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Hypothecation

Overview

Hypothecation can also be termed as trust receipt. It’s a rare form of security interest whereby one pledges a mortgage or an underlying asset as collateral for a loan. This means that once you hypothecate, the lender has the right to liquidate the underlying asset or mortgage if you are unable to service the loan as agreed. Note that while hypothecating, you’ll not deliver the assets like in a traditional pledge but rather you will deliver a document that will serve as proof of ownership. You will be said to “hypothecate” an underlying asset or the mortgage when you pledge it as security for a loan.

Hypothecation can also be used to refer to securities used as collateral for borrowed money in a margin account from a brokerage. A particular property is given to a creditor on the basis that the property is to be returned once the debts are paid in full. As such, the property doesn’t pass to the creditor neither does the creditor get any possession rights, he only gets partisan rights to have his debt paid out of the property i.e. he can sell the property and pay for his debt out of the proceeds or better still he can become the owner of the property in question in case of a default on the side of the borrower to service the loan accordingly. In general terms, a hypothecation is a legal contract which creates a lien on security to secure a debt whereby the possession of the collateral remains with the borrower.

Securities Hypothecation in capital markets

In the capital markets, hypothecation is used to depict the means by which dealers and security brokers extend credit on margin to their clients by using pledged securities as guarantee, and then pledge the securities owned by and held in the client’s margin account as security for the brokerage’s bank loan. As such, hypothecation depicts the posting of a guarantee to secure the client’s obligation to the security dealer or broker.

Re-hypothecation

Hypothecation and re-hypothecation are commonly used terms in the capital markets. Re-hypothecation is whereby the security dealer or broker pledges the customer-owned securities in a margin account to get a loan from the brokerage’s bank. However, the use of these two terms is deemed inaccurate technically because once the client pledges his securities collateral to the broker, the broker is deemed to have full possession rights over the securities.

Repurchase Agreement (repo)

Repo is a means of re-hypothecation whereby in a repo agreement involving two parties, one party sells the other party security at a particular price with a pledge/commitment to purchase the security back at a later specified date for another set price.

Note that in hypothecation, the property, mortgage or goods pledged as security remain solely under the custody of the borrower or in some cases a third party until otherwise stipulated by law. The borrower has the right to deal with the collateral in the normal course of business and hypothecation doesn’t in any way impose on the creditor a duty of care over the collateral.

Tags: bank, collateral, credit, law, Legal, loan, market, money, mortgage, price

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