In normal financial runs lenders want their money back. In collateral runs borrowers want their collateral back. In today’s highly collateralized financial system the institutions at risk are broker-dealers that lend and borrow cash in secured transactions and that use part of that liquidity to fund their own asset holdings. In collateral runs cash borrowers, such as hedge funds, have an incentive to rush to repay secured loans as soon as the liquidity of a broker-dealer is being questioned. That is because haircuts keep collateral value above loan notional. The demise of Bear Sterns in 2008 illustrates that the peril of collateral runs is real. Still, this source of liquidity risk has not been well explored.

Infante, Sebastian and Alexandros Vardoulakis, “Collateral runs”, Federal reserve Board, March 28, 2018.

The post ties in with SRSV’s summary lectures on Shadow Banking and Managing (Systemic) Risk.
The below are quotes from the paper. Emphasis and cursive text have been added.

Collateralized transactions of broker-dealers

“Broker-dealers are unique because they transform liquidity on both sides of their balance sheet. On the liabilities side, they borrow funds, typically short-term, from cash lenders, using financial securities as collateral. On the asset side, they extend credit, also typically short-term, against similar collateral provided by cash borrowers“.

“[In a simplified stylized model] a dealer providing short-term secured financing, interpreted as repurchase agreements (repos), to a large number of counterparties, called hedge funds. Hedge funds borrow from the dealer because they want to take leveraged positions in the asset that they pledge as collateral. The dealer is able to extend said financing by re-using the collateral she receives to issue secured debt to cash lenders, called money market funds, a process known as re-hypothecation”.

“The dealer’s market power allows her to set favorable contracting terms on both secured financing transactions. In particular, she has incentives to distribute only a fraction of the cash she raises from money funds and use the difference to finance higher-yielding risky assets, which are illiquid. “

Basic mechanics of a collateral run

“[The term ‘collateral run’] characterizes a relatively little explored risk that can affect large broker-dealers: a run from their collateral providers or cash borrowers…Unlike traditional wholesale funding runs, where dealers risk an abrupt withdrawal of funds from cash lenders, in collateral runs, dealers risk an abrupt withdrawal of collateral from collateral providers… The instability…is borne from the asset side of an intermediaries balance sheet; borrowers may collectively withdraw their collateral even if cash-lenders’ claims are safe with stable haircuts (and not pro-cyclical) and have no incentive to run…[This] highlights fragility that can arise from the re-use of collateral in a short-term collateralized lending context.”

“In case the dealer defaults, money funds have immediate access to the collateral and can sell it to make their claims whole, essentially insulating them from the dealer. In contrast, hedge funds risk losing their collateral altogether, which is more valuable than the initial loan they received. This arrangement effectively gives hedge funds an unsecured claim on the dealer and creates incentives for them to withdraw their collateral early, rather than roll over their repos.”

“The incentive to withdraw the collateral creates strategic complementarities amongst hedge funds’ actions because each hedge fund’s optimal action and payoff can depend on what other hedge funds do. For example, if all other hedge funds roll over their repo positions, then the dealer does not need to liquidate any of her illiquid assets, making it optimal for an individual hedge fund to roll over as well. On the contrary, if all other hedge funds withdraw their collateral, then the dealer may need to sell off all of her illiquid assets, making it optimal for an individual hedge fund to withdraw their collateral. Hence, an individual hedge fund’s payoff not only depends on the dealer’s solvency, but also on its beliefs about the actions/beliefs of other hedge funds.”

“Even though fundamentals may not be bad enough to make the dealer insolvent, hedge funds incentives to withdraw early can render the dealer illiquid. This mechanism highlights a novel fragility in the short-term funding intermediation process: a coordination failure amongst collateral providers….The situation of a solvent but illiquid dealer introduces a coordination problem among hedge funds akin to coordination problems in currency attacks, risky debt rollover and bank runs [and] credit market freezes.”

“The underlying collateral can be extremely safe, yet there can still be a collateral run. The risk that collateral providers face does not come from their own assets, but rather from the dealer’s use of the excess funds she raises with them. “

The Bear-Sterns case

“An important motivating example…is the demise of Bear Stearns in March 2008. Anecdotally, in the days leading up to its collapse, the firm suffered a large outflow of counterparties that not only pulled their cash but also their collateral from the firm.”

“[The figure below] shows Bear Stearns’ repo activity in the months leading up to its default. The difference between ‘Securities Out’ (green line) and ‘Securities In’ plus the firm’s net position (red line) is an estimate of a lower bound on the total amount of funds raised through differences in haircuts. From the figure, it can be appreciated that 1) the lion’s share of securities the firm could post in secured financing transactions came from collateral sourced from their counterparties (blue line), and 2) before the sharp drop in activity, the estimated cash stemming from different contracting terms reached USD50 billion, approximately a third of the firm’s entire repo book. A withdrawal of collateral effectively eliminated this additional liquidity windfall. “

“[The next figure below] plots the estimated cash windfall as a fraction of the total repo book for both Bear Stearns and the average fraction for the remaining primary dealers. These estimates suggest that, relative to its peers, Bear Stearns relied heavily on differences in contracting terms as a source of liquidity.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.