Borrowing by Brokers: An Illustration
When a customer buys securities on margin, the customer borrows money 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. This is because the pledged securities become “hypothetically” controlled by the creditor. When this occurs, the borrower retains ownership, but the creditor may seize possession if the borrower defaults. In a hypothecation agreement, the lender, who is the broker-dealer, agrees to a loan and the borrower, who is the customer, pledges the purchased securities as collateral.
A hypothecation agreement also gives the broker-dealer the right to use the collateralized securities as collateral to finance its own investing activities. The practice of using the collateralized securities either to pay for the securities the customer purchased on margin or to finance another loan is called rehypothecation.
Rehypothecation 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 the customer protection rule, broker