Rehypothecation
Rehypothecation is a practice whereby banks and brokers use, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees.In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades.
Definition: Rehypothecation refers to the practice where banks and brokers use the assets provided by clients as collateral for their own purposes. Clients who allow their collateral to be rehypothecated may receive compensation in the form of lower borrowing costs or fee rebates. A typical example of rehypothecation is when a hedge fund pledges securities to a prime broker, and the broker uses those securities to support its own trades.
Origin: The concept of rehypothecation originated with the development of financial markets, particularly in the late 20th century. As financial instruments and trading methods diversified, banks and brokers began using clients' collateral to enhance their own liquidity and trading capabilities. Key events include the financial market liberalization in the 1980s and the reassessment of financial institution behaviors following the 2008 financial crisis.
Categories and Characteristics: Rehypothecation can be divided into two categories: bank rehypothecation and broker rehypothecation. Bank rehypothecation typically involves banks using clients' collateral to obtain additional funds or make other investments; broker rehypothecation involves brokers using clients' securities to support their proprietary trading. The main characteristics of rehypothecation include: 1. Increased liquidity: Financial institutions can more effectively utilize existing assets through rehypothecation. 2. Reduced costs: Clients allowing rehypothecation can benefit from lower borrowing costs or fee rebates. 3. Risk management: Rehypothecation also introduces additional risks, especially during periods of market volatility.
Specific Cases: Case 1: A hedge fund pledges $100 million worth of securities to a prime broker, and the prime broker uses those securities for proprietary trading, generating profits. Case 2: A bank accepts a client's real estate mortgage and rehypothecates these collateral assets to other financial institutions to obtain more loan funds.
Common Questions: 1. Does rehypothecation increase the risk of the financial system? Yes, rehypothecation can increase systemic risk, especially during periods of high market volatility. 2. How can clients ensure the safety of their collateral? Clients should carefully read contract terms to understand the specific arrangements and risks of rehypothecation.
