Rehypothecation

Rehypothecation is when a prime brokerA financial institution that provides comprehensive services to hedge funds including trade execution, custody, securities lending, margin financing, and capital introduction. takes securities that a hedge fund has pledged as collateral and uses those same securities for the broker's own business activities. The prime broker might sell, lend, or trade these securities to support its own operations.

This practice creates a trade-off. On one hand, it allows prime brokers to operate more efficiently and offer better terms to their hedge fund clients. On the other hand, it exposes hedge funds to additional risk. If the prime broker runs into financial trouble, the hedge fund might have difficulty getting its securities back.

All prime brokerage agreements give the prime broker the right to rehypothecate assets held in client margin accountsTrading accounts where investors borrow money from brokers to purchase securities, using the securities as collateral for the loan.. However, U.S. securities regulations place clear limits on how much and what types of assets SEC-registered broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. can rehypothecate at any given time.

These restrictions come from Rule 15c3-3Securities Exchange Act rule requiring broker-dealers to segregate customer assets and maintain reserve accounts to protect client funds, also known as the customer protection rule. of the Securities Exchange Act of 1934 Securities Exchange Act of 1934 The Securities Exchange Act of 1934 is the primary U.S. legislation governing securities trading, establishing the SEC and imposing various reporting requirements on public companies and institutional investors, including certain hedge fund managers and activities. , which we'll discuss in more detail below. Prime brokers that are not registered with the SEC as U.S. broker-dealers do not face these same restrictions. As a result, hedge funds working with non-SEC-registered prime brokers often try to negotiate contractual limits on rehypothecation that mirror the protections found in U.S. Exchange Act rules.

Rule 15c3-3 sets comprehensive requirements for how SEC-registered broker-dealers must handle customer assets. The rule includes two main protection mechanisms for clients.

First, it requires broker-dealers to segregate customer cash in special reserve accountsSpecial accounts maintained by broker-dealers containing cash or qualified securities to cover customer obligations under regulatory requirements.. Second, it establishes strict standards for how broker-dealers must handle securities, including specific limits on rehypothecation.

The goal of this regulatory framework is straightforward: prevent broker-dealers from using customer assets to finance their own business activities. This reduces the risk that customers will lose money if their broker-dealer becomes insolventA financial state where an entity cannot meet its debt obligations as they come due or has liabilities exceeding assets..

Recent amendments that took effect in December 2024 made these protections even stronger. Large broker-dealers with average total credits of $500 million or more must now calculate their customer and proprietary account reserve requirements daily instead of weekly. These firms had until December 31, 2025 to comply with the new requirements.

The rule categorizes customer securities into distinct types. Fully Paid Securities are securities that customers have purchased with complete payment, typically held in cash accounts. Margin Securities are customer securities held in margin accounts where customers have not provided full payment. Excess Margin Securities are the portion of margin securities where the market value exceeds 140% of what the customer owes the broker-dealer.

The regulatory rules are clear and strict about what can and cannot be rehypothecated. Broker-dealers are completely prohibited from rehypothecating customer fully paid securities. When margin securities pledged by customers are worth more than 140% of what the customer owes, broker-dealers must keep control of those excess securities using the same safekeeping requirements that apply to fully paid securities.

Here's a practical example. Suppose a customer buys $80,000 worth of securities using 50% margin, creating a $40,000 debt balance. The maximum amount the broker-dealer can rehypothecate is $56,000 (which equals 140% times $40,000). This leaves $24,000 in excess margin securities that must be kept segregated under strict control requirements.

Broker-dealers can agree to even stricter rehypothecation limits than the regulatory 140% threshold, but this is not standard market practice. Whether such agreements are made depends on various factors, including how actively the customer trades on margin.

Special reserve requirements serve two important purposes. First, they prevent broker-dealers from using customer assets for their own business activities. Second, they ensure that sufficient segregated assets remain available to protect customers if the broker-dealer goes into liquidation, even when general creditors might not be paid in full.

Broker-dealers can meet their required deposits using cash, qualified securities with equivalent market value, or combinations of both.

The December 2024 amendments provided some benefits for large broker-dealers subject to the new daily computation requirements. These firms now benefit from reduced aggregate debit item charges, which decreased from 3% to 2% for firms using the alternative net capital methodA regulatory calculation method that allows qualifying broker-dealers to compute their net capital requirements using alternative formulas, often providing more favorable treatment than standard methods..

Broker-dealers must recalculate their reserve account deposits according to the new frequency requirements. They cannot withdraw cash or securities from reserve accounts unless they can demonstrate that the remaining amounts still meet the required deposit levels.

The reserve computation works by taking consolidated customer cash balances across all accounts and calculating the difference between what customers owe and their available credits. The formula also requires deposits equal to hypothecated securities values beyond 100% of margin debits, up to the 140% rehypothecation limit.

These enhanced daily computation requirements became effective for qualifying firms by December 31, 2025. They strengthen customer protection while providing some operational flexibility through the reduced buffer requirements.

Enhanced prime brokerage arrangements present particular challenges when it comes to asset rehypothecation. These arrangements, typically offered by financial institutions outside the United States, allow hedge funds to borrow more money than traditional U.S. regulations would permit under Regulation TSEC regulation that governs the amount of credit that broker-dealers can extend to customers for purchasing securities on margin..

However, these enhanced arrangements come with additional legal risks. Prime brokers operating outside the United States generally have much broader rights to rehypothecate client assets compared to their U.S. counterparts. The U.S. regulatory system includes specific restrictions on rehypothecation that protect clients, but these protections may not exist in other countries.

This difference creates a significant problem. If a non-U.S. prime broker encounters financial difficulties, hedge funds may face substantial challenges recovering their securities that have been rehypothecated. The legal protections that exist in the U.S. market simply may not be available elsewhere.

Rehypothecation creates a significant problem for hedge funds that want to vote their shares. Once securities have been rehypothecated, they typically cannot be returned to the prime brokerage account in time for the hedge fund to exercise voting rights.

This is particularly important for activist hedge fundsInvestment funds that acquire significant positions in companies to influence management decisions and drive changes in strategy or operations. that rely on voting rights as part of their investment strategy. These funds should address voting rights during their prime brokerage agreement negotiations. Some solutions include establishing separate custody arrangements that preserve voting capabilities or requesting that assets be segregated when voting is needed.

Some funds negotiate agreements that allow them to demand asset segregation or require prime brokers to make their best efforts to segregate assets when requested for voting purposes.