# Rehypothecation Explained: Definition, Examples, and Impacts

## What Is Rehypothecation?

Rehypothecation involves banks and brokers using client collateral for their transactions, offering benefits such as lower borrowing costs and fee rebates. Commonly, a hedge fund's collateral with a brokerage can be utilized by the brokerage for further financial dealings.

### Key Takeaways

*   Rehypothecation is when banks and brokers use client collateral, like securities, for their own transactions, potentially increasing leverage.
*   While rehypothecation can reduce borrowing costs, it also increases the risk of default and complicates asset recovery during bankruptcies.
*   The practice, prevalent before the 2008 financial crisis, is now limited in the U.S., where broker-dealers can only rehypothecate up to 140% of a client's loan.
*   Clients can protect against rehypothecation by avoiding margin accounts and ensuring they don’t allow their brokers to reuse their collateral.
*   The MF Global collapse exemplifies the risks of rehypothecation, where client funds were used for speculative trades, and the clients became unsecured creditors.

![Rehypothecation: When financial firms use assets that have been posted as collateral by their clients.](https://www.investopedia.com/thmb/5Kf1QZ5kkhIROAoHBtIrg4a1HR0=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/rehypothecation.asp-final-f97fd76b76604d05ac54becf5e465030.png)

*— Investopedia / Julie Bang*

## How Rehypothecation Impacts Financial Markets and Participants

Rehypothecation was a common practice until 2007, but hedge funds became much more wary about it in the wake of the [Lehman Brothers](https://www.investopedia.com/terms/l/lehman-brothers.asp) collapse and subsequent credit crunch in 2008-09. In the United States, rehypothecation of collateral by broker-dealers is limited to 140% of the loan amount to a client, under Rule 15c3-3 of the SEC.

Rehypothecation occurs when a lender uses an asset, supplied as collateral on a debt by a borrower, and applies its value to cover its own obligations. In order to do so, the lender may have access to a variety of assets promised as collateral including tangible assets and various securities. This innovative cycle of leveraging another party's assets as collateral generates a type of derivative that can expound positive results or bankrupt companies quickly should the strategy fail.

Most often, brokers rehypothecate assets as they need temporary working capital. These parties often have illiquid assets they own yet have operating requirements that demand cash. Clients must be aware of rehypothecation as it is technically their own assets that have been pledged for someone else's debt. This creates complicated creditor issues where an investors shares may longer be in their possession due to their custodian's default.

> **Important**
>
> When assets have been rehypothecated, the original owner may turn into an unsecured credit and not reclaim assets during bankruptcy proceedings.

## Comparing Rehypothecation and Hypothecation

Rehypothecation happens if a customer leaves a number of securities with a [broker](https://www.investopedia.com/broker-awards-4587871) as a deposit, most often in a margin account, and the broker then uses the securities as a pledge for the margin on his own margin account or as backing for a loan.

[Hypothecation](https://www.investopedia.com/terms/h/hypothecation.asp) occurs when a [borrower](https://www.investopedia.com/articles/investing/092315/7-best-peertopeer-lending-websites.asp) promises the right to an asset as a form of collateral in exchange for funds. One common example occurs in the primary housing market, where a borrower uses the home he is purchasing as collateral for a mortgage loan.

Even though the borrower asserts a level of ownership over the property, the lender can seize the asset if payments are not made as required. Similar situations occur in other collateralized loans, such as a vehicle loan, as well as with the setup of margin accounts to support other trading actions.

> **Fast Fact**
>
> With rehypothecation, the asset in question has been promised to an institution outside of the borrower’s original intent.

For example, if a piece of real estate functions as collateral on a mortgage loan and the lender pledges the asset to another financial institution in exchange for a loan, if the mortgage lender fails, the second financial institution may make a claim on the real estate.

## Strategies to Safeguard Assets from Rehypothecation

There's a few ways individuals can protect against rehypothecation and preserve their claim to assets during liquidations. The most straightforward way relating to brokerage accounts is not open a margin account and utilize a cash account. This account should not be allowed to have any margin capability.

Although this type of account will be limited in what it can do, this account may only be able to place stock trades using buy or sell orders. It may also be able to purchase derivative products. However, you'll only be limited to the cash levels on hand within the account to cover settlements. These types of accounts can never face a margin call as there are no margin requirements to satisfy.

There may be cases where owners of assets may opt-in or opt-out of allowing a custodian to pledge their assets. In most cases, these types of agreements are baked into the service agreement of the company; if you do not agree, most often the company (especially if they are large and operate online) may not extend to you service. For one-off transactions in which you wish to protect your collateral, you may explicitly restrict rehypothecation of your collateral in the contract.

## Weighing the Pros and Cons of Rehypothecation

### Pros of Rehypothecation

Rehypothecation often makes it cheaper for individuals to incur debt. Borrowers who rehypothecate are often given rebates or lower costs of debt as opposed to traditional loans. Therefore, though there may be more risk, individuals often face less charges to raise capital.

This concept is especially important for financial institutions that rely on short-term working capital to thrive but financial securities to maximize profits. Banks, brokers, or other financial institutions may navigate a liquidity crunch and access capital by rehypothecating client funds. Not only can this leverage strategy introduce liquidity, it is conceptually a more efficient use of funds and promotes profitability.

### Cons of Rehypothecation

The largest downside of rehypothecation is keeping potential customers in the dark. When banks or brokers rehypothecate, they may "go behind their clients backs" to use funds in the client's accounts. Some clients may not prefer that treatment of their assets, especially if they are risk adverse or do not want their assets misused for speculative endeavors.

There are also leverage considerations that increase that risk of default. Overleveraged investments often face covenants; when specific conditions are met, trading accounts may receive a margin call or face debt default. As a row of dominos fall after a single collapse, a single margin call may cause other debts to fail their account maintenance requirements, setting off a chain reaction that places the institution at higher risk of overall default.  

### Rehypothecation Pros and Cons

Pro

*   Often leads to lower costs to borrow funds
    
*   Helps promote efficient use of capital in markets and institutions
    
*   Generates higher profitability when rehypothecation is successful
    
*   Allows risk-seeking investors to leverage capital
    

Cons

*   Results in potentially not transparent practices
    
*   May be unsettling to customers who do not want their assets touched
    
*   Often increases the risk of default
    
*   May entice bad actors to misuse assets
    

## Real-Life Illustrations of Rehypothecation

Rehypothecation is often used in the financial sector, allowing traders and investors access to more liquid assets such as capital that can be directly invested in assets or securities of their choosing. For example, imagine a trader who owns 100 shares of Microsoft stock. If the investor wants to buy shares ofa different company but can not afford to so, they can open a margin account.

Using the margin account, the investor can post their Microsoft shares as collateral to take out a loan. Then, they can use those loan proceeds to buy more shares. In theory, the investor can continually post the most recently acquired shares as collateral, then secure financing against those assets.

### Real-World Example of Rehypothecation

One of the more popular real examples of rehypothecation was the activity of MF Global and its bankruptcy. In 2011, MF Global made a speculative bet in Euro zone bonds. Financed via an off-balance sheet arrangement, MF Global likely used client funds as collateral to secure financing for its trades.

The benefit for customers is they are often incentivized by cheaper fees as the company may be able to pass along lower expenses to the client as they do not need to take out debt. One major regulation was limits up to the liability amount, and it is suspected that MF Global took advantage of international limits that were greater (or limitless) compared to that of the U.S.

When the securities failed and the trade collapsed, MF Global's $6.3 billion bet resulted in its clients having to fight over residual company assets. MF Global's customers, as unsecured creditors, were last in line for recovery during bankruptcy.

## How Is Rehypothecation Legal?

Rehypothecation is legal because it is often agreed to by clients. Clients may have to agree to terms in order to use a service. For example, when they deposit shares into a specific brokerage account, they may have agreed that the broker may do certain things to those shares. Second, rehypothecation. The same may be said about bank deposits; in order to open a bank account at an institution, the fine print may state that the firm is allowed to manage your funds as they see fit.

## What Is Bitcoin Rehypothecation?

There is nothing unique about Bitcoin rehypothecation compared to other securities. Bitcoin rehypothecation is the act of leveraging the asset Bitcoin into debt that is used to finance future investments, though the party taking out the loan on the collateral does not own the Bitcoin. In this example, because Bitcoin is highly volatile, the investor is at greater default risk compared to other securities as a single margin call may unwind all of their positions.

## How Much Can a Broker Rehypothecate?

In the United States, the Securities and Exchange Commission restricts rehypothecation to 140 percent of the loan amount. For example, if collateral of $300 is used to take out a loan for $100, $140 may be rehypothecated. As was seen in the MF Global bankruptcy, there are no rehypothecation limits in some other countries.

## The Bottom Line

Rehypothecation allows financial institutions to use client assets as collateral for their transactions, which can lead to lower costs for borrowing but also increases risk. While this practice can provide short-term liquidity and profitability, it places the original asset owner at risk of becoming an unsecured creditor. To mitigate such risks, consumers should refrain from using margin accounts and should explicitly limit how their assets can be used by brokers or banks. This approach ensures better control over one's assets and reduces the impact of a custodian's potential default.

> **Article Sources**
>
> 1.  Eqip. "[MF Global Holdings Ltd., et al.](https://dm.epiq11.com/case/mfglobal/dockets)"