15.8. Borrowing by Brokers: Rehypothecation

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 rehypothecation. The broker-lender might want to rehypothecate the loan to pay for the securities the customer purchased on margin or to finance its own investing activities.

Rehypothecation is regulated in two ways. 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 customer’s 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 balance. This rule is also called the 140% rule and it was put into place to prevent broker-dealers from rehypothecating too much of their customers’ securities.

Example: If a customer purchases 1,000 shares at $60 and deposits 50% in a margin account, the cust