Template:Rehypothecation capsule

Rehypothecation and reuse in a Nutshell™

Economically, to “rehypothecate” an asset you have been pledged is to take full legal and beneficial title to it, against an obligation to return an equivalent, fungible asset at a later date. This means you can sell the asset in the market, thereby realising funds with it, or to use it as collateral in a market transaction elsewhere.

Legal beagles will be fascinated, while no-one else will care, that in a New York law “rehypothecation” construct, the pledgor retains title to the rehypothecated asset at all times, even when it is sold outright in the market, whereas in an English law “re-use” constrruct, title to the asset passes outright to the person re-using it, and is replaced by a debt obligation to return an equivalent asset. Economically the two constructs are the same; it is just that the NY one makes no logical sense at all, while the English one makes perfect sense. Don’t @ me Americans: you know this is true.

Assets a counterparty posts you as collateral — especially as variation margin — are meant to be credit support for the amount that counterparty would owe you (your “exposure”) if you closed out the transaction today — the replacement value of the transaction, so to say.

This is all fine from a credit perspective, but there is a funding angle, too. That exposure is rather like indebtedness — it is as if you have lent your counterparty that money. If you are a prime broker, you probably have lent your counterparty that money. This is money your treasury department will gleefully, usuriously, charge you for using.

Now if only you could use these assets as collateral you owe someone else, or convert them into cash to repay your treasury department — like you could if that collateral was title-transferred to you — wouldn’t that be a fine thing? Well, as long as the collateral is only pledged to you, you can’t: it isn’t your asset to sell.

But this is exactly what rehypothecation allows you to do. But at a cost: the pledgor, who used to own the asset and could reclaim it in your insolvency (on settling its outstanding indebtedness to you) now becomes your unsecured creditor for the return of the “equivalent” asset. If you go bust, the pledgor must file a claim like all other creditors for the net value of the asset. Which is why the pledgor will be grateful for the effects of close-out netting.