Hypothecation

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See also hypothec.

Generally, a hypothecation is a contract which pledges or creates a lien on collateral to secure a debt, where the debtor keeps possession of the collateral. The arrangement is common with modern mortgages and the financing of business equipment and some consumer goods purchases - the borrower retains legal ownership of the property but provides the lender with a lien over the property until the debt is paid off.

Hypothecation of securities in capital markets

Hypothecation and re-hypothecation, respectively, are commonly used to describe the means by which securities brokers and dealers first extend credit on margin to their customers using pledged securities as collateral, and then pledge the client-owned securities held in the client's margin account as collateral for the brokerage's bank loan. In this example, hypothecation describes the posting of collateral to secure the customer's obligation to the broker; rehypothecation is the pledging by the broker of hypothecated client-owned securities in a margin account to secure a loan to the broker from a bank. This common use of the terms hypothecation and re-hypothecation is technically inaccurate, since the pledgee of the securities collateral, in the case of the broker, may be deemed to have possession of it.

While rehypothecation is not permitted in some jurisdictions, it is common practice in the United States, generally under the terms of a written collateral agreement that explicitly permits it. In addition to the re-hypothecation of a securities broker-dealer's collateral by re-lending it or posting it as collateral for one of its own obligations, another means of re-hypothecation is the repurchase agreement (or repo). In a two-party repo agreement, one party sells the other a security at a specified price with a commitment to buy the security back at a later date for another specified price. Overnight repos, the most commonly used form of this arrangement, comprise a sale which takes place the first day and a repurchase that reverses the transaction the next day. Term repos, less commonly used, extend for a fixed period of time that may be as long as several months. Open-ended term repos are also possible. A so-called reverse repo is not actually different than a repo; it merely describes the opposite side of the transaction. The seller of the security who later repurchases it is entering into a repo; the purchaser who later resells the security enters into a reverse repo. Notwithstanding its nominal form as a sale and subsequent repurchase of a security, the economic effect of a repo is that of a secured loan.^[1]

No creditor's duty of care

Since under a strict hypothecation, goods remain in the custody of the borrower or third party, who also enjoys the right to deal with them in the ordinary course of business, the hypothecation itself does not normally impose upon the creditor a duty of care over the hypothecated property. Accordingly, a judgment of the Kerala High Court of India^[2] held that where hypothecated property was lost and the banker was not aware of the loss otherwise than in the ordinary course of business, the surety was not discharged.

See also

• Security interest - hypothecation

External links

• Collateral Management article on Financial-edu.com

References