Rehypothecation

Rehypothecation is a common practice in the hedge fund industry where prime brokersA financial institution that provides comprehensive services to hedge funds including trade execution, custody, securities lending, margin financing, and capital introduction. take client assets that have been posted as collateral and use them for their own financing and trading needs. Think of it as your broker using your stocks as backing for their own loans or trades.

This practice forms a key part of how prime brokerage business works. When prime brokers can use client collateral for their own purposes, they can raise money more cheaply and run their operations more efficiently. These cost savings allow them to offer hedge funds better lending rates and enhanced services.

However, rehypothecation creates a clear trade-off. While hedge funds benefit from better terms and services, they also face increased risk. Once their assets are rehypothecated, hedge funds lose direct control over those securities. More importantly, they become more exposed to their prime broker's financial health—if the broker runs into trouble, the hedge fund's assets could be at risk.

The United States places strict limits on rehypothecation through Securities Exchange Act Rule 15c3-3, known as the customer protection ruleSecurities Exchange Act Rule 15c3-3 that requires broker-dealers to segregate customer assets and maintain reserve accounts to protect client funds.. This regulation creates a comprehensive system designed to prevent broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. from using customer assets to fund their own business activities while ensuring customers remain protected.

Under US rules, registered broker-dealers can only rehypothecate securities held in margin accountsTrading accounts where investors borrow money from brokers to purchase securities, using the securities as collateral for the loan.—accounts where customers have borrowed money to buy securities. Even then, the total value of rehypothecated securities cannot exceed 140% of what the customer owes the broker-dealer. This creates a mathematical ceiling that provides meaningful protection for hedge fund clients.

The rule divides customer securities into three categories, each with different treatment requirements. Fully paid securitiesSecurities that have been paid for in full by the customer and cannot be rehypothecated by broker-dealers under US regulations., where customers have paid in full, cannot be rehypothecated at all. Margin securities, representing positions where customers haven't made full payment, may be rehypothecated up to the regulatory limits. Excess margin securitiesThe portion of margin securities exceeding 140% of a customer's debt that must be segregated and protected from rehypothecation.—the portion of margin securities exceeding 140% of the customer's debt—must be kept separate and protected like fully paid securities.

Outside the United States, particularly in European and other international markets, prime brokers typically have much broader rights to use client assets. International prime brokers may claim ownership rights over both cash and securities held in client accounts, even for fully paid positions where the client doesn't owe any money.

This difference allows international prime brokers to offer more flexible arrangements that can provide higher leverage to hedge fund clients. However, the expanded rights create much greater risk for clients. If the prime broker encounters financial difficulties, clients may face significant challenges recovering their assets.

Hedge funds working with non-US prime brokers should carefully negotiate contractual limits on rehypothecation rights. They may want to seek protections similar to those available under US securities laws through private agreement terms.

Standard prime brokerage agreementsContracts between hedge funds and prime brokers that establish the terms for trading, custody, financing, and other services. typically give brokers broad rights to use assets held in margin accounts, but the specific terms vary significantly between providers and jurisdictions. Hedge funds can negotiate several protective provisions to manage their exposure and associated risks.

Common negotiation points include setting contractual limits on rehypothecation below the regulatory maximums, requiring regular reports on which assets have been rehypothecated, and creating provisions that allow for asset segregationThe practice of keeping client assets separate from the broker's own assets to protect them from the broker's creditors. when the client demands it. Some agreements include "best efforts" language requiring prime brokers to accommodate client requests for asset segregation when practically possible.

Negotiating rehypothecation terms often involves balancing costs against risk management goals. Prime brokers typically offer better pricing and terms to clients who grant broader rehypothecation rights. This creates economic incentives that must be weighed against the increased exposure to the broker's financial stability.

US regulations establish several protective mechanisms to safeguard customer assets from prime broker insolvencyA financial state where an entity cannot meet its debt obligations as they come due or has liabilities exceeding assets. risks. The customer protection rule requires broker-dealers to maintain special reserve accountsSpecial accounts maintained by broker-dealers containing cash or qualified securities to cover customer obligations under regulatory requirements. containing cash or qualified securities equivalent to what they owe customers.

These reserve requirements operate through a complex formula that accounts for customer cash balances and the extent of securities rehypothecation. Recent regulatory changes have increased how often large broker-dealers must calculate these reserves, moving from weekly to daily computations. This change improves the matching of customer obligations with reserved assets.

The Securities Investor Protection Corporation (SIPC)A nonprofit corporation that protects customers of failed broker-dealers by providing limited insurance coverage for securities and cash. provides additional protection for customers of failed broker-dealers. However, the extent of coverage and recovery timelines can vary significantly depending on the circumstances of any insolvency and how well customer assets were segregated.

Rehypothecation directly affects shareholders' voting rights in their portfolio companiesCompanies in which a fund has made an investment, typically through equity or debt securities.. Once securities are rehypothecated by a prime broker, they typically cannot be returned to the client account in time for the hedge fund to vote on corporate matters.

This limitation can be particularly problematic for activist hedge fundsInvestment funds that acquire significant positions in companies to influence management decisions and drive changes in strategy or operations. and other investment strategies that rely on shareholder engagement and voting participation. Such funds should address voting rights preservation during prime brokerage agreement negotiations. They may need to establish separate custody arrangements for securities where voting rights are strategically important.

Some hedge funds request contractual provisions requiring prime brokers to make reasonable efforts to return rehypothecated securities for voting purposes. However, the practical effectiveness of such provisions depends on the prime broker's operational capabilities and the timing of corporate actionsEvents initiated by publicly traded companies that affect their shareholders, including dividends, stock splits, mergers, and proxy votes..