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Collateral Unchained: Rehypothecation networks, concentration and systemic effects

Luu, DT; Napoletano, M; Barucca, P; Battiston, S; (2020) Collateral Unchained: Rehypothecation networks, concentration and systemic effects. Journal of Financial Stability 10.1016/j.jfs.2020.100811. (In press).

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Abstract

We study how the practice of collateral rehypothecation impacts the generation of liquidity and the emergence of systemic liquidity risk, and how both depend on the structure of the financial network. We build a basic model where banks interact via chains of “repo” contracts (i.e. repurchasing agreements) and use their proprietary collateral or re-use the collateral obtained by other banks via “reverse repos”. We then extend the model to allow banks to determine endogenously the optimal amount of collateral to rehypothecate, based on the equilibrium level of Value-at-Risk. In this framework, we first show how total collateral volume and its velocity are affected by characteristics of the network such as the length of rehypothecation chains and the existence of closed (i.e. cyclic) chains of contracts, the presence of sink nodes (wherein collateral remains trapped), the direction of collateral flows, and the density of the network. We then demonstrate that a trade-off between liquidity and systemic risk exists for certain classes of networks structures. On the one hand, we show that structures where collateral flows are concentrated among fewer densely connected nodes allow for larger collateral volumes, even at low levels of network density. On the other hand, the same networks are also more exposed to larger cascades of collateral hoarding, as a result of localized liquidity shocks.

Type: Article
Title: Collateral Unchained: Rehypothecation networks, concentration and systemic effects
DOI: 10.1016/j.jfs.2020.100811
Publisher version: https://doi.org/10.1016/j.jfs.2020.100811
Language: English
Additional information: This version is the author accepted manuscript. For information on re-use, please refer to the publisher's terms and conditions.
Keywords: Rehypothecation, Collateral, Repo contracts, Networks, Liquidity, Collateral-hoarding effects, Systemic risk
UCL classification: UCL
UCL > Provost and Vice Provost Offices
UCL > Provost and Vice Provost Offices > UCL BEAMS
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science > Dept of Computer Science
URI: https://discovery.ucl.ac.uk/id/eprint/10119668
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