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FRM Part II · FRM Exam Part II · The Failure Mechanics of Dealer Banks

A dealer bank is rumored to be in trouble. Hedge fund clients with prime brokerage accounts begin withdrawing free credit balances and moving positions to other prime brokers. Which feature of the dealer's practice of rehypothecation makes this withdrawal particularly damaging to the dealer's liquidity?

Rehypothecated client securities and free credit balances are used to fund the dealer's own positions. When clients withdraw them, the dealer must replace that funding quickly, often in stressed markets, which creates a sudden liquidity drain.

  1. ARehypothecated client securities used to raise the dealer's own funding must be replaced when clients withdraw them, requiring new financingCorrect
  2. BRehypothecation reduces the dealer's haircuts on repo, so withdrawals increase collateral
  3. CClient assets are always held in segregated accounts, so the dealer loses only fee income
  4. DRehypothecation transfers all client claims to the central bank

Explanation

Dealers reuse client collateral to fund their own inventory. When clients withdraw assets or balances, the dealer must return them, funding the gap from other sources at the worst time. Segregated assets would not create this problem, so that option is wrong.

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