A Primer on Re-hypothecation
Hypothecation happens when a borrower pledges collateral to secure a debt. Even though the borrower retains ownership of the collateral, the lender has a right to seize said collateral should the borrower default. This way, the creditor ‘hypothetically’ has control over the collateral.
Re-hypothecation happens when a bank or prime broker uses the collateral posted by its clients to back its own proprietary trading activities or for other purposes. This practice is widespread and is typically written into the fine print of customer account agreements. Re-hypothecation of clients’ assets runs into the trillions of dollars.
Regulations in the US limit a broker-dealer from using its customer’s securities to finance their own proprietary activities to an amount up to 140% of the customer’s debit balance. In the United Kingdom, however, there is no such limit. In other words, a UK broker-dealer can re-hypothecate its customers’ assets by an unlimited amount.
Since re-hypothecation is so profitable, prime brokers take advantage of this glaring regulatory lapse by having another set of fine prints in their customer account agreement, allowing them to transfer the clients’ assets to their UK subsidiaries to get around any re-hypothecation rules in other jurisdictions.
When Lehman Brothers’ UK unit went under during the 2008 financial meltdown, it was found that some $22 billion of its customer assets were used as collateral for loans taken out by the UK unit. As a result, these clients became unsecured creditors and their assets got frozen. Only portions of the money were ever returned years later.
Re-hypothecation reared its ugly head again when MF Global, a $40 billion US firm and one of the largest global financial derivatives brokers, filed for bankruptcy in 2011, during which $1.2 billion of its clients’ money was ‘lost’ or, as the firm described it, ‘vaporized’.
New regulations introduced by the UK’s Financial Services Authority (FSA) since Lehman require a prime broker to provide disclosure on its right to re-hypothecate clients’ assets and more reporting to its clients as to how their assets are being pledged.