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I had a thought experiment: suppose you wanted to borrow an equity security from me (perhaps to short sell it). I ask you for collateral and a borrow fee, and in exchange you get the stock.

If you give me cash collateral, I will buy Treasuries and make the risk-free rate until you cover. In a year, you give me back the securities, and I sell the bonds to give you back the collateral, keeping the difference.

Now, what if you give me Treasuries as collateral? Is there any way to profit from this? At first I thought I'd use the Treasuries as collateral to borrow cash, but by no-arbitrage whomever I'd borrow from is charging me the risk-free rate at least, which takes my profits away.

Intuitively it seems wrong to me that RFR bonds and cash wouldn't be fungible in every material way, but I can't find an analogous yield-generating move here that would suggest otherwise.

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First of all your statement is not quite correct. If you receive cash as collateral, you have to pay me interest at whatever rate we have agreed to (probably Fed Funds). If you receive bonds as collateral, you have to pay to me any bond coupons you receive during the transaction. You can use the bonds as collateral to borrow cash in the repo market , in which case you pay the repo rate as interest. Thus, cash and bonds are almost fungible , the only difference being Fed funds versus repo rate.

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    $\begingroup$ So if you take collateral from someone - you need to pay interest on it? Didn't know that. $\endgroup$
    – rubikscube09
    Sep 3, 2022 at 2:13
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Cash is King.

The way I see it is that they are not fungible because they have different market risk profiles, Cash is truly market risk neutral while government bonds are not.

In your scenario, what would happen if the treasuries you bought with the cash collateral are down by the time of the short cover? you'd need to sell them at a loss, come up with the missing cash and give it back.

Now, same situation but this time you received bonds as collateral, not cash... well, your collateral in case of a credit event would be degraded, but you could give it back without a loss at the cover.

In both instances you can do a collateral or margin call if the short position is souring, but nominally you need consider your obligation in terms of what needs to be returned.

Note all of this analysis does not include inflation.

hope this helps,

M

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