What is rehypothecation?

Rehypothecation is when a financial institution takes assets a client has posted as collateral and reuses them as collateral for its own borrowing or trading. The client still has a claim on the assets. The institution has also pledged them somewhere else. Two parties now point at the same pile.

The word sits inside a longer one. Hypothecation is the original act: a borrower pledges an asset to a lender as security for a loan without giving up ownership. A mortgage is hypothecation. The bank doesn't own your house; it has a lien on it. Rehypothecation is when the lender then takes that pledged asset and pledges it again, to someone else, for the lender's own purposes.

How it actually works

A hedge fund posts $100 million of Treasuries to its prime broker as collateral for a margin loan. Under a standard prime brokerage agreement, the broker is allowed to take those Treasuries and use them as collateral for its own borrowing from a different counterparty. The broker uses cheap repo funding against the client's bonds, books the spread, and the client never sees the Treasuries move.

This is the normal state of the world in prime brokerage and securities lending. The economics of the prime brokerage business depend on it. Brokers offer competitive financing rates to clients precisely because they can recycle the collateral.

There are limits. In the US, broker-dealers can rehypothecate client assets up to 140% of the client's debit balance, under SEC Rule 15c3-3. In the UK, there's no statutory cap, which is why a lot of rehypothecation activity historically routed through London. The cap matters because it sets the ceiling on how much exposure a client takes to the broker.

Why it matters

Rehypothecation is fine when the institution in the middle is solvent. The client gets cheap financing, the broker earns the spread, the third-party lender holds collateral against a loan. Everyone is paid.

The collapse of Lehman Brothers in 2008 is the textbook case of rehypothecation gone wrong. Lehman's UK arm had rehypothecated client assets aggressively. When Lehman failed, those clients found their assets entangled in the bankruptcy estate, frozen for years, and ultimately recovered at a fraction of value. The contractual claim was still there. The actual securities were gone.

Crypto repeated the lesson. Celsius, Voyager, BlockFi, and FTX all rehypothecated client crypto in ways their users didn't understand and in some cases hadn't been told about. Each collapse left depositors as unsecured creditors of a defunct entity. The crypto they thought they owned had been pledged, lent, or traded by the platform.

This is why institutional crypto custody is built around the opposite principle. Qualified custodians in the US are prohibited from rehypothecating client assets at all. The whole point of qualified custody is that the assets sit segregated, not reused, not pledged, not touched by the custodian's own balance sheet. If the custodian fails, the assets aren't in the estate.

Anti-rehypothecation isn't a feature. It's the entire model.