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Rehypothecation in a Nutshell™

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.

It means, in a nutshell, you can monetise that asset.

Now if you think about assets that a counterparty has posted to you as collateral; especially as variation margin, these are meant to be credit support for your exposure to that counterparty; that “exposure” being the amount that counterparty would owe you if you closed out the transaction today — the replacement value of the transaction, so to say.

This is all well and good, 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 would doubtless like to use elsewhere, and it will gleefully, usuriously, pass to you the opportunity cost of it not being able to do so.

Now if only you take these assets and use them as collateral to someone else as variation margin for their exposure to you, or convert the asset into cash you can use to repay the extortioneers in 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.

So 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 (subject to discharging 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.