What is Rehypothecation?

Do you fully trust your broker and bank?

Many people do—otherwise, we wouldn’t deposit so much of our hard-earned money into our accounts. Nevertheless, there are some activities your bank or broker could be involved in without you being aware of it. Most of it might be happening behind the scenes, but the potential consequences often make the front page. 📰

Thankfully, you don’t have to remain in the dark about this—you can find out exactly what’s going on and how to protect your assets.

We don’t blame you for not reading through all of the Terms and Conditions before signing up somewhere—they are many pages long and filled with boring jargon. One of the terms you might have skipped over while scrolling down quickly to the “agree’’ button is Rehypothecation. 

It’s a term you’ve probably only heard once or twice at the coffee machine, but there’s a high chance you’ve agreed to rehypothecation nonetheless. With this phenomenon spilling over from the legacy financial system to crypto, there is all the more reason to learn what rehypothecation exactly is and how it could affect your own finances. 

To help you protect your portfolio against the potentially negative fallouts from rehypothecation, we’ll go beyond just the definition. We’ll tell you how it works, the problems associated with it, and its relation to day trading. We’ll also go over rehypothecation’s role in the whole AMC/GME saga and its relevance to DeFi.

What Exactly is Rehypothecation? 🙋

The financial world is famous for its—for many—incomprehensible jargon, but the definitions are often not that hard to grasp. Simply put, rehypothecation is the re-use of collateral that someone has put up to get access to a loan.

It is mainly used by bankers and brokers to get more capital—they can take the collateral originally pledged to them and put it up as collateral for a new loan. This way, a derivative financial product is created and the final lender in the chain now has a claim on the collateral that the first borrower put up.

How Does it Actually Work? ⚙️

If you want to borrow money, you usually have to put up collateral before the lenders are willing to hand you the loan. Now, let’s say the same lenders who gave you the loan use the collateral you put up to borrow money themselves—with the same collateral you pledged to them.

The person or institution that lent money to your lenders now has a claim on the collateral that you originally put up—they now control the collateral and decide what to do with it. All of this most likely happened without you knowing about it—and it’s all perfectly legal. 

Regulation 👮

This practice is allowed thanks to regulation commonly referred to as “Regulation T” or “Reg T” for short—but brokers often stretch the rules a bit by making use of “regulatory arbitrage.” Brokers choose a jurisdiction where regulation is more in their favor than in another jurisdiction.

This way, they’re able to remove limits that would’ve been imposed on them in the less favorable jurisdiction. In the United States, there is regulation that requires brokers and other institutions to segregate assets that have been fully paid from assets paid for with borrowed money. 

The institutions get around it by moving money to countries where this regulation doesn’t exist. Those subsidiaries and foreign affiliates come in handy for the institutions, but all of this can have disastrous consequences for investors and the markets in general.

Through these constructions, they enable themselves to seize all your assets. So, if you think only the assets you’ve borrowed against are at risk, think again. 

Hypothecation Explained 🏠

We all need a roof above our heads and to get it, we often need a mortgage—but the bank wants to make sure it gets repaid. That’s why you put up your new house as collateral—the bank has the right to take your house when you stop paying off your mortgage.

This process is called “hypothecation” and it’s very common—think of car loans or a margin account with your broker. You have ownership of the house or car—but since you entered an agreement, the collateral can be taken away from you.

Now imagine your bank uses the house you put up as collateral to secure a loan for itself—they pledge your house as collateral for their loan. Now we’re talking about rehypothecation—your house has been used as collateral once again.

What Are the Risks of Rehypothecation? 🚨

The financial world is no stranger to shenanigans and the world of rehypothecation is no exception. Your collateral being used for a variety of loans already sounds ludicrous—but at least you know about it, right? 

Unsuspecting Participant 📝

There we have problem number one—people often don’t have a clue their assets are being rehypothecated. If—like many—you don’t read the fine print, there’s a high chance you signed a rehypothecation clause without being aware of it. 

It’s also common for brokers to try to convince you to agree to rehypothecation by offering you more favorable credit terms or rebates. For many people that’s hard to resist—but is it really worth it? 

Last in Line ⏳

There are many examples of banks and brokers taking speculative bets using their clients’ collateral. Unsurprisingly, that doesn’t always end well—we’ve all heard the name Lehman Brothers at least a couple of times.

Lehman’s bankruptcy showed the world the dangers of rehypothecation and put the term on the front pages. When Lehman went bankrupt, their clients ended up last in line and became mere creditors—rehypothecation had combined their assets with Lehman’s other assets. 

The bank or broker that the collateral has been rehypothecated to has priority over the clients by law. If you’re lucky, there’s something left for you after all the court proceedings. In reality, however, many clients wind up flipping the bill for someone else’s failures. 

Your assets could be seized due to no fault of your own and we’re not just talking about assets you’ve borrowed against. As shown by the bankruptcy of MF Global, your other assets could also be taken away from you. The broker took highly speculative bets using clients’ collateral and later took the same clients’ money to cover the giant losses.

Are There any Benefits to Rehypothecation? ✅

Luckily, it’s not all bad—rehypothecation does offer some benefits to the markets and to you as an investor as well. Keep in mind that many of these advantages can actually become disadvantages in the long term. 

Leverage 💰

If you’re a buy-and-hold investor with mainly blue-chip company stocks in your portfolio, you probably won’t need a margin account. If you’re taking a bit more risk and using a variety of trading strategies, you will most likely need a margin account.

Once you have a margin account, you need to pay your broker a margin rate—which varies per broker. To convince investors to agree to rehypothecation, brokers often offer you a lower interest rate and/or rebates.

This could potentially save you quite a bit of money, but remember there’s no such thing as a free lunch—your brokerage can now use your collateral as it deems necessary. This leads us to the benefit of rehypothecation for financial institutions.

Even big financial institutions are sometimes short of cash and need to borrow some money—with a couple more zeros behind the comma. Rehypothecation makes it possible for them to get capital quickly without their operation being obstructed. 

All of this—enhanced by historically low interest rates—leads to more and more leverage in the financial system. On the one hand, more leverage means better price discovery and it makes financial markets more efficient. On the other hand, it encourages speculative bets and leads to market bubbles.

How Does Rehypothecation Affect the Markets? 📈

At the beginning of 2021, the so-called “meme stocks” $GME and $AMC shook the financial markets in spectacular fashion. Thousands of retail investors—who organized themselves on forums and social media—bought shares of the two ailing companies en masse. 

David vs. Goliath 🥊

They did so with one goal in mind—squeezing out the hedge funds who had taken massive short positions in GME and AMC. As a result, renowned hedge funds lost billions of dollars and some even had to close their doors. 

With the army of retail investors not backing down halfway throughout the year, politicians and even—former—central bankers are calling for more scrutiny of brokers and clearing houses. The “apes”—as many of these retail investors call themselves—often point out the negative effects of naked short-selling. 

Keep on your clothes, because it might not mean what you’re thinking. Naked shorting happens when people or entities short shares that in reality don’t exist—made possible by regulatory loopholes. Combine this with the differences between paper and electronic systems—used for trading—and we know why it persists till this very day.

A Flawed Story 📖

As nefarious as it may sound, naked short-selling’s role in the whole meme stock saga is smaller than it seems at first glance. In reality, rehypothecation is the most likely culprit for pushing short interest in some stocks above 100%. 

To short a stock, a trader has to first borrow the shares from a broker and sell them. These shares can then be sold again by the buyer who bought the shares from the first short-seller. This process could—in theory—go on forever and explains the massive short positions in companies like GameStop and AMC. 

Can You Lend Me a Billion? 🤝

Have you ever lent someone a couple billion dollars and expected the money back—with interest—overnight? Neither have we, but it’s everyday business in the repo market. Many large financial institutions—from banks to pension funds—use this market to get quick access to short-term capital.

Lenders provide these short-term loans only if the borrower puts up collateral and pays interest. The collateral used in these repurchase agreements is usually government bonds.

With activity in the repo market climbing to record levels, it’s important to take a look at how rehypothecation plays a role in this murky part of the financial system. Often the collateral used for these transactions—e.g. the bonds we’ve mentioned—are rehypothecated. 

Money managers, brokers, and the like could use the assets you’ve pledged to them as collateral themselves to get other financial institutions to lend them money. Everything gets caught up in a tangled web of collateral and loans—making it hard to keep track of who owes what to whom.

All of this makes it incredibly hard to get your assets back when your broker or money manager goes bust. The last lender in the chain can seize the asset without regard for you as the investor who originally put up the collateral. It doesn’t matter whether you’ve been paying off your debt or not.

With the Federal Reserve having had to come to the rescue of the repo market more than once, it comes as no surprise that it played a major role in the 2007-8 financial crisis. The quick loans provided by the repo market allow financial institutions—some of which you entrust with your money—to make speculative bets with a lot of leverage. 

An Example of Rehypothecation 💭

Let’s say you have a portfolio of 100 shares of Company A worth $100.000 and you want to buy 100 shares—also worth $100.000—of Company B. The only problem is that you don’t have the cash on hand to buy the shares, so what do you do?

Given that you have a margin account with your broker, you can just borrow the money. There’s a catch though—you have to put up collateral your lender can seize when you can’t pay them back the margin debt. The collateral, in this case, is your position of a hundred shares in Company A.

All good so far, but your broker needs to get the $100.000 from somewhere and not all brokers have the cash on hand. To make the financial markets run more efficiently, your broker can borrow money from a so-called “clearing house”—usually a bank.

To borrow the money, the clearing house demands collateral from your broker. So, the brokerage firm takes your collateral and pledges it to the clearing house. Your assets have now been rehypothecated and the clearing house is now the final lender in the chain. 

Let’s say your broker goes bankrupt, what happens then? In our example the clearing house—let’s say Wells Fargo—will take your $100.000 of Company A shares plus your $100.000 of Company B shares which the broker put up as collateral.

To give you an idea of what that might look like—imagine logging into your account and seeing your assets have disappeared like snow in the sun.

The Ways to Avoid Rehypothecation 🦺

There is only one way you can truly prevent your assets from being rehypothecated and it sounds quite simple—don’t hypothecate anything to begin with. In practice, it’s sometimes not that easy—some brokers give you a margin account by default.

Cash Account 💵

Try to avoid this and only sign up for a “cash account” or “type 1 account”—the name depends on your broker. With this type of account, you’re not able to borrow any money to make trades. In other words, you have to pay every cent yourself when you buy a security.

This makes trading options and other types of derivatives more complicated—you need to have enough money in your account to cover everything. The flip side of the coin is that you probably get better sleep at night—you won’t have to fear a margin call and you can’t lose more money than what’s in your account. 

Always read the fine print and understand what you’re agreeing to—if something sounds too good to be true, it probably is. The rebates and lower borrowing costs sound great, but ask yourself whether it’s really worth the risk you’re taking with rehypothecation.

The Role of Rehypothecation in DeFi 💻

On to the world of decentralized finance—DeFi for short—where rehypothecation also plays a big role. This novel financial system makes all types of financial transactions possible without intermediaries. 

To make DeFi work, borrowers often have to put up collateral in the form of cryptocurrency—which one depends on the protocol. Just like in the “legacy” financial system, asset derivatives can be created in this system. 

Let’s say you put up 5 MKR—Maker—as collateral in a DeFi application. The lender in the transaction can then take your collateral and use it in another application. There’s no limit, so this could—in theory—go on and on. 

There are DeFi applications that are made just for enabling users to get leverage by using rehypothecation. Nothing out of the ordinary so far, but there are some problems with using rehypothecation in DeFi.

Total Value Locked 🔒

To measure the success of DeFi in general and of specific applications, we use something called “Total Value Locked’’—TVL for short. We get to the TVL by adding up all collateral that’s locked up in an application. 

Unfortunately, the TVL number doesn’t give us a realistic image of an application’s real adoption. You might have heard of the terms “hard fork”, “soft fork”, “chain split’’ and—perhaps vaguely—understand what they mean. 

All these mutations and new launches are the reasons that crypto and rehypothecation don’t go well together. They also make it incredibly hard to monitor and record all the collateral that belongs to a Blockchain. 

There are often many different types of collateral used in an application—leading to the second problem. We can’t count on all the collateral being as valuable as it seems at first glance—there is a lot of manipulation in the DeFi market. 

Another reason to distrust TVL as an accurate measure of DeFi adoption is the use of rehypothecation. Constantly re-using collateral throughout a variety of applications leads to a “multiplier effect”—TVL takes into account all collateral whether it’s rehypothecated or not. 

This leads to unrealistic and TVL numbers—the collateral is not that “locked” after all.

The use of TVL continues only because we don’t have a better way to measure DeFi adoption yet. This might change soon—other ways to measure adoption are gaining momentum.

Final Words 📌

Some people argue that the financial world is full of complicated terms to prevent normal people from becoming financially successful. Whether it’s true or not, nothing can stop you when you educate yourself—the next time you’ll read about rehypothecation, you’ll know exactly what’s going on. 

You now know what rehypothecation is, how it works, and what problems it might cause for you and for the markets. You’ve learned about its relation to day trading and what role it played in the GME/AMC saga. Finally, we talked about rehypothecation’s relevance to DeFi and why TVL isn’t the best way to measure whether your coin is going to the moon. 🚀 

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