What Does Hypothecation Mean?
Hypothecation is when a borrower pledges collateral as a means of securing a debt. The borrower retains ownership of the collateral, but it is hypothetically under the control of the creditor who can seize possession of the collateral if the borrower defaults.
For example, if you own a house and have a mortgage, you have hypothecated it to your mortgage company. This means that you still own it, but in the event of a default, your bank or your mortgage company (the creditor) can take ownership and do what it wishes.
“Rehypothecation” varies slightly when it is applied in the financial markets.
For example, if you put a buck in your checking account and the bank has to keep 10% of that in reserve, it can loan out 90 cents. But then, if somebody else deposits 90 cents, the bank can loan out $81 cents of that, or 90% of the total asset on deposit. And so on, until literally all the money on deposit is effectively hypothecated to another entity. This is why banks are constantly seeking new depositors — to feed the hypothecation machine and their profits.
Obviously a buck is still a buck no matter which way you cut it, so cash does count for something. But at the end of the day, any banks can create a daisy chain of rehypothecated assets that results in as much as $10 in new checking accounts and rehypothecated assets against every $1 in actual deposits. Perhaps more.
If you’re a brokerage house, the process is similar. Have equities? The collateral gets posted and used accordingly. Bonds? Same thing. The brokers will reuse them by rehypothicating them at their discretion while making sure a fraction of the actual underlying value remains in reserve as collateral.
Typically, banks and investment houses have rehypothecated customer assets to back their own trades, their own borrowing and their own operations.
Just like your house, which can be seized if you don’t pay up, assets on deposit with a broker may be sold by the broker (hypothecated) if investors fail to keep up with margin payments or if the securities drop in value and the investors in question fail to respond to requests to boost their collateral — all at the broker’s discretion depending on their margin and clearing requirements.
Now here’s where it starts to get sticky.