Reuse of Collateral: Rehypothecation and Pyramiding
46 Pages Posted: 6 Sep 2016 Last revised: 15 Sep 2016
Date Written: May 14, 2016
Abstract
I study the optimality of the reuse of collateral, a practice which is widespread in the shadow banking system. Rehypothecation is the direct repledging of the collateral received in a debt contract by the lender, while securitisation (pyramiding) is the use of the debt contract itself as collateral. With securitisation, the value of the repledgeable collateral, and hence the amount that can be borrowed, is limited by the face value of the original debt contract. Rehypothecation of the collateral enables borrowing of an amount that is typically greater than the face value of the debt backed by that collateral. The rehypothecating lender effectively borrows from the borrower the excess value of the collateral over the face value of the debt. I show that when the lender’s cash flows are sufficiently pledgeable to the borrower, rehypothecation is a Pareto improvement on securitisation. I also study the effects of the collateral risk and lender’s pledgeability on bilateral repo contracts which are characterised by rehypothecation. I find that an increase in the collateral risk raises haircuts, and a decrease in the lender’s pledgeability raises repo rates, in line with the facts documented by Gorton and Metrick (2013).
Keywords: Collateral, Shadow Banking, Rehypothecation, Securitisation, Pyramiding, Repo, Mortgage
JEL Classification: G21, G23
Suggested Citation: Suggested Citation