Rehypothecation is, plain and simple, the velocity of collateral*, but there’s one difference between the two terms – rehypothecation is a bad word for some reason. Rehypothecation occurs when an asset is borrowed and re-pledged to another party. It’s when banks use the same collateral received from one counterparty and pledge it to another counterparty. Basically, it’s the foundation of the modern Repo and securities financing markets.
The legal basis for a Repo transaction is that it’s the sale of a security with a re-purchase at a future date. The legal title transfers from the seller to the buyer and the buyer can pledge it, sell it, repo it, or just keep it. At the end of the term of the Repo trade, the same or equivalent collateral must be delivered back to the seller. The proprietary rights of the buyer are referred to as the right of ‘re-use,’ and it’s a fundamental property right.
Rehypothecated collateral is like a chain with many links, and the amount of links is the amount of rehypothecated securities. In practical terms, the amount of rehypothecated securities is the number of times it takes before a security goes from end-seller to end-buyer.
The Velocity of Collateral (VofC)
The Velocity of Collateral is like the economics term, the Velocity of Money. In economics, the Velocity of Money is how much, on average, a single dollar is re-used in the economy over a period of time. It’s how fast currency passes from one holder to another. Think of it as the same principle, except in the Repo market.
The VofC is how much, on average, a security turns over before it gets from end-seller to end-buyer. The current Repo market has a high velocity because there are many players making-markets, speculating on interest rates, and borrowing and lending with customers. In the chart [below], $100 million of securities are loaned from a leveraged portfolio to Bank A, then to Bank B, then to Bank C, before they reach their final destination, the cash provider. Every time the same security is re-used (rehypothecated) in this series of Repo transactions, assets and liabilities are created by the velocity of the collateral.
Here’s a real-world example of this transaction chain: The leveraged fund is a prime brokerage customer of Bank A. Bank A must work to get the best rate for their client and lends the $100 million securities to Bank B. Bank B is a market-market in Repo, borrowing securities on the bid-side and lending securities on the offered-side. Bank B, in turn, lends the securities to their customer Bank C, and Bank C has a money fund customer who is the end-buyer of the collateral. In the end, the $100 million of securities was rehypothecated three times before it reached it’s final destination. The total amount of assets in this Repo chain is $400 million, based on an initial $100 million in securities. The velocity of collateral with three dealer banks intermediating is 4.
Here’s another scenario, but this time there’s one bank doing the intermediation [below]. The $100 million in securities is only rehypothecated once before it reaches the end-buyer. There’s one market-maker (Bank B) and the VofC is 2. The amount of assets in this Repo chain is $200 million. Note, the size of the Repo chain just decreased by half. In this series of Repo transactions, it took half as many rehypothecations to get the securities from end-seller to end-buyer.
Now, here’s an extreme example [below]. There are no market-makers and there’s no bank intermediation in the Repo market.** Collateral goes directly form end-seller to end-buyer. Perhaps we can call it the “natural size of the repo market.” There’s no rehypothecation and the VofC is 1. There’s $100 million of securities, $100 million in Reverse-Repo and $100 million in Repo transactions. If collateral rehypothecation were eliminated, this is what the market would look like.
Estimating The Velocity of Collateral
The size of the U.S. Repo market is estimated to be around $4 trillion in 2014. As a mathematical formula, the VofC is equal to the size of the Repo market divided by the amount of collateral in the Repo market. I’ve seen the VofC of the U.S. Repo market estimated to be 2.4 and 3.* That means, on average, the amount of times collateral is Repo’d and Reversed as it goes from end-seller to end-buyer is between 2.4 times and 3 times. It also means there are, on average, between about 1.5 and 2 banks standing in between the end-sellers and end-buyers on each transaction. That appears about right to me.
There are factors which affect the velocity of collateral – capital costs, securities haircuts, taxes (FTT), and a market crisis will all slow down the VofC. Wider Repo bid/offer spreads, booming markets, more Repo market-making, and banks running large balance sheets will increase the VofC. Naturally, both the size of the Repo market and the amount of collateral available in the Repo market changes regularly. Therefore, the size of the Repo market also increases or decreases with more or less collateral velocity.
Dangers of Rehypothecation
Rehypothecation is only a danger if one of the counterparties files for bankruptcy or defaults. Think of it like a break in the collateral chain. When one party is in default, the two counterparties on either side of the chain must liquidate their securities to mend the chain. One counterparty sells the collateral into the market and the other one buys the collateral from the market. For highly liquid and large issue securities, like U.S. Treasurys, this is easily done. A problem can arise when the collateral is non-fungible, a private-label issuer, or a small issue size. In that case, when the entity in the middle goes bust, there’s a problem for the original seller to get back the equivalent collateral.
The Future of Collateral Velocity
The Velocity of Collateral (rehypothecation) creates assets and liabilities in the financial system, but it doesn’t make the system any riskier. From a policy perspective, eliminating rehypothecation is the same as eliminating intermediation in the Repo market. It would force the Repo market down to transactions between end-sellers and end-buyers. In fact, some collateral velocity is actually good for the financial system. It’s not good to have a closed loop where end-sellers only trade with end-buyers, or end-sellers and end-buyers are beholden to just one bank.
Decreasing collateral velocity is, perhaps, the current trend in the bank Repo market. Banks are cutting back on the size of their Repo books, but the amount of collateral going from end-sellers to end-buyers has not significantly decreased. That is, securities are still getting from end-seller to end-buyer. As the trend continues, there will be fewer institutions standing in between. Right now, the size of the Repo market is shrinking only because the VofC is declining. In a way, the Repo market can shrink without really shrinking. The declining collateral velocity means there are fewer intermediaries, but not much loss of liquidity.
* For more on the Velocity of Collateral, see Manmohan Singh and Peter Stella; “The (other) deleveraging: What economists need to know about the modern money creation process”; July 2, 2012
** This is what a fully exchange-traded Repo market would look like.