Rehypothecation

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Rehypothecation refers to the use the assets held as collateral for one client ("hypothecated" funds) in transactions for another. [1]

Hypothecation occurs when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults. A mortgage is an example of hypothecation, since the borrower has legal ownership of the property but the bank retains the title and has the legal right to sell the property should the borrower default. [2] Because of this "hypothetical" control structure, the bank is allowed to re-pledge or "rehypothecate" the asset. Rehypothecation is a common practice among prime brokers of hedge funds.

Under U.S. securities regulations, a prime broker may rehypothecate assets to the value of 140% of a client's liability to the prime broker. In the UK, there is no statutory limit on the amount that can be rehypothecated.

Rehypothecation became a central issue in the MF Global bankruptcy in October 2011, as the company used rehypothecation to leverage its position. The company was forced into bankruptcy when it could not meet its margin calls and, in the process, $1.6 billion of customer segregated funds went missing. [3]


References

  1. Rehypothecation. Financial Times.
  2. MF Global and the great Wall St re-hypothecation scandal. Thomson Reuters.
  3. MF Global trustee sees $1.6 billion claims gap. Reuters.