In the aftermath of the "rehypothecation" analysis exposing the quantum differences between the US and the UK, where the former at least tries to put some breaks on "fractional reserve" synthetic liquidity creation by Prime Brokers (which these days would be virtually anyone) while the latter believes that virtually boundless risk is a welcome thing, there has been a barrage of inquiries seeking further clarification of the nuances of shadow banking, a topic Zero Hedge has covered since July of 2010 (for much more see here) and which we will update on tomorrow for the latest Flow of Funds report (spoiler alert: in Q3 US shadow banking declined by at least $300 billion, a trend started at the credit bubble peak, over $6 trillion higher).
In order to bring some clarity to the matter we present two of the seminal pieces on the topic: first, fro the IMF: "The (sizable) Role of Rehypothecation in the Shadow Banking System" and then from one of the best scholars of shadow banking, Gary Gorton, "Haircuts." We will let readers digest the wealth of information contained in these two pieces on their own, however, we will point out the two key messages: on one hand we get a definitive explanation of why not NY but London is true hub of financial engineering and infinite leverage (recall that the UK is in fact the most levered nation on a GDP basis in the world when one takes into account all outstanding debt, not just sovereign - a fact well known to S&P and explaining why the UK will be the last to be downgraded as this would bring attention to the last domino in the chain) as follows: "Mathematically, the cumulative ‘collateral creation’ can be infinite in the United Kingdom" - that's from the IMF basically telling everyone that courtesy of no rehypothecation haircuts one can achieve infinite shadow leverage. And the other one comes from Gorton who explains why haircuts are the functional equivalent of information arbitrage: "Increases in repo haircuts are withdrawals from securitized banks—that is, a bank run. When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive; liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent."
And the punchline: "Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization." Reread the last statement as it explains perhaps better than anything, the true functioning of modern capital markets and why they are terminally broken: in order to preserve the system, the banking cartel need to make everything of virtually infinite complexity so that no one has a clear understanding of what is going on! Which is where sites like Zero Hedge step in - to expose "shadowy" places where things are best left unseen.
Incidentally one of the catalysts of the market collapse in the Lehman aftermath was not some market scalar metric being breached, or a bunk shutting down physically, but the seminal report by Citi's Matt King "Are The Brokers Broken" from September 2008 which explained all of the above (and below) in clear and concise detail, in effect bringing the proverbial Eureka moment to every market participant, of why everything was terminally broken. Since we are now again at the same stage, we will shortly repost the same report from King to stop "everyone from being ignorant" and comprehend just how broken both the traditional and shadow banking systems are
... But first: