The Paradox of Conservative Haircuts

Abstract

Collateral requirements affect counterparty selection. I show empirically that conservative Central Counterparty (CCP) repo haircuts push low-risk borrowers away from the CCP and into the over-the-counter (OTC) repo market. When a CCP increases repo haircuts, its policy change applies to all participants uniformly but most strongly affects borrowers whose funding constraints are binding. Affected borrowers with high credit ratings are more likely to switch to borrowing over the counter due to the risk preferences of OTC repo lenders. As a result, conservatively high haircuts induce negative selection in the CCP repo market, potentially threatening its stability.

Keywords: CCP, Central Counterparties, OTC, Haircut, Collateral Requirements, Repo

JEL Classification: G21, G23, G28, G32