Liquidating Illiquid Collateral

Abstract

Defaults of financial institutions can cause large, disorderly liquidations of repo collateral. This paper analyzes the dynamics of such liquidations. The model shows that (i) the equilibrium price of the collateral asset can overshoot; (ii) the creditor structure in repo lending involves a fundamental tradeoff between risk sharing and inefficient 'rushing for the exits' by competing sellers of collateral; (iii) repo lenders should take into account creditor structure, strategic interaction, and their own balance constraints when setting margins; and (iv) the model provides a framework to analyze transfers of repo collateral to 'deep pocket' buyers or a repo resolution authority.

Keywords: Collateral, Liquidation, Repo Market, Illiquidity, Fire Sales, Creditor Structure, Counterparty Risk Management

JEL Classification: G00, G20, G32, G33