Rehypothecation Risk

[brian.field]

I may be mistaken here, but this is truly surprising to me. Based on what I have read of the Part II material, it seems that the following scenario is possible.

Party A and Party B enter into a bilateral agreement.

Party A posts collateral to Party B and A maintains economic ownership of the collateral.

Party B uses the collateral that Party A provided for a bilateral agreement between B and Party C.

Party B defaults.

The bilateral agreement between B and C was "in-the-money" for Party C, so Party C retains the collateral that B posted (which was really A's property!)

Party A loses since Party B couldn't return A's collateral after B defaulted.

There is something terribly wrong about this reality......and it appears to be the norm rather than the exception. I do not know how this practice could not magnify systemic risk exponentially.

 

[Mkaim]

I may be mistaken here, but this is truly surprising to me. Based on what I have read of the Part II material, it seems that the following scenario is possible.

Party A and Party B enter into a bilateral agreement.

Party A posts collateral to Party B and A maintains economic ownership of the collateral.

Party B uses the collateral that Party A provided for a bilateral agreement between B and Party C.

Party B defaults.

The bilateral agreement between B and C was "in-the-money" for Party C, so Party C retains the collateral that B posted (which was really A's property!)

Party A loses since Party B couldn't return A's collateral after B defaulted.

There is something terribly wrong about this reality......and it appears to be the norm rather than the exception. I do not know how this practice could not magnify systemic risk exponentially.

Hi Brian,

Now that you put it this way, I find it very interesting as well. Never even thought about it for a second. I guess I need to pay more attention when reading. But what I do find interesting is that the exposure from A to C is the same as it would have been if B was still around. Basically, A still has a negative exposure so C has the collateral since it has a positive exposure and B is out of the picture. But I agree with you, if A loses collateral only because B had defaulted and there is no mechanism to "connect" A and C, that would suck big time. In the table below, I am assuming B is hedging all of its risk from A with C.

 

[brian.field]

This gets to compression or netting, I suppose.....but still, since the bilateral agreement between A and B has nothing to do with the agreement between B and C, it bothers me that C benefits from A's property, effectively.

 

[Mkaim]

This gets to compression or netting, I suppose.....but still, since the bilateral agreement between A and B has nothing to do with the agreement between B and C, it bothers me that C benefits from A's property, effectively.

I wish there was some sort of an automated system that would connect A and C if B defaults. As a matter of fact, I would take it a step further and say if it could connect A and C if certain credit related triggers between A and B or B and C failed (input by A and C) failed then that would be awesome. I'm thinking too much about this.

 

[brian.field]

Actually, I think you are right @Mkaim - I haven't synthesized the concepts well yet, but I believe that this is precisely the rationale for a CCP.....and the effect of a CCP as well, at a price of increased systemic risk, once again.

 

[Mkaim]

Actually, I think you are right @Mkaim - I haven't synthesized the concepts well yet, but I believe that this is precisely the rationale for a CCP.....and the effect of a CCP as well, at a price of increased systemic risk, once again.

And I thought I had a business idea...Just kidding.