Arbitrage Run and Collateral Run
38 Pages Posted: 11 Sep 2017 Last revised: 14 Nov 2019
Date Written: November 18, 2017
We investigate the channel through which fluctuations in the market liquidity of real-sector repo collateral cause arbitrage crashes and failure of systemically important intermediaries during the global financial crisis. Intermediaries pledge productive capital as repo collateral to fund the margin for their arbitrage positions. A tiny drop in the market liquidity of capital induces higher haircuts and forces arbitrageurs to collectively unwind trading positions, resulting in adverse price movements and losses. This further reduces the collateral value of arbitrage portfolios and triggers more fire-sales in both capital and arbitrage trades. This channel creates stronger amplification effects than in Brunnermeier and Pedersen (2009), and can easily incur a simultaneous repo run and arbitrage crashes, where liquidity in several markets dry up altogether. We also show that "flight-to-liquidity'' effects in intermediaries' collateral choices after the repo run prolong the real-sector recession.
Keywords: limit of arbitrage, financial intermediary, haircut, segmented markets, financial crises, market liquidity, collateral constraints
JEL Classification: D52, D58, E44, G01, G12, G33
Suggested Citation: Suggested Citation