Hypothecation is a term used to describe a borrower offering an asset as a security to a lender in exchange for a loan. The lender becomes the new owner of the secured asset while the borrower still has physical possession of it.
The lender can only exercise their right over the asset in case of a default, in which case they can seize the asset. If the borrower does not default, or in other words, fully repays the loan, the ownership of the asset goes back to the borrower.
Hypothecation is very common for businesses and financial institutions that provide loans. There are many advantages and disadvantages to it. For the buyer, it can provide a way to obtain a loan at a lower interest rate and with lower requirements at the risk of losing the secured asset.
For the lender, the risk of the loan is significantly reduced but may come with lower interest rates. One term that is closely related to hypothecation, although not as common, is rehypothecation.
Rehypothecation is a term that means to hypothecate an already hypothecated asset. Or in simpler words, rehypothecation means re-using collateral from one loan transaction to finance another one. However, the borrower does not rehypothecate the asset.
Instead, lenders rehypothecate, or offer as security, the asset that borrowers have provided them as security. Usually, margin account holders exposed the most to rehypothecation.
For example, a borrower wants to take a loan from a lender. As security, the borrower offers a building to the lender, which is known as hypothecation. After a while, the lender also wants to receive it from a bank.
As security, the lender offers the building, received as security from the borrower, to the bank. The asset is still in use of the original borrower, but the lender uses it to obtain a loan. This is known as rehypothecation.
In some jurisdictions, rehypothecation may be banned or limited, as financial institutions can easily abuse it. For example, a borrower takes a loan from a lender and provides an asset with security, which the lender further uses as security when obtaining a loan from a third party.
If the lender defaults the loan received from the third-party, the third-party confiscates the asset. However, the original owner of the asset, the borrower, may not have defaulted but will still have to suffer as a result.
Why do lenders rehypothecate assets?
Lenders choose to rehypothecate assets for several reasons. First of all, rehypothecating allows them to borrow additional funds even though they may not have any assets themselves.
Due to this, the asset can act as security in two different loan contracts, the first one being from the lender to the borrower, while the other being from the third-party to the lender. Theoretically, the asset goes from the borrower to the third-party while the lender acts as a middleman in between.
Rehypothecation reduces the risk for the lender while overburdening the borrower. As discussed above, the reason for the overburdening is straightforward. The borrower has to suffer due to any default by the lender against the loan received from the third-party.
Similarly, the borrower also risks the hypothecated asset in case of default in the original deal with the lender. Ultimately, under both the hypothecated and rehypothecated loans, the borrower bears the consequences of defaults.
How can borrowers protect themselves against rehypothecation?
There are several ways in which borrowers can protect themselves and their assets from rehypothecation. The first and the best way to protect against it is to refuse to offer any assets as collateral. While this may reduce the chances of borrowers getting a loan or may cost them a higher interest rate, it still protects them from any potential loss of their assets.
Similarly, as mentioned above, margin account holding borrowers are most exposed to rehypothecation. Borrowers can also mitigate the risk of rehypothecation by not opening a margin account but opening a cash account instead. Some institutions try to enforce margin on borrowers by default. Borrowers can still have the option to refuse to accept it.
Hypothecation is when a borrower provides an asset as a collateral to a lender. Rehypothecation is when a lender, who has received an asset as collateral, further provides the same asset as collateral to obtain a loan from a third-party. Rehypothecation involves a single asset offered as collateral for two different loans.
However, the burden of the loan ultimately falls on the original borrower. It is because the borrower may lose the asset even if there is no default on the original loan. The risks of rehypothecation are the highest in margin accounts. Borrowers can protect themselves against rehypothecation by opting out of loans where lenders enforce rehypothecation.