Collateral, Rehypothecation, and Efficiency

This paper studies rehypothecation, a practice in which financial institutions re-use or re-pledge collateral pledged by their clients for their own purposes. We show that rehypothecation enhances provision of funding liquidity to the economy, but it also incurs deadweight cost by misallocating the asset among the agents when counterparties fail. We also examine the possibility of a conflict between the intermediary and its borrower on rehypothecation arrangements. The direction of this conflict depends on haircuts of the contract between them: if the contract involves over-collateralization, there tends to be an excessive use of rehypothecation, and if the contract involves under-collateralization, there tends to be an insufficient use of rehypothecation. This offers an empirical prediction that if the borrower has imperfect information about the intermediary, she tends to be overly cautious to allow rehypothecation, resulting in reduced occurrence of rehypothecation