Keep an Eye on That Shadow Banking, Folks

Because it's starting to rear its ugly head again.

Turns out that what may be at the heart of MF Global's gaping hole on its (off) balance sheet: collateral that may have been shifted over to its U.K. unit to permit rehypothecation.

"Rehypothecation" is one of those mouth-filling words that basically says you can repledge the same piece of collateral (a useful trick in the shadow banking world of repo).

In the U.K., the collateral can be endlessly rehypothecated, again and again and again, creating long, unstable, dangerous chains -- and the interesting concomitant, lots of liquidity (which tends to act like a stimulant -- call it cocaine for the financial system -- and we know how hard it is to break a drug habit). Reuter's Christopher Elias:

This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.

Ladies and gentlemen, this is h-u-g-e. Too few people have wrapped their brains around this. We have central banks that greatly influence money supply/liquidity through their open market operations. Then we have a massive, off-balance sheet system of shadow banking that does the same with no oversight, in complex ways we barely comprehend.

This is a powder keg waiting for a spark.

For more, check out Alphaville's "Shadow Banking and the Seven Collateral Miners."