Borrowing by Brokers: Hypothecation and Re-hypothecation
When a customer buys securities on margin, the customer borrows from a broker-dealer to enable the purchase and pledges those securities as collateral for the loan. The customer is said to hypothecate the loan. Recall that the hypothecation agreement allows the lender, in turn, to use the collateralized securities in the margin account as collateral for another loan. This practice is called re-hypothecation. The broker-lender might want to re-hypothecate the loan to pay for the securities the customer purchased on margin or to finance its own investing activities.
Re-hypothecation is regulated in two ways. Under SEC Rule 15c2-1, broker-dealers cannot borrow more from outside sources than their customers have borrowed from them. In other words, they can only borrow up to the total amount of their customers’ debit balances. Under SEC Rule 15c3-3, broker-dealers are restricted in how much of their customers’ securities can be used as collateral for the loans. The amount of collateral is capped at 140% of a customer’s debit bal