Avoiding the Risks of Rehypothecation

Rehypothecation is a practice where lenders use collateral for their own transactions, aiming to benefit financially. It involves borrowers offering assets as collateral in exchange for funds, known as hypothecation. Rehypothecation allows for higher earning potential but also increases portfolio risk. To protect against rehypothecation, consumers should avoid margin trading and prevent debtholders from using their collateral. After the Lehman Brothers collapse and the subsequent credit crunch in 2008-09, hedge funds became more cautious about rehypothecation.

Basics

Rehypothecation is a practice where banks and brokers utilize assets posted as collateral by their clients for their own purposes. Clients who agree to rehypothecation may receive benefits like lower borrowing costs or fee rebates. This typically occurs when securities posted as collateral by a hedge fund with a prime brokerage are used by the brokerage to support its own transactions and trades.

How Does Rehypothecation Work?

Rehypothecation used to be common until 2007, but hedge funds became more cautious after the Lehman Brothers collapse and the credit crunch in 2008-09. In the United States, rehypothecation by broker-dealers is limited to 140% of the loan amount under SEC Rule 15c3-3.

Rehypothecation occurs when lenders use assets provided by borrowers as collateral to meet their own obligations. This can include various types of assets, such as tangible assets and securities. Brokers often rehypothecate assets when they need temporary working capital, even if those assets belong to their clients. This practice can create complications if the broker defaults, potentially leaving clients as unsecured creditors and unable to reclaim their assets during bankruptcy proceedings.

Rehypothecation Pros

Rehypothecation can lower borrowing costs for individuals. It is especially important for financial institutions that rely on short-term working capital and aim to maximize profits through financial securities. By rehypothecating client funds, these institutions can access capital during liquidity crunches and promote profitability through efficient fund utilization.

Rehypothecation Cons

Rehypothecation has the drawback of lacking transparency for customers. Banks and brokers may use client funds without their knowledge or consent. This may concern risk-averse customers or those who don't want their assets used for speculative purposes. Additionally, excessive leverage increases the risk of default. If margin calls or debt defaults occur, it can trigger a chain reaction of failing account requirements, putting the institution at a higher risk of overall default.

Rehypothecation vs. Hypothecation

Rehypothecation occurs when a customer deposits securities with a broker, typically in a margin account, and the broker uses those securities as collateral for their own margin account or to secure a loan. On the other hand, hypothecation happens when a borrower pledges an asset as collateral in exchange for funds. A common example is in the housing market, where a borrower uses the home they're purchasing as collateral for a mortgage loan.

In both cases, the lender can seize the asset if the borrower fails to make the required payments. Rehypothecation involves the asset being pledged to an institution other than the borrower's original intent. For instance, if a property is used as collateral for a mortgage loan and the lender pledges it to another financial institution in exchange for a loan, the second institution may claim the property if the mortgage lender defaults.

Individuals Protection

To protect against rehypothecation and ensure ownership of assets during liquidations, there are a few straightforward steps individuals can take. One effective measure is to avoid opening a margin account and instead opt for a cash account. In this type of account, there is no margin capability, limiting its functionality to executing buy or sell orders for stocks and purchasing derivative products. However, transactions within this account can only be conducted using available cash on hand, eliminating the risk of facing margin calls or having to meet margin requirements.

In certain cases, asset owners may have the choice to allow or disallow a custodian from pledging their assets. Such agreements are often part of the company's service agreement, and if one disagrees, the company may not provide service, particularly when dealing with large online companies. For specific transactions where collateral protection is crucial, individuals can explicitly restrict the rehypothecation of their collateral through contract agreements.

Rehypothecation in Practice

Rehypothecation is a common practice in the financial sector, enabling traders and investors to access more liquid assets for investment. For instance, a trader who owns 100 shares of Apple stock may wish to purchase shares of another company but lacks sufficient funds. In such cases, they can open a margin account.

With a margin account, the trader can use their Apple shares as collateral to obtain a loan. They can then use the loan amount to buy more shares of the desired company. In theory, this process can be repeated, using the recently acquired shares as new collateral to secure additional financing.

Real-World Example

Using client funds as collateral, MF Global made a speculative bet on Eurozone bonds, leading to its bankruptcy in 2011. This allowed them to secure additional funds for their trades. Clients benefited from lower fees, as the company didn't need to borrow money. However, when the trade failed, clients became unsecured creditors and had to compete for the remaining company assets during the bankruptcy proceedings.

Consent, Risks, and Limits of Rehypothecation

Consent

Rehypothecation is permitted because clients willingly agree to it. When clients use certain services, such as depositing shares into a brokerage account or opening a bank account, they typically agree to specific terms and conditions. These agreements grant the broker or bank the authority to take certain actions with the deposited assets or funds. So, rehypothecation is allowed based on the client's consent outlined in the terms and conditions.

Limits

Rehypothecation in the United States is limited by the Securities and Exchange Commission, which allows for up to 140 percent of the loan amount to be used for this practice. For instance, if $300 worth of collateral is used to secure a $100 loan, up to $140 can be rehypothecated. However, in certain other countries, such as in the case of the MF Global bankruptcy, there are no specific limits on rehypothecation.

Risks of Bitcoin Rehypothecation

Bitcoin rehypothecation is similar to the practice seen with other securities. It involves using Bitcoin as collateral to secure a loan for future investments, even though the borrower doesn't own the Bitcoin. However, due to Bitcoin's high volatility, there is a higher risk of default compared to other securities. A single margin call can result in the unwinding of all the investor's positions.

Conclusion

Using collateral they don't own, banks, brokers, or individuals may engage in rehypothecation to obtain financing for assets. They use already pledged collateral as collateral for new loans, creating a cycle of leverage that can boost profits but also heighten the risk of default. To avoid rehypothecation, consumers can opt for non-margin accounts and place restrictions on how their collateral is used by the custodians.