Journal of Financial Market Infrastructures

Risk.net

Collateral chains and incentives

Charles M Kahn and Hyejin Park

  • In collateral chains (e.g., rehypothecation) one unit of collateral can back multiple loans.
  • Collateral reuse can lead to misallocation if the middleman in the collateral chain fails.
  • When haircuts adjust incentives, a wedge arises in valuation of collateral by parties in the chain.
  • The wedge in valuation can lead to a conflict between agents' preferences for reusing collateral.

ABSTRACT

Collateral reuse, either through explicit permission from the borrower or through a repo agreement, economizes on scarce liquid collateral but leaves the possibility of mismatch of collateral allocation in the event of the failure of a party in the middle of the collateral chain. If haircuts are determined to solve incentive problems, there may be a wedge between the shadow values of the collateral to parties in the collateral chain. This can tempt parties down the chain to overuse the collateral provided them and therefore cause parties up the chain to be unwilling to extend permission for reuse. We consider a variety of financial arrangements in light of this framework.

Sorry, our subscription options are not loading right now

Please try again later. Get in touch with our customer services team if this issue persists.

New to Risk.net? View our subscription options

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here