Unfractional Repo Banking: When Leverage Is "Limited" By Infinity

Tyler Durden's picture

Today's release of the 2013 edition of the Global Shadow Banking Monitoring Report by the Financial Stability Board doesn't contain anything that frequent readers of this site don't know already on a topic we have covered since 2009. It does however have a notable sidebar which explains the magic of "(un)fractional repo banking" - a topic made popular in late 2011 following the collapse of MF Global - when it was revealed that as part of the Primary Dealer's operating model, a core part of the business was participating in UK-based repo chains in which the collateral could be recycled effectively without limit and without a haircut, affording Jon Corzine's organization virtually unlimited leverage starting with a tiny initial margin.

Naturally, any product that can allow participants infinite leverage is something that all "sophisticated" market participants not only know about, but abuse on a regular basis. The fact that this "unfractional repo banking" is at the heart of the unregulated $71.2 trillion shadow banking system, the less the general public knows about it the better.

Which is why we were happy that the FSB was kind enough to explain in two short paragraphs and one even simpler chart, just how the aggregate leverage for the participants in even the simplest repo chain promptly becomes exponential, far above the "sum of the parts", and approaches infinity in virtually no time.

From the FSB:

As a simple illustration of the way in which repo transactions can combine to produce adverse effects on the system that can be larger than the sum of their parts, suppose that investor A borrows cash for a short period of time from investor B and posts securities as collateral. Investor A could use some of that cash to purchase additional securities, post those as further collateral with investor B to receive more cash, and so on multiple times. The result of this series of ‘leveraging transactions’ is that investor A ends up posting more collateral in total with investor B than they initially owned outright. Consequently, small changes in the value of those securities have a larger effect on the resilience of both counterparties. In turn, investor B could undertake a similar series of financing transactions with investor C, re-using the collateral it has taken from investor A, and so on.


Exhibit A2-5 mechanically traces out the aggregate leverage that can arise in this example. Even with relatively conservative assumptions, some configurations of repo transactions boost aggregate leverage alongside the stock of money-like liabilities and interconnectedness in ways that might materially increase systemic risk. For example, even with a relatively high collateral haircut of 10%, a three-investor chain can achieve a leverage multiplier of roughly 2-4, which is in the same ball park as the financial leverage of the hedge fund sector globally. It is therefore imperative from a risk assessment perspective that adequate data are available. Trade repositories, as proposed by FSB Workstream 5, could be very helpful in this regard.


So... three participants result in 4x leverage; four: in roughly 6x, and so on. Of course, these are conservative estimates: in the real, collateral-strapped world, the amount of collateral reuse, and thus the number of participants is orders of magnitude higher. Which means that after just a few turns of rehypothecation, leverage approaches infinity. Needless to say, with infinite leverage, even the tiniest decline in asset values would result in a full wipe out of one collateral chain member, which then spreads like contagion, and destroys everyone else who has reused that particular collateral.

All of this, incidentally, explains why down days are now prohibited. Because with every risk increase, there is an additional turn of collateral re-use, and even more participants for whom the Mutual Assured Destruction of complete obliteration should the weakest link implode, becomes all too real.

That, in a nutshell, are the mechanics. As to the common sense implications of having an unregulated funding market which explicitly allows infinite leverage, we doubt we have to explain those to the non-Econ PhD readers out there.


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insanelysane's picture

We only need to worry when we get to Infinity+1.

SafelyGraze's picture

fortunately for the entire system, those securities include long-dated bonds backed by the ff&c etc etc






Rainman's picture

Anybody seen Brooksley Born around ?

Hey Larry ... you built this !

moneybots's picture

"I want in.  BTFD!"


No dips, just all time highs.

NOTaREALmerican's picture

A REAL "Keynesian" can comprehend debt beyond infinity!

yogibear's picture

Bernanke, Yellen and the 12 Fed PhD stooges say it's match Zimbabe's economic model or bust.

Winston Churchill's picture

Nobody fart, you could bring this whole thing down.

buzzsaw99's picture

which exactly why stocks will always be cheap no matter how high they go

Carl Popper's picture

Then I was right to decide after listening to Mr. Yellen's comments to go full retard.

centerline's picture

The system already hyperinflated.  In the shadows.

RaceToTheBottom's picture

n doesn't matter as long as the FED is there

Stuck on Zero's picture

Just imagine four gamblers entering a casino at the same time with the same strategy to win: The Martingale double betting.  All four are backed with deep pockets, as is the casino. 


L G Butz PhD's picture

my head jus sploded . . .

looks like I picked the wrong week to stop stiffin' glue!

Seer's picture

Come on, quit over-reacting, it's all under control!


Carl Popper's picture

So I borrow a treasury security for a small charge. I then use that security as collateral for a loan. The bank then lends that security out for a small fee. The guy who now owns it presents it to his bank as collateral for a loan.

How can there be a shortage of treasuries if one bond can be infinitely rehypothecated? Someone please explain that. There must be some practical limit.

Winston Churchill's picture

TBTF can play these games , but the shadow banking system will not.

This is exactly what caused 2008 , when the SBS realized their clean

collateral was actually pledged multiple times via RMBS frauds hiding

behind the MERS strawman.

No doubt TBTF would not do this again \s.

Paracelsus's picture

Lessee,they print,print,print to keep interest rates down.But they have been creeping up anyhow,and the Doomers say anything over 3% on ten year won't work because the toxic crap that the Fed has (MBS crap and others) will explode when more interest rate linked stuff begins to smell.And they paid full price for this stuff.And they have destroyed the incentive for the consumer to save,for their kids education,for a home down payment,a new Tesla,etc.

And we think the Taliban are the bad guys? Guillotines now please....

Vin's picture

Durden, you've made a key error.  "Investor A could use some of that cash to purchase additional securities, post those as further collateral with investor B to receive more cash, and so on multiple times". 


If you're talking about the primary dealers, this is very wrong.  I primary dealer uses repo to fund the securities positions that the dealer is holding.  After a haircut, the dealer gets cash worth about 98% or so of the value of the security in order to finance the position. The remaining 2% is funded with either bank loans or capital.  Therefore, they absolutely cannot use the cash from the first repo to buy more securities and so on and so on as you indicate.  If the dealer buys more securities it then must repo these out in order to pay for them.  This is how the securities market operates.  Without repo, dealers cannot hold positions and therefore cannot create liquidity which is their main function.  Please make sure that you distinquish between banks and dealers because they are NOT the same thing. 

Flakmeister's picture

Thank you for posting something relevant...

Tyler Durden's picture

That's not Durden. That's a quote from the Financial Stability Board. But then again, what do they know.

And furthermore, since you are 100% incorrect, may we suggest re-re-reading "Are The Brokers Broken?" so you actually understand how shadow banking for dealers works: link here.