Rehypothecation
Candlefocus EditorRehypothecation may occur when a borrower puts up shares as collateral and the lender—the custodian —later pledges them to another party, such as a broker, for its own gain. The broker would then owe the lender money and use the shares as collateral for that debt, often to trade against their own positions in the market. In other words, the broker or financial institution leverages the assets provided by the borrower.
The practice is attractive to those professionals because they can bet on the market with a potentially lower cost of borrowing thanks to the allocated assets. For example, a broker may be able to secure a lower interest rate because they are providing the assets they are trading by re-pledging, rather than borrowing the capital.
The problem with rehypothecation is that it can make portfolios much riskier as the first lender, as well as any other party involved, has the right to repossess the assets. In the case of a market crash, this could mean the lender takes them all, leaving the borrower without enough collateral to cover the full amount of the debt.
There have unfortunately been significant cases of fraud involving the practice. For example, in 2008, the UK’s Financial Services Authority found that Lehman Brothers rehypothecated assets illegally and without disclosure. This led to a dramatic increase in the avoidance of the practice.
For consumers, it is important to protect oneself against rehypothecation. This can be done by avoiding trading with borrowed funds or margin, as this will increase the chances of the assets being rehypothecated. If a loan must be taken, one should make sure to only use a reliable financial institution and to provide clear guidelines of what is allowed to happen with the assets. Additionally, one should always obtain the consent of debtholders before proceedings with any collateral re-use.
Ultimately, rehypothecation is a financial practice that can be highly beneficial but also incredibly risky and susceptible to fraud. It is important to be aware of the dangers that this practice poses and to protect oneself by avoiding certain transactions, such as trading with borrowed funds. By doing so, consumers can ensure that their assets remain safe and not fall victim to fraudulent practices.