Rehypothecation: Difference between revisions

{{anat|pb|{{subtable|{{rehypothecation capsule}}}}}}{{pbprov|Reuse}} — often labeled {{pbprov|rehypothecation}}<ref>Normal [[hypothecation]], by the way, is a term you don’t often see (and which means simply to [[pledge]] assets by way of [[security]] for a [[debt]]).</ref> (the two are legally very different but economically the same) — is the right a {{pbprov|prime broker}} has over its client’s {{pbprov|custody assets}} to take them and sell them in the market to offset its lending costs, against an obligation to return equivalent assets (which it must buy in the market) when the client wants them back.

===Anorak’s corner: The difference between rehypothecation and reuse===

The English law “[[right of use]]” is quite straightforward. Under it, contractually, a custodian may transfer a custody asset into its own name absolutely, against a concurrent liability to redeliver and equivalent assets into custody on demand. This converts a trust relationship over the assets into one of outright indebtedness. Once the reuse transfer has happened, the custodian — Who is now no longer a custodian, of course — is free to deal with the asset as it sees fit, and ''whether or not it sells it into the market'', the client is exposed to custodian credit risk Until the custodian has returned and equivalent asset, whereupon the custody and security relationship resume.

So far so good. But now we board our liner at Southampton and head for the New World. Here things are never easy. There is a strain of American jurisprudence that admits of [[paradox]] — that revels in it — and rehypothecation is its high water mark. To “[[rehypothecate]]” an asset is to take it and sell it outright ''without depriving its owner of legal title to the asset''. Now of course that doesn't make literal sense, and U.S. attorneys will regard you beadily should you ask them to explain it, and will decline to do so. It just is. The best I can do is a section on the ICMA website:

That sounds to me, readers, like title transfer reuse — perhaps only at the point it leaves the custodian’s hands and not before, granting a scintilla of additional protection, but really not much.

It is a fundamental part of a [[prime brokerage]] business. This is how a {{pbprov|prime broker}} funds its costs of lending to its Hedge Fund clients, which allows them to gain [[leverage]], buy the assets and conflate [[alpha]] with [[vega]]: it is ''not'' a [[credit risk mitigation technique]] (for that see {{pbprov|security}} and {{pbprov|margin}}.

It seems a rather drastic right, until you put it in context:

*running a [[prime brokerage]] business, and holding in [[custody]], is an expensive business. If the [[prime broker]] can raise finance against assets that would otherwise be sitting in custody (for example as [[collateral]] under its own [[securities financing]] programme) it can improve its [[balance sheet]] position, repay its internal treasury department the funds they made available at eye-watering rates, therefore markedly cheapening their own cost of lending and avoiding [[custody]] charges. Both of these mean it can price its offering more attractively to the client.

In a {{tag|prime brokerage}} arrangement, the [[prime broker]] has financed the purchase of a client’s asset, and it holds that asset in [[custody]], with {{tag|security}} over it as surety for repayment of the amount it lent the client to buy it in the first place. As [[custodian]], the [[prime broker]] has legal title but not [[beneficial interest]] in the asset. So it is rather as if the client had “pledged” the asset under a [[New York law]] {{t|CSA}} to the [[prime broker]]. therefore the term rehypothecation, to describe the process whereby the [[prime broker]] takes that asset and sells it to defray the cost of financing it, with a [[contingent obligation]] to redeliver something identical back on request, is not an outrageous distortion of the facts of what is happening.