FRIC/Finance Seminar with Hongjun Yan, Yale School of Management
Upcoming Seminar with Hongjun Yan, Yale School of Management
Title: Collateral-Motivated Financial Innovation
The paper proposes a collateral view of financial innovation: Many innovations are partly motivated by alleviating collateral/margin constraints for trading (speculation or hedging). We analyze a model of investors with disagreement. The trading need motivates investors to introduce derivatives, which are endogenously determined in equilibrium. In the presence of a collateral friction in crossnetting, the “optimal” security is the one that isolates the variable with disagreement. It is optimal in the sense that alternative derivatives cannot generate any trading. With an arbitrarily small trading cost, the optimal security is “unfunded”—i.e., has a zero initial value. The endogenous difference in collateral requirements across assets leads to a basis—a spread between the prices of an asset and its replicating portfolio. This basis reflects the shadow value of collateral, leading to a number of novel predictions. Our model also shows that financial innovations diminish the impact of policies that target spot markets only (e.g., Regulation T, Tobin tax). More broadly, our analysis highlights the common theme behind a variety of innovations with strikingly different appearances: the invention of securities (e.g., futures, swaps), legal practice (e.g., the superseniority of repos and derivatives), legal entities (e.g., special purpose vehicles), as well as the efforts in improving cross-netting.