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.

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