As investors, you may not hear hypothecation and rehypothecation in day-to-day conversation. However, it can be devastating consequences if you encounter the wrong set of circumstances.
Therefore, investors and traders need to understand the concept of hypothecation and rehypothecation.
Hypothecation
The term refers to taking certain assets and pledging them as collateral for a debt. That collateral can be seized, later, in the event of a default.
For instance, if you buy a home and take out a mortgage, then, you make a hypothecation agreement. You keep the title to the house, and your failure to pay the mortgage will result in the bank or the lender to seize it.
There are various types of hypothecation agreements. In some countries, for example, it is easier to seize a car than a home. The latter of which requires a much more specific and drawn-out series of legal events
Rehypothecation
Rehypothecation is when the person or institutions you pledged collateral to borrow money using that collateral. In that situation, your lender no longer enjoys the ultimate control over that collateral.
This arrangement may result in serious problems once things go wrong. Especially, if that happens due to regulatory arbitrage. That is a practice whereby firms capitalize on loopholes in regulatory systems in order to bypass unfavorable regulation.
If that happens, a brokerage house plays by the rules of a country to effectively remove any or all limits to a number of rehypothecated assets it has access to. They borrow money to get access to stocks, bonds, and commodities, instead.
Also read: 3 Ways to Buy Stock without a Broker
Brokerage Account Rehypothecation
Imagine if in your brokerage account, you have $100,000 worth Coca-Cola shares. Then, you have opted for a margin account to buy $100,000 worth of P&G shares.
Now, you put in the trade order and your account now consists of $200,000 in assets ($100,000 in Coke and $100,000 in P&G), with a $100,000 margin debt owed to the broker.
Consequently, you have to pay interest on the margin loan in accordance with the account agreement governing your account and the thin-margin rates in effect for the size of the debt.
