Rehypothecation and Intermediary Leverage

This paper provides a theory of endogenous leverage through rehypothecation in collateralized intermediation. Overcollateralization with an rehypothecation option arises as an optimal contract form between broker dealers and their clients to mitigate adverse selection on collateral quality. Such contract prevents the broker dealers from taking advantage of private information on collateral quality, thus enabling them to repledge the collateral with lower margins or resell it with lower discounts, and obtain "money for nothing". This type of unsecured funding increases the broker dealers’ risk-shifting incentive. The clients expecting this will increase the compensation requirement for granting rehypothecation rights, which affects the broker dealers’ optimal choice of leverage through rehypothecation. As collateral becomes riskier, this leverage first increases due to the margin spread, and then decreases due to the adverse selection problem. When the broker dealers and their clients are trading in over-the-counter market, their leverage through rehypothecation is inefficiently too high when the quality of collateral starts to become questionable, and too low when it is too questionable.