Asset scarcity and collateral rehypothecation

Abstract

This paper introduces collateral rehypothecation, a widespread practice in derivatives, swaps, and repo markets, in a general equilibrium model with default. Rehypothecation frees up collateral because it allows lenders to resell or repledge assets pledged by borrowers. The risk that lenders will not return the asset, however, limits gains from rehypothecation. Still, when markets are contractually incomplete or decentralized, rehypothecation can achieve a superior use of scarce collateral. These results have implications for the repo market and suggest that limits to rehypothecation can cause price fragmentation.