Rehypothecation

When a hedge fund borrows securities or cash from a prime broker, it typically posts collateral to secure the loan. Rehypothecation is the broker's right to turn around and re-use that pledged collateral for its own purposes — pledging it again to raise financing elsewhere, lending it out, or using it in its own trading. The client's assets end up standing behind the broker's borrowing as well as the client's own.

This is valuable to the financial system because it lets the same pool of collateral support multiple layers of financing rather than sitting idle, which is one reason prime brokers can offer cheaper financing than an arrangement without rehypothecation rights. But it also means a client's assets are no longer simply held in custody — if the broker fails while holding rehypothecated collateral, the client becomes an unsecured creditor for whatever was re-pledged, rather than getting their specific assets back. This is exactly what happened to many hedge fund clients of Lehman Brothers' UK prime brokerage in 2008, where rehypothecated assets were frozen in the bankruptcy for years.

Regulations in most jurisdictions now cap how much of a client's assets a broker can rehypothecate (often a multiple of the client's own debit balance), and clients can negotiate limits or outright bans on rehypothecation in their prime brokerage agreements, usually at the cost of paying more for financing.