Rehypothecation Definition Examples How Does It Work

Rehypothecation Definition

Rehypothecation refers to a practice where financial institutions like brokers and banks reuse the assets posted as collateral by their clients to secure their borrowings. Therefore, they provide a rebate or lesser cost of borrowing to the client who permits rehypothecation of their collateral.

When an individual decides to give away his asset as collateral to get a loan sanction from a bank or financial institution, it is known as hypothecationHypothecationHypothecation is a process where a lender receives an asset offered to him/her as collateral security. It is done mainly in assets that are movable in nature to establish the charge against collateral security for a particular loan.read more. However, when the bank now decides to use the collateral posted by the client for purposes or transactions of its own with that of another financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more by providing the same asset of the client as collateral, the first bank is said to have engaged in rehypothecation. As a result, the client will now be rewarded with a lower cost of borrowing on his funds or maybe even a certain rebateA Certain RebateA rebate is a cashback to the customers against the purchase as a completing transaction incentive. Rebates are offered after the sale. Thus, it is a form of marketing strategy provided to the client to facilitate future transactions.read more amount.

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Examples of Rehypothecation

Example #1

Let us consider the example of Scott, who requires capital for his business. He owns a house and thus decides to hypothecate the bank to sanction the amount for his business. Therefore, Scott has made hypothecation to bank A.

Now, the bank wishes to indulge in another financial transaction by borrowing money from bank B using the asset posted by Scott as collateral. So, Scott is now rewarded with a lower financing cost Financing CostFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains.read more and some rebate.

Example #2

Another example would be Mr. Tony, who owns shares of Good Co. to the extent worth $100. He wants to purchase shares of Better Co. but lacks the financial resources. He can now make use of his margin account by hypothecating $100 to the borrower and borrowing against shares of Good Co.

The balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more would now tend to look like this.

How Can I Plan for Rehypothecation?

If an individual is planning for rehypothecation, he needs to be ready to let go of his asset that gets pledged as collateral and enter into an agreement with financial institutions like banks and brokerages, stating that they are ready to allow the financial institution to use his asset as collateral against which the bank can now rely on to engage in transactions for purposes of its own.The individual needs to assess the requirement and extent of the loan required and then proceed with the exercise of hypothecation. Normally, only 70%-80% of the collateral value is sanctioned as a loan, and the individual needs to gauge their requirement and then make the assessment in this regard.The banker or lender will now have access to the individual’s collateral, which can then make use of and pledge with other banks and financial institutions to gain further funding or borrowing for purposes of its own. The lender has the right to seize the collateral if payments are not being made, and the individual who pledges his asset needs to be careful in this regard.

Advantages of Rehypothecation

Disadvantages

Consumers in Dark: There may be times when an individual is unaware that they have signed on to the rehypothecation clause and the asset is being used for further rehypothecation by the entity for its speculative purposes. The customer would not want that, and the bank would tend to act against the consumer’s interest by misusing the asset for its speculative purposes. Securities are often misused in this fashion.Risk of Default: Owing to leverage and borrowing if the underlying entity defaults, it causes enormous stress on the whole financial system. That happens to have a cumulative effect causing repercussions on the entire economy. One default would magnify the impact owing to the significant leverage involved, and rehypothecation tends to cause massive losses in this regard.Misuse: There may be times when banks may often misuse the underlying pledged collateral to their advantage and even for speculative activities.

Conclusion

Rehypothecation being a method commonly adopted by banks and financial institutions to undertake further transactions for purposes of its own, allows banks to gain access to further such capital by using the borrower’s assets as collateral. As a result, the borrower is also gaining due to the lower cost of funds and rebate income. However, it becomes of utmost importance for companies to use such collateral carefully and not misuse the borrower’s assets for their speculation and advantage.