Rehypothecation is a way of generating credit from assets, and allows multiple financial transactions to be collateralized by the same asset. How this works is a little counter-intuitive, though, and there are systemic risks involved too.
To get clarity on what rehypothecation is, we first need to understand hypothecation.
What is hypothecation?
Hypothecation is the process of pledging assets as collateral for a debt. This is common in lending; it’s what happens when people “take out a loan against” something. For example, when you buy a home and take out a mortgage, you enter into a hypothecation agreement, and if you don’t keep up your repayments the bank or lender can seize it.
It’s also common in the business world, where business equipment and assets are often hypothecated.
The word itself is made from two Greek words: hupo, meaning “under”, and thesis, “placing”. Thus to hypothecate means to place under.
Hypothecation in investments
Another common form of hypothecation is margin lending in brokerage accounts. When investors purchase securities on margin, they agree that those securities can be sold on a margin call if necessary. The fully owned securities in the brokerage account can also be sold if the state of the margin account calls for it.
What is rehypothecation?
Rehypothecation is a process of using hypothecated collateral as an asset in itself, and offering that as collateral when seeking a loan. It’s common to offer clients a reduced cost of borrowing or a rebate on fees in return for the right to rehypothecate their assets.
One example of rehypothecation is of securities that have been posted with a prime brokerage as collateral by a hedge fund; the brokerage can then use its conditional right to those hypothecated securities as an asset to hypothecate in its own loan applications.
The practice of rehypothecation is relatively much rarer than it used to be; it reached its height in the years immediately preceding the 2008 financial crisis in the USA, but it is still done. In the USA, SEC regulations prohibit rehypothecation of collateral above 140% of the amount of money loaned to the client.
Rehypothecation, custody and ownership
Historically, there has long been an option in custody relationships whereby a custodian can transfer ownership of an asset into its own name. The custodian takes full ownership of the asset, not merely custody. In return the asset’s original owner gets an undertaking from the custodian to return an equivalent asset on demand. Thus a custodian relationship becomes one based on debt.
However, rehypothecation takes this relationship a stage further. When an asset is rehypothecated, the custodian or broker takes the asset and sells it outright — but without depriving the initial owner of any ownership rights.
This is why rehypothecation is so counterintuitive: because the broker or other entity acting to custody the asset behaves as if they have ownership rights, without those rights actually being transferred.
The ICMA (International Capital Markets Association) explains it this way:
…”the collateral-giver remains the owner but only until the collateral-taker exercises his right of rehypothecation. When this right is exercised, there is a material change in the legal relationship between the parties. The pledge is extinguished and the collateral-giver loses his title to the collateral, which is transferred to the third party to whom the collateral has been rehypothecated. In exchange, the collateral-giver is given a contractual right to the return of the same or similar collateral but this claim is intrinsically unsecured”. (My emphasis.)
Why do people use rehypothecation?
Rehypothecation makes sense in situations where the broker-custodian has loaned the principal the money to purchase the assets in the first place. This is the case in many prime brokerages. In situations like this, the broker is at risk of becoming overextended and has their own balance sheet to take care of.
This can leave prime brokers with liquidity problems, and rehypothecation can be a good way for them to defray the initial cost of financing the asset in the first place.
In general, hypothecated assets are at rest. Yet, as Hye Jin Park points out
“valuable assets that can be used as collateral are scarce in the economy and… the demand for collateral has also been significantly increased… probably the easiest way to save on collateral would be by re-using it”.
One way to re-use collateral is to re-pledge, or rehypothecate it. This creates liquidity for individual market participants and across the market, increasing access to capital for businesses and delivering social benefits. Even the creation of “collateral chains” (see below) has positive benefits in increasing the interdependence of agents across the market.
History of rehypothecation
Hypothecation — collateralization of loans — is a very ancient practice, of which the first recorded example is the pawn shop. For loans like this to make sense there has to be a money market, and in feudal societies access to money usually came via land grants; loans were based on reputation where they were made at all. In more advanced societies, access to credit accelerates the economy and individual participants desire it for leverage, so a money market evolves, sometimes quite rapidly. The oldest collateralized loan documentation we have comes from a pawn shop in Tang Dynasty China, around 650AD.
The step from hypothecation to rehypothecation is a complex one and the specific form of rehypothecation we see in today’s money markets is an outgrowth of the English common-law concept of right of use, a part of the body of common law dealing with ownership, possession and custody.
The major break with this traditional form of right of use occurs with the transfer of the major financial center of the world to the United States. There, rehypothecation became a major feature of Wall Street practice and then spread to other jurisdictions — including the United Kingdom, where there is no limit on rehypothecation.
How rehypothecation works
For example, if you held a margin account with a broker, and own shares in a company worth $1,000. You wish to make further shares purchases in a different company but you don’t have the liquidity to do so. So, you can borrow $1,000 against your extant share holdings as collateral.
That gives you a balance sheet that looks like this:
|Equity (used to purchase your initial shares)||$1,000||Shares (pledged)||$1,000|
|Debt, with margin offered by broker by pledging||$1,000||Newly-purchased shares||$1,000|
In this scenario, you have put $1,000 into the system, and now have $2,000 in shares. The broker holds these, and both you and the broker have the right to the original asset. The entity the broker pledged it to must return it to them when their debt is paid; the broker must return it to you. It’s obvious that, in the words of Caitlin Long, this “enable[s] the financial system to create more claims to an underlying asset than there are underlying assets”.
This is referred to as a “collateral chain”; the Federal Reserve warns that “the use and re-use of collateral can create long ‘collateral chains’ in which one security is used for multiple transactions. These collateral chains have the potential to propagate uncertainties and amplify fragility in times of market stress.”
In addition, multiple claims against the same asset can reduce the price of that asset and others like it by diminishing its functional scarcity. There’s only one Mona Lisa, so if you’re the owner and you put it up for collateral against a loan you can be fairly sure of getting a high valuation. But if four other people also think they own a Mona Lisa because it has been rehypothecated, the value of it is depressed because it is now functionally less scarce; as far as the market can see there are four of them, after all.
In art, this example is largely spurious; no-one thinks Mona Lisas can be replicated. But fungible assets are susceptible to this effect, though how strong it is depends on the asset, the market and many other factors.
When one asset is the collateral for multiple transactions that may account for many times its value, there can be issues with who receives the asset in case of default, for instance. The chain of transactions that relies on the asset can become unstable. It’s easy to see how this can become fragile, which is why there are regulations limiting the use of rehypothecation.
Rehypothecation in digital assets
The digital assets economy quickly adopts effective asset management techniques from the traditional financial world. Often these techniques are rendered even more effective by being married to rapid, secure trading and the underlying security of the blockchain. We can see this process in action with the advent of digital asset custody, as well as with the growth in DeFi in recent months.
Rehypothecation in digital assets can be traced to the entry of classic Wall Street practices into the digital asset space.
One of the most crucial elements of the core part of the traditional financial system’s debt management — clearing-houses and exchanges — is ICE, which entered the Bitcoin market in 2018. At that point, the traditional financial practices of commingling and rehypothecation also entered the digital assets world.
Thus far, early warnings that rehypothecating BTC and other digital assets could work to destabilize the digital assets space, suppress BTC prices and reduce the efficacy of blockchain security by taking claims to ownership off-chain have not materialized. Bitcoin has more than tripled in value since 2018, suggesting price-suppression effects have been minimal.