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3. Why is the repo market so important and why has the use of repo grown so rapidly?
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The repo market is pivotal to the efficient working of almost all financial markets. Its importance reflects the wide range and fundamental nature of its functions:
  • Providing an efficient source of money market funding. By offering deposits secured against high-quality liquid assets, by diversifying the credit exposure of cash investors beyond the banking sector and by disintermediating traditional but less competitive financial channels, the repo market mobilises cheaper and deeper funding for financial intermediaries, which in turn lowers the cost of financial services to investors and issuers. In contrast to the unsecured deposit market, the European repo market can also provide longer-term funding and has proved much more resilient during episodes of market turbulence.
  • Providing a secure home for liquid investment. The capacity of repo, collateralised by high-quality liquid securities, to mitigate risk is particularly valued by risk-averse end-investors seeking a secure and liquid investment for temporary cash balances and working capital.
  • Broadening and stabilising the money market. The collateralised nature of repo allows a wider array of borrowers and lenders into the wholesale money market than just commercial banks. The resulting diversification creates a deeper and more robust market, which facilitates liquidity management between financial intermediaries and reduces systemic risk. In a financial crisis, the repo market also mitigates risk by providing more reliable and longer-term funding, particularly through CCP-cleared repos, whereas unsecured longer-term funding (to the extent it exists) tends to evaporate. Although the repo market was not immune to the disruption triggered by the default of Lehman Brothers in 2008, it did not suffer a seizure and has helped to avoid total and unsustainable dependence on central bank liquidity.*
  • Facilitating central bank operations. The repo market provides a ready-made collateral management framework without which central banks would not be able to implement monetary policy so efficiently under normal market conditions or act as lenders of last resort so swiftly during periods of market turbulence. Central bank repo feeds seamlessly into the interbank repo market.
  • Hedging primary debt issuance. In the primary debt market, repo allows dealers to fund their bids at bond auctions and underwriting positions in syndicated bond issues at reasonable cost, thereby providing cheaper and less risky access to the capital markets for issuers. Primary dealers and other underwriters also rely on the repo market to hedge the underwriting risk on new debt. Thus, a long position in a new issue can be hedged by taking an off-setting short position in an existing issue with similar risk characteristics. The delivery of securities into the short position is covered by borrowing in the repo market. Alternatively, a long position in a new issue can be hedged by taking a short position in an existing issue or in a related derivative instrument such as a bond future or interest rate swap, which will ultimately be hedged by someone else borrowing in the repo market. Without hedging, bond issuance would be riskier for underwriters and therefore more expensive for issuers. The primary market function of repo will become increasingly important over the next few years, given the quantity of debt which European governments and banks are expected to have to issue, not to mention the aim of the EU to reduce the reliance of the real economy on bank funding by encouraging greater use of securities financing.
  • Ensuring liquidity in the secondary debt market. Liquidity in the secondary market for securities depends upon primary dealers and other market-makers being willing to quote prices continuously to investors.
    • To quote selling prices continuously to investors, market-makers often hold inventory from which to sell to investors on demand. But if an investor wishes to buy an issue which market-makers do not hold in their inventory, and if market-makers cannot or do not wish to purchase immediately from someone else in the market, their ability to deliver to the investor depends on being able to borrow that issue in the repo market. The liquidity provided by market-makers reduces risk for investors by allowing them to buy on demand, which in turn reduces the cost of borrowing for issuers. The alternative would be for the market-maker to hold a larger inventory, which would raise the cost of market-making and therefore the cost of debt to issuers and investors. Several debt management agencies offer special repo facilities to market-makers to allow them to borrow whenever the available supply in the market is inadequate.
    • To quote buying prices continuously to investors, market-makers rely on their ability to hedge temporary accumulations of long positions by taking short positions in issues with similar maturities, which means borrowing in the repo market, or in a related derivative instrument such as a bond future or interest rate swap, which will ultimately be hedged by someone else borrowing in the repo market. Without the ability to cover the temporary short positions taken to hedge temporary long positions, market-making would be constrained to a rigid matched-book style of activity (only buying when there is a seller and vice versa) and secondary market liquidity would suffer. Portfolio management by investors would be made more difficult and debt securities would become a less attractive investment, raising the cost of debt to issuers.
  • Hedging and pricing derivatives. The use of repo to fund long positions and cover short positions in underlying securities is fundamental to the hedging and pricing of derivatives, which are the essential tools of risk management for both financial intermediaries and end-users of the financial markets, including official debt and reserve management agencies. Indeed, an active repo market is an absolute prerequisite for liquid markets in derivative instruments. Attempts to establish new derivatives markets, exchange-traded or over-the-counter (OTC), have foundered where there have been no active repo markets.
  • Fostering price discovery. The enhanced liquidity generated by repos in the primary and secondary markets for securities fosters the trading and arbitrage which helps equilibrate imbalances between the supply and demand of securities, and facilitates their correct valuation, which generates the smooth and consistent yield curves that are essential for the accurate pricing of other financial instruments, and thus the efficient allocation of capital by financial markets. Repo rates are a key component of the cost of carry of long and short positions in securities, and thus of the forward prices that measure the true value of a security.
  • Preventing settlement failures. Repo plays a mundane but nonetheless critical role in supporting the day-to-day operational efficiency of securities markets by allowing issues to be borrowed. Borrowing is needed in order to ensure timely onward delivery, where short positions have arisen unintentionally, usually because of unexpected lags between inward and outward deliveries of securities, infrastructure frictions or a tight secondary market or particular issues. And changes in repo rates in response to the demand to borrow securities help to attract new supply. The facility to overcome delivery failures is important in Europe because of the persistence of national barriers to efficient cross-border clearing and settlement.
  • Preventing market ‘squeezes’. By allowing the borrowing of securities, repo helps to prevent or contain the ability of individual institutions to ‘squeeze’ individual securities by cornering supply and thereby exacerbating imbalances between supply and demand. Squeezes can lead to settlement failures and disorderly markets. They can also fuel the volatility of yields, as well as creating large and persistent distortions in the yield curve, which would deter investors and intermediaries from participation in the market and confuse price discovery. Frequent settlement fails could lead to ‘buy-ins’ being exercised against intermediaries, the cost of which might cause them to cease providing liquidity to the market.**
  • Permitting faster settlement times. The role of repo as a means of borrowing securities has been, and will continue to be, crucial in allowing settlement periods to be shortened in order to reduce systemic risk in securities settlement systems. Faster settlement leaves less time for delivery problems to be corrected and therefore requires an efficient source of securities borrowing to prevent delivery failures. Securities settlement periods in the EU changed from T+3 to T+2 in October 2014.
  • Allowing more efficient collateral management. The trading of securities in the repo market is key to the valuation and management of collateral, and allows collateral resources to be more fully mobilised and efficiently allocated. Collateral management is becoming ever more important. Demand for collateral for use in payments and settlement systems, as well as in the exchange-traded and OTC derivatives markets, is being compounded by regulatory pressure on market users to hold larger liquidity reserves and make greater use of (collateralised) central clearing counterparties (CCPs), at the same time as a loss of confidence in some sovereign debt is creating uncertainty over the future supply of high-quality collateral.
  • Allowing more efficient employment of capital. The global economic impact of the increasing regulatory risk capital charges introduced since the 1980s was mitigated by the more efficient use of capital that was allowed by the underlying shift from unsecured to secured financing. The capital efficiency of repo will become even more important in the future as regulators increase capital charges and impose new liquidity requirements. 

* Papadia & Välimäki point out that, between 2008 and 2011, the unsecured eurozone money market shrank by EUR 327 billion, forcing the ECB into exceptional emergency lending in order to prevent a seizure of the financial system and serious damage to the real economy. In fact, the ECB lent EUR 115 billion. But growth in the repo market contributed another EUR 212 billion, without which, the burden on the ECB would have been dramatically greater.

** A ‘buy-in’ is a process whereby a buyer of a security that has not been delivered by the seller, appoints a third party to buy in the security on his behalf. Any cost over and above the original purchase price is charged to the failed seller.

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