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FRM Part II · FRM Exam Part II · Tokenization and Financial Market Inefficiencies

A supervisor worries that tokenized collateral could be rehypothecated rapidly through automated smart contracts across many platforms. Which outcome is the most plausible stability risk of this market structure?

Rapid automated rehypothecation creates faster and more interconnected collateral chains. When haircuts or margin requirements rise, calls propagate quickly across platforms and amplify liquidity spirals, increasing procyclicality, rather than lowering leverage or liquidity needs.

  1. ALower procyclicality because automated margin calls are always delayed
  2. BFaster, more interconnected collateral chains that amplify liquidity spirals when haircuts riseCorrect
  3. CReduced need for liquidity buffers because settlement is instant
  4. DElimination of leverage because collateral is transparent on the ledger

Explanation

Automated, rapid reuse of collateral creates tightly linked chains, so a rise in haircuts or margin calls can propagate quickly and amplify liquidity spirals. Automation tends to speed up, not delay, margin calls. Instant settlement can actually raise liquidity demand since funding must be available immediately. Transparency does not eliminate leverage.

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