Collateral chains and incentives

Charles Kahn and Hyejin Park

Journal of Financial Market Infrastructures

Abstract: ABSTRACT Collateral reuse, either through explicit permission from the borrower or through a;repo agreement, economizes on scarce liquid collateral but leaves the possibility of;mismatch of collateral allocation in the event of the failure of a party in the middle of;the collateral chain. If haircuts are determined to solve incentive problems, there may;be a wedge between the shadow values of the collateral to parties in the collateral;chain. This can tempt parties down the chain to overuse the collateral provided them;and therefore cause parties up the chain to be unwilling to extend permission for;reuse. We consider a variety of financial arrangements in light of this framework.

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