Rehypothecation occurs when the collateral posted by a prime brokerage client (i.e. hedge fund) to its prime broker is used as collateral also by the prime broker for its own purposes. Every customer account agreement or prime brokerage agreement with a prime brokerage client will include consent to use this practice unless stated otherwise. Collateral assets (i.e. client funds) can be recycled by pledging and re-pledging. In the aftermath of the recent crisis when Lehman Brothers was allowed to fail, a decrease of up to $5 trillion in high-grade collateral due to reduced rehypothecation caused a run on the shadow banking system. Many brokerage firms are shifting client assets to the United Kingdom where there is no European Union law to cap the amount of collateral that can be rehypothecated. This “churn” of collateral known as “collateral velocity” is the new Fractional Reserve Banking. Rehypothecation has become the new Fractional Reserve Banking putting the hands of leverage and money creation not into the hands of the Federal Reserve but into the hands of Prime Brokers and Investment Banks like Goldman Sachs.
Fractional Reserve Banking is a form of banking where banks maintain reserves that are only a fraction of customer deposits. Rehypothecation is a form of banking where Prime Brokers maintain reserves that are only a fraction of client deposits.
The margin call on Prime Brokers to post more rehypothecated collateral is a big risk and must be monitored. MF Global is a good example of what happens when a broker or a bank uses rehypothecation excessively.