation is that in case the broker becomes insolvent, the client could lose part or all of their collateral. This happened in prominent cases such as the collapse of Lehman Brothers and MF Global.
What is the benefit of rehypothecation?
The primary benefit of rehypothecation is that it amplifies liquidity in the financial markets, making more funding available for investment and growth. It can also decrease the borrowing costs for the person or entity that owns the assets being rehypothecated.
Can an investor prevent a broker from rehypothecating their assets?
Yes, an investor has to provide consent for their assets to be rehypothecated. This is typically outlined in the brokerage account agreement. If an investor does not consent to rehypothecation, then the broker must not rehypothecate the investor’s assets.
How is rehypothecation related to short selling?
Rehypothecation is often a key component of short selling. The broker may lend out securities (received as collateral) to short sellers, enabling them to sell the security with the hope to buy it back later at a lower price.
Related Finance Terms
- Collateral: It refers to an asset that a borrower offers to a lender to secure a loan. If the borrower defaults, that asset may be seized by the lender.
- Securities Lending: This is when an individual or institutional investor (the lender) temporarily loans securities to a financial intermediary, such as a brokerage firm, bank, or other financial institution (the borrower).
- Margins: In the context of rehypothecation, this is the amount of equity contributed by a customer into a margin account, which then could possibly be rehypothecated by the brokerage firm or bank.
- Over-collateralization: It involves the provision of collateral that is worth more than enough to cover potential losses in cases of default.
- Haircut: In finance, Haircut refers to the difference between the market value of an asset used as loan collateral and the amount of the loan. The haircut is expressed as a percentage and is used to protect the lender from losses in case the collateral’s value decreases.
