Hypothecation and Rehypothecation
Hypothecation is when a debt is secured by collateral. In a margin account, the amount that the customer owes the broker is secured by the securities that the customer has purchased. If the price of the security declines substantially, and the customer’s equity falls below 25%, the broker is allowed to sell the securities if the customer does not deposit more funds.
Broker-dealers sometimes use customers’ securities as collateral on their own loans from banks. When a firm uses a customer’s securities as collateral for a loan that is not for the customer’s own account, it is called rehypothecation because the firm is rehypothecating the securities. Clients who permit rehypothecation of their collateral are usually attracted by a lower interest rate or a rebate on fees. Member firms may not combine securities across customer accounts without written consent from each customer, however, and they may never commingle customer securities with securities owned by their firm.
There are two important SEC rules relating to rehypothecation. The first indicates that broker-dealers cannot borrow more from outside sources th