Key Takeaways
- Collateral reuse is normal — the same bond can secure multiple transactions simultaneously
- This creates "collateral velocity" — how many times each unit of collateral is used
- When chains break, multiple parties claim the same asset — bankruptcy courts decide who wins
- Rehypothecation rules vary by jurisdiction — US has limits, UK historically had fewer
- Chain breaks amplify crises — what starts as one default cascades into many
The Bond That Belonged to Everyone
Let's trace the life of one Treasury bond through the financial system.
Monday morning: A pension fund owns a 10-year Treasury worth $100 million. They don't need cash, but they want to earn a small return. So they lend the bond to a hedge fund via a securities lending agreement.
Monday afternoon: The hedge fund uses that Treasury as collateral to borrow cash from a prime broker. They use the cash to buy more securities.
Tuesday: The prime broker pledges the same Treasury to a bank as part of their overnight repo funding.
Wednesday: The bank uses that Treasury to meet a margin call at a CCP for their derivatives positions.
Thursday: The CCP posts that Treasury to a central bank facility as part of their liquidity buffer.
One bond. Five institutions. Each thinks they're holding solid collateral.
But there's only one bond.
"In normal times, collateral chains are miraculous — they multiply the effectiveness of safe assets. In crisis, they become a horror show. Everyone runs to claim the same collateral, and most of them find it's not there."
— Manmohan Singh, IMF Collateral Specialist
The Mechanics of Reuse
Collateral reuse (also called rehypothecation) is a legal mechanism that allows the recipient of collateral to use it for their own purposes — including pledging it to someone else.
Here's how it works:
The collateral velocity measures how many times each unit of collateral is reused. Historically, this has ranged from 2-3x in normal times, meaning each bond supports 2-3 transactions.
When velocity is high, the system is efficient — less collateral needed for the same amount of activity. But it's also fragile — each break affects more parties.
Why Anyone Allows This
You might ask: why would the pension fund allow their bond to be used this way?
Because they get paid for it.
Securities lending generates income. The pension fund earns a fee. The hedge fund pays a borrowing cost. Each link in the chain has a spread. Collateral reuse is profitable.
Lending Fees
Original owners earn 10-50 bps annually for lending high-quality collateral. For a $10B portfolio, that's $10-50 million per year.
Leverage Enablement
Hedge funds can take larger positions when they can repo out their holdings. Collateral reuse enables leverage.
Funding Efficiency
Banks reduce funding costs by using received collateral for their own repo needs. Less equity required.
System Efficiency
If every bond could only be used once, we'd need 3x as much collateral. Reuse makes markets function with less.
The agreements that enable this are called rehypothecation rights. They're in the fine print of every prime brokerage agreement, every ISDA credit support annex, every securities lending agreement.
You signed away the right to exclusive possession of your collateral. You just didn't read that part.
How Chains Break: The Three Triggers
Collateral chains break in three ways:
Counterparty Default
Someone in the chain goes bankrupt. Their positions are frozen. Collateral is stuck in bankruptcy proceedings. Everyone downstream suddenly has no collateral.
Collateral Demand Surge
Market moves trigger margin calls. Everyone needs to post more collateral simultaneously. The chain can't supply enough — someone can't deliver.
Collateral Quality Downgrade
What was acceptable collateral suddenly isn't. Haircuts increase. Eligibility criteria tighten. The same bond that supported 3 transactions now supports 1.
Usually, it's a combination. A market shock (trigger 2) causes defaults (trigger 1), which prompts surviving parties to tighten standards (trigger 3). The chain doesn't just break — it shatters.
Case Study: Lehman Brothers' Collateral Chaos
When Lehman Brothers filed for bankruptcy on September 15, 2008, they were at the center of hundreds of thousands of collateral chains.
The immediate problem: where was the collateral?
Lehman's Collateral Web
| Entity | Status | Problem |
|---|---|---|
| Lehman Brothers Inc (US) | SIPC liquidation | Customer assets segregated (mostly protected) |
| Lehman Brothers International Europe (UK) | UK administration | No segregation — client collateral reused and commingled |
| Hedge Fund Clients | Trapped | Collateral posted to LBIE stuck in UK bankruptcy for years |
| Counterparties | Scrambling | Collateral received from Lehman now subject to claw-back claims |
Here's what happened to hedge funds that had used Lehman's London unit:
They had posted collateral — often more than required as margin cushion. Under UK law at the time, Lehman was allowed to rehypothecate this collateral without limit. And they did.
When Lehman failed, that collateral was in the hands of Lehman's counterparties. Those counterparties claimed they had received it in good faith. The hedge funds claimed it was their property.
Courts had to sort it out. It took years. Some funds got back 20 cents on the dollar.
"We had $500 million in excess margin at Lehman. We thought it was our money, just held by them. It wasn't. They had used it. When they failed, we were just another unsecured creditor."
— Hedge Fund COO, post-Lehman interview
The Rehypothecation Rules: US vs UK
After Lehman, the world realized that rehypothecation rules mattered — a lot.
Rehypothecation: US vs UK (Pre-2008)
| Aspect | United States | United Kingdom |
|---|---|---|
| Limit on reuse | 140% of client debit balance | No limit (often in contracts) |
| Segregation | Required for excess margin | Often waived by contract |
| Bankruptcy treatment | SIPC provides some protection | General creditor — last in line |
| Lehman impact | US clients mostly recovered | UK clients devastated |
Why did hedge funds use Lehman's London unit? Tax and regulatory arbitrage. It was cheaper to book through London. The rehypothecation flexibility meant Lehman could offer better rates.
Post-Lehman, prime brokerage agreements became more restrictive. Clients demanded segregation. But the fundamental issue remains: if you post collateral that can be reused, you don't fully control it.
Collateral Scarcity: When Everyone Wants the Same Thing
Not all collateral is equal. During stress, everyone wants the same thing: high-quality liquid assets (HQLA).
Government bonds. Central bank reserves. Cash.
Corporate bonds? Maybe. Equities? Haircuts increase. Exotic securities? Not accepted.
Flight to Quality
In crises, everyone upgrades collateral. What was acceptable last week isn't anymore. The pool of "good" collateral shrinks.
Haircut Spirals
Haircuts on risky collateral increase: 10% becomes 20% becomes 40%. You need to post more. You might not have it.
Fire Sales
Forced to raise quality collateral, holders sell risky assets. Prices crash. More margin calls. The spiral accelerates.
Hoarding
Those with good collateral stop lending it. Velocity crashes. The same bonds that were reused 3x are now reused 1x. System capacity drops.
This happened in March 2020. Even Treasury markets — the safest, most liquid market in the world — showed stress. Everyone wanted Treasuries for collateral. The chain demanded more than existed.
The Fed had to step in and buy Treasuries directly to provide liquidity. The collateral chain was breaking even for the safest assets.
India's Collateral Framework
How does India handle collateral chains? The system is simpler but evolving.
CCP Collateral (NSCCL/ICCL)
Margin posted to CCPs is strictly segregated. No rehypothecation of client collateral by the CCP. Cleaner than bilateral OTC.
Securities Lending (SLB)
Exists but smaller than developed markets. Exchange-traded SLB through NSE. Off-exchange bilateral also happens.
Pledging via Depositories
Shares pledged as collateral are tracked by NSDL/CDSL. The pledge is recorded electronically. Less chance of the same share being pledged twice.
G-Sec Repo
The main repo market is G-Sec based, cleared through CCIL. Triparty repo (TREPS) is the workhorse. Relatively simple chains.
India's advantage: less complex financial engineering means simpler chains. The absence of widespread rehypothecation means less hidden leverage.
India's challenge: as markets develop and foreign participants increase, the pressure to allow more collateral reuse will grow. The question is whether India can get the benefits without the fragility.
The Collateral Transformation Game
Here's a sophisticated use of collateral chains: collateral transformation.
Suppose you have corporate bonds, but the CCP only accepts government bonds. What do you do?
You find someone who has government bonds and wants yield. You do a swap: you give them your corporate bonds (plus a fee), they give you government bonds. Now you can meet the CCP margin call.
This looks innocent. But it creates hidden risks:
- The hedge fund is now exposed to the collateral bank's creditworthiness
- The collateral bank holds risky assets instead of safe ones
- The CCP thinks it has safe collateral — it does, but the chain behind it is weaker
- If corporate bonds crash, the whole transformation trade unwinds violently
Collateral transformation doesn't eliminate risk. It relocates and disguises it.
Regulatory Responses: Trying to Shorten the Chains
After 2008, regulators tried to reduce chain fragility:
Segregation Requirements
More jurisdictions now require client collateral to be held separately. Can't be used for firm's own purposes.
Rehypothecation Limits
Even where allowed, there are now caps. EU's SFTR requires detailed reporting of reuse.
Central Clearing Mandates
Move OTC derivatives to CCPs. Standardizes collateral handling. Reduces bilateral chain complexity.
SFTR Reporting (Europe)
Securities Financing Transaction Regulation requires detailed reporting of repos, securities lending, and collateral reuse.
But here's the challenge: shorter chains mean more collateral needed.
If rehypothecation is banned, every transaction needs fresh collateral. The system needs more government bonds, more cash, more HQLA. If there isn't enough, markets shrink or costs rise.
It's a trade-off: safety vs. efficiency. Regulators are still finding the balance.
What This Means For You
You're a retail trader. You don't run collateral chains. Why does this matter?
Retail Implications
- Your broker is part of chains — their solvency depends on their counterparties, who depend on their counterparties
- Margin rules reflect chain health — when chains stress, margin requirements rise for everyone
- Collateral value affects you — if you pledge shares as margin and share prices crash, you face forced sales
- Systemic crises start in collateral — before stocks crash, collateral chains seize up
- "Safe" isn't always safe — your shares might be lent out by your broker; understand your agreement
When the next crisis hits, watch the repo rates. Watch the collateral markets. Watch for signs that chains are breaking.
By the time it shows up in stock prices, the collateral damage is already done.
The Music and the Chairs
Collateral chains are a game of musical chairs. While the music plays, everyone moves smoothly. Bonds flow from owner to borrower to pledgee. Cash flows the other way. The system hums.
When the music stops — when someone defaults, when collateral demand spikes, when quality standards tighten — everyone rushes for a chair.
But there aren't enough chairs. There never were. The same bond was promised to five people.
Lawyers sort out who gets the chair. Courts decide. But by then, the party is over, and the damage is done.
The chains that connect modern finance are invisible until they snap. And when they snap, everyone feels it.
The Collateral Chain Reality
- Collateral is reused — one bond can secure multiple transactions simultaneously
- Velocity measures leverage — higher reuse means more activity per unit of collateral
- Chains break through defaults, demand surges, or quality downgrades
- Lehman showed the consequences — frozen collateral, years of litigation, massive losses
- US limits rehypothecation; UK/Europe have been looser — jurisdiction matters
- Collateral transformation hides risk — making bad collateral look good
- Regulators are shortening chains — but that requires more collateral to exist
- When chains break, systemic crises follow — watch for the warning signs