Intermediary Funding Liquidity and Rehypothecation as Determinants of Repo Haircuts and Interest Rates
37 Pages Posted: 27 Jun 2014 Last revised: 17 Nov 2015
Date Written: July 2015
This paper offers a theory by which dealer banks obtain funding liquidity by serving as intermediaries between hedge funds and cash investors in the markets for repurchase (repo) agreements. The model explains how the demand by dealer banks for funding liquidity determines repo haircuts and repo pricing. A dealer bank obtains liquidity to the extent of the spread between the haircut on its repos with cash investors and the haircut on its reverse repos with hedge funds. Dealer banks optimally choose the extent to which they use this funding mechanism over alternatives such as cash holdings and fire sales of illiquid assets. Rehypothecation and over-collateralization might expose hedge funds to the bankruptcy risk of dealer banks. The model pins down repo haircuts and interest rates jointly. Haircut spreads are low and hedge funds are not exposed to the bankruptcy risk of dealers when liquidity is abundant. When liquidity is relatively scarce, haircut spreads are high and hedge funds are exposed to the bankruptcy risk of dealers. The model highlights the volume of lending by cash investors and dealer balance sheets as key determinants of haircut spreads. The predictions of the model are consistent with the data.
Keywords: rehypothecation, liquidity, repo, haircuts, interest rates, over-collateralization, dealer banks, hedge funds, cash investors, money market funds, prime brokerage
JEL Classification: G21, G24
Suggested Citation: Suggested Citation