We examine the role of collateral in a dynamic model of optimal credit contracts in which a borrower values both … the role collateral as a deterrent to manipulation. Some assets, those that generate consumable services will necessarily …

collateral to support arbitrage trades. We show that with volatile asset demands, arbitrage becomes risky. With information … frictions, a looser collateral policy might render the economy more vulnerable to extremely large demand shocks, while a tighter … collateral constraint helps maintain the stability at the cost of market liquidity supply …