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I've read in many places that rehypothecation causes systemic risk (not to be confused with systematic risk), but none offer an explanation. Is this because of the daisy-chain effect that would happen if a posted collateral to b who then posted it to c who then went into bankruptcy leaving A's original collateral tied up in bankruptcy proceedings?

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  • $\begingroup$ Appreciate the upvotes, but an answer would be awesome :) $\endgroup$ – AfterWorkGuinness Sep 15 '15 at 18:10
  • $\begingroup$ Wouldn't additional haircuts be enough to trigger contagion the more frequently collateral is reused? Doesn't require an actual bankruptcy... $\endgroup$ – experquisite Sep 15 '15 at 18:23
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With some help of Wikipedia I pieced together an answer, the meat is in this IMF paper.

First a definition:

Re-hypothecation occurs when banks or broker-dealers re-use the collateral posted by clients such as hedge funds to back the broker's own trades and borrowing.

Indeed, a daisy chain involving enormous amounts was created before the Lehman collapse as in the UK it is possible to rehypotecate without limit which led to \$1 trillion of original collateral pledges to be transformed in \$4 trillion collateral. The ratio between the transformed collateral and the original factor has a name:

$$\textrm{Churn Factor} = \frac{\textrm{Transformed collateral}}{\textrm{Original collateral}}.$$

The paper agrees with the @experquisite's suggestion and because of the size of the outstanding collateral and the dependence of the banks on it for funding a real problem was created. In cases of stress systemic risk appears as follows:

Asset values went down because the bubble deflated. Furthermore, the original providers of the collateral demanded that their collateral was not reused by the bank so that their assets would not end up in bankruptcy proceedings. This leads to both a decrease in the original collateral and the churn factor greatly reducing the transformed collateral and thus to a funding crisis for all banks. A systemic crisis.

Also worth mentioning is that the valuation and legal issues surrounding this collateral can be messy resulting in uncertainty, delays and disputes. For example: two parties disagree about the value of assets (for which there is no liquid market (any more)) and both make claims on each other.

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  • $\begingroup$ Thanks for the detailed reply. You describe the systemic crisis as resulting from preventing re-hypothecation rather than arising from it "...the original providers of the collateral demanded that their collateral was not reused by the bank so that their assets would not end up in bankruptcy proceedings. This leads to both a decrease in the original collateral and the churn factor greatly reducing the transformed collateral and thus to a funding crisis for all banks. A systemic crisis.". In allowing re-hypothecation, how do we get a systemic crisis ? $\endgroup$ – AfterWorkGuinness Oct 10 '15 at 1:12
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    $\begingroup$ I think I see what you mean so I hope this clarifies. Re-hypothecation was not prevented institutions stopped allowing it on their own initiative in a reaction to the shock. The risk was that the system depended on re-hypothecation happening and then suddenly it stopped. Therefore the system stopped working. $\endgroup$ – Bob Jansen Oct 12 '15 at 19:04

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