The repo market is pivotal to the efficient working of almost all financial markets. Its importance reflects the wide range and fundamental nature of repo's applications:
- Providing an efficient source of short-term funding. By being able to offer deposits secured by legal title to high-quality liquid assets (HQLAs) and diversification to include lenders other than commercial banks, repo is able to mobilise cheaper and deeper funding for financial intermediaries, in particular, securities dealers. And by reducing the degree of dependence on commercial banks, access to short-term funding is made easier and more reliable. Cheaper and easier funding helps to lower the cost of financial services provided by intermediaries to investors and issuers. Institutional investors also use repo, to meet temporary liquidity requirements without having to liquidate strategic long-term investments. Since the introduction of the Basel regulatory requirement to clear standardised OTC derivatives across central counterparties (CCPs) and the related imposition of margin on uncleared OTC derivatives, the repo market has become an important source of cash for non-banks to provide as variation margin to CCPs.
- Providing a more resilient money market. The resilience of the repo market helps to mitigate systemic risk. Repo is a more stable source of short-term wholesale funding than unsecured deposits, because collateral in the form of HQLA (overwhelmingly the most common type) and secured by the transfer of legal title hedges both the credit and liquidity risks of lenders (see question 1). This means lenders are more willing to offer longer-term funding and, as recognised in the Basel Liquidity Coverage Ratio (LCR), are less likely to refuse to roll-over lending, even in a stressed market. For example, 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 been essential in avoiding total and unsustainable dependence on central bank liquidity.* The stability of repo funding is reinforced by the wide range of lenders who are willing to lend in the wholesale money market on a suitably secured basis. Diversification creates a market which is deeper and naturally more resilient. Repo also mitigates systemic risk by allowing traders and investors who need liquidity in a stressed market to convert assets temporarily into cash in a way that is less disruptive than outright sales. Outright sales would depress the price of collateral securities and crystallize any unrealised losses on the holdings being liquidated or on hedges that have to be unwound when holdings are sold. Falling prices and mounting losses could amplify market stress and fuel the self-reinforcing dynamics of a crisis.
- Providing a secure and flexible home for short-term investment. The capacity of repo collateralised by HQLA to mitigate credit and liquidity risks is particularly valued by risk-averse money market investors seeking a secure and liquid investment for their working capital or other cash balances. Such investors include large non-financial corporates, money market mutual funds and other non-bank financial institutions (NBFIs), asset managers (including pension funds and insurance companies), the treasuries of financial market infrastructures such as CCPs and central securities depositories (CSDs), and official agencies such as sovereign wealth funds, foreign exchange reserve managers and debt management offices (DMOs). Repo allows these investors to reduce their exposure to commercial banks and diversify counterparty credit risk by shifting cash out of bank accounts. Repo is also the most secure short-term asset available to many such investors, given that they are often ineligible for deposit protection schemes because of the size of their deposits and that most do not have access to risk-free deposit accounts at central banks. While treasury bills could provide an alternative risk-free investment to repo, in most countries, the supply of treasury bills is oversubscribed by investors who hold these bills to maturity. This makes the secondary market narrow and forces investors to compete in the crowded primary market, which (like most money market securities) offers only a few tenors, whereas repo offers a full range of maturity dates without broken date penalties or premuims.
- Facilitating central bank operations. Repo is a widely-used instrument for central bank open market operations. Its collateralised nature reduces the credit risk of the central bank. And it allows the use of wider range of assets than outright purchases, which are limited to short-term securities with maturities similar to the horizon of most money market operations. The repo market is a ready-made collateral market which enables central banks to implement monetary policy more efficiently under normal market conditions and to act more swiftly as lenders of last resort during periods of market stress. Central bank repo can feed seamlessly into the interdealer repo market through which liquidity can be efficiently redistributed to banks and non-banks. Moreover, a liquid repo market is a source of near risk-free interest rates which can provide the central bank with a sensitive gauge of monetary and macro-economic conditions and, in the form of a repo rate index, a meaningful operational target for open market operations.
- Financing leveraged investors and covering short investors. Institutional investors such as alternative investment funds (hedge funds) borrow cash in the repo market to fund leveraged investment strategies on a cost-efficient basis and also borrow securities to allow them to take short positions. These funds play an important role in feeding market liquidity and driving price discovery through trading and arbitrage, and their ability to borrow securities to sell short is important in helping to stop asset price bubbles from developing. Repo is also used as a source of leverage by many traditional investment firms, especially liability-driven pension fund managers, who need to borrow to fund purchases of government bonds to hedge the long-term exposure of pension liabilities to interest rate and inflation risks. Such investors also borrow securities in the repo market to sell short in order to hedge their investment portfolios against temporary adverse movements in securities prices. And repo allows investors to buy and finance purchases of foreign securities in the same currency, avoiding exchange rate risk and facilitating the cross-border diversification of investment portfolios.
- Hedging primary debt issuance. In the primary debt market, repo allows dealers to fund their bids at bond auctions and their underwriting positions in syndicated bond issues at reasonable cost, thereby providing cheaper and less risky access to the capital markets for issuers, both governments and corporates. Primary dealers and other underwriters also rely on the repo market to hedge the interest rate risk on a long position in a new issue while it is in the process of distribution to investors by taking an off-setting short position in an existing issue with similar risk. For example, a new 5-year government bond issue can be hedged with a short position in the current 5-year government bond and a new 5-year corporate bond issue can be hedged with a short position in the 5-year government bond in the same currency.** The delivery of securities to settle the short position is covered by borrowing in the repo market. Without hedging, bond issuance would be riskier for primary dealers and other underwriters and therefore more uncertain and expensive for issuers.
- Supporting corporate bond investors. Investors in corporate bonds often seek to neutralize their exposure to general interest rate movements in order to target just the credit risk of these securities in the form of the credit spread. This can be done by taking a short position in the benchmark government bond with the closest duration to the corporate bond (investors are said to ‘spread corporate bonds against government bonds’). The delivery of the benchmark government bond to settle the short hedge position is covered by borrowing in the repo market.
- Ensuring liquidity in the secondary debt market. Liquidity in the secondary market for securities depends upon market-makers being willing to offer ‘immediacy’ or 'urgency' to investors by continuously quoting prices at which they are committed to trade on demand.
The importance of repo to secondary market liquidity is recognised in the regulatory definition of HQLA under the LCR, which includes the existence of an active and resilient repo market.
- To be able to quote immediately-executable selling prices, a market-maker may hold inventory which allows him to sell to investors on demand in the knowledge that he will be able to make good delivery. The market-maker has to finance inventory and also hedge any material interest rate risk on that inventory. Only repo can provide cost-effective funding for market-makers, given the scale of their financing requirements, the thin margins on market-making and the fact that most securities dealers have relatively low credit ratings due to their leverage. Hedging the interest rate risk on inventory means taking an off-setting short position in another security with a similar duration, which means borrowing the other security in the repo market.*** On the other hand, if an investor wishes to buy an issue which a market-maker does not hold in inventory, and the market-maker cannot or does not wish to source that sale by immediately purchasing the security from someone else in the market, the market-maker’s ability to sell and be confident of being able to make good delivery will depend on being able to borrow that issue in the repo market until such time as he is able or willing to purchase. 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 or to fund his inventory in the unsecured market (assuming unsecured funding was actually available) or both. Or market-making would have to be constrained to a rigid matched-book style of activity (only buying when there is a seller and vice versa). All these alternatives would raise the cost of market-making, damaging secondary market liquidity and making portfolio management by investors riskier and more onerous, which would make debt securities a less attractive investment and raise the cost of debt financing to issuers. Several debt management agencies recognise the importance of repo to market-makers by offering special facilities from which market-makers can borrow whenever the available market supply is inadequate.
- To be able to quote immediately-executable buying prices, a market-maker needs to be able to buy a security from an investor, even if he is unable or unwilling to sell that security immediately to another investor or dealer. To do this, the market-maker has to take the security onto his trading book and both fund the long position and hedge any material interest rate risk until such time as he is able or willing to sell the security. Funding means borrowing cash by repoing out the security. Hedging means taking an off-setting short position in another security which has a similar duration, which means borrowing the other security in the repo market
- Fostering price discovery. The repo market fosters price discovery by facilitating primary market activity but, most crucially, by feeding liquidity in the secondary market, which fosters trading and arbitrage. At a technical level, 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 relative value of a security. Repo itself can be used to arbitrage inconsistent valuations between securities from the same issuer of similar maturity and thereby generate an accurate yield curve. In addition, repo links the money and capital markets, creating a continuous yield curve. Accurate and complete yield curves are essential for the correct pricing of other financial instruments and thus the efficient allocation of capital by financial markets.
- Hedging and pricing derivatives. The use of repo to efficiently fund long positions in securities and cover short positions is fundamental to the hedging and pricing of derivatives, given that securities are the ultimate hedge for their own derivatives (eg a position paying fixed rate in an interest rate swap can be hedged by a long position in a bond of the same maturity financed by a repo of the same tenor as the swap’s floating rate). Derivatives are essential tools of risk management for both financial intermediaries and end-users of the financial markets. An active repo market is therefore a 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 to facilitate basis trading, hedging, arbitrage and pricing.
- Preventing settlement failures. The repo market plays a critical role in maintaining the confidence of investors in the securities market by helping to ensure that the securities which they purchase are delivered on time. Where an intermediary has sold securities to one party which it has purchased from another, but the inward delivery fails to arrive on time, the intermediary can borrow those securities in the repo market to ensure that it can make timely delivery to the first party until such time as the second party delivers or an alternative purchase can be made from a third party. Without the ability to borrow securities, delivery failures might propagate through the market, leading to disorderly conditions, which could interrupt trading and damage investor confidence. Widespread failure to deliver can also make yields more volatile, and create large and persistent distortions in the yield curve, which would deter investors from participation in the market and discourage issuers by confusing price discovery. The role of repo in stemming delivery failures is enhanced by its ability to attract new supply into the market to meet increased borrowing demand by means of changes in repo rates. Thus, intermediaries seeking to borrow a security that is in demand offer cheaper cash by reducing the repo rate on that security in order to incentivize holders of the security to repo it out (see question 9). The reinvestment of the cheap cash will directly improve the overall portfolio return to investors (an improvement called yield enhancement). Investors lending securities also reap an indirect benefit. By helping to keep supply and demand in balance, they will support the longer-term efficiency and liquidity of the market in the securities which they hold, making it easier and cheaper for them to sell when the time comes. Delivery failures in Europe in actively-traded securities are generally rare and short-lived but can occur for a variety of reasons, including operational problems within firms and structural inefficiency in cross-border settlement (a persistent problem in Europe). In addition, bouts of market illiquidity can lead to involuntary delivery failures by market-makers. Given that they are obliged or committed to quote immediately-executable prices to investors, they have to sell even if they do not hold a security in their inventory. If they cannot immediately buy that security in the market or borrow it from the repo market, they would be forced to fail on delivery. Frequent settlement fails could lead to buy-ins being exercised against market-makers, 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. While faster settlement reduces systemic risk, it leaves less time for delivery problems to be corrected and therefore requires an efficient source of securities borrowing to overcome delivery failures. This is provided by the repo market. The settlement period for most securities transactions in the EU changed from T+3 to T+2 in October 2014.
- Preventing market ‘squeezes’. By allowing the borrowing of securities, repo helps to prevent individual institutions ‘squeezing’ the market in a particular security issue by cornering supply and thereby creating or exacerbating temporary imbalances between supply and demand. Squeezes can lead to settlement failures and disorderly markets.
- Allowing more efficient collateral management. Trading in the repo market is key to the valuation and management of collateral, and therefore to its efficient mobilisation and allocation. Where a firm’s investment or trading portfolio does not include the types of securities required as collateral (for example, HQLAs or CCP-eligible collateral), it can exchange the securities it does hold for those that it needs by using a repo to lend what it has and a reverse repo to borrow what it needs, with the opposite cashflows largely offsetting each other (this is a collateral swap performing collateral transformation). Collateral management is becoming ever more important. Traditional demand for collateral --- for use in payments and settlement systems, in derivatives exchanges and in securities finanancing transactions (SFTs) --- is being increased by the wider use of SFTs and regulatory requirements to hold larger liquidity reserves and to either centrally-clear or collateralise OTC derivatives. At the same time, quantitative easing by central banks has reduced the supply of HQLA currently available to the market, while loss of confidence in some sovereign debt has created uncertainty over future aggregate supply. The trading of collateral is particularly useful to investors such as pension funds and insurance companies, as it allows them to acquire securities eligible to use as collateral against the derivatives positions hedging their investment risk, while keeping their investment portfolios as close as possible to the optimum asset allocation and asset-liability management position.
- Allowing more efficient employment of capital. The global economic impact of the increasing regulatory risk capital charges which have been introduced since the 1980s has been accommodated by the more efficient use of capital through a shift from unsecured to secured financing.
* 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.
*** Market-makers in corporate and other credit bonds also hedge the credit risk on any long positions that they accumulate. This can be done, subject to various degrees of basis risk, by: (1) shorting a security from the same issuer but issued in another part of the capital structure (eg senior against subordinated tranches); (2) shorting a security from a similar issuer with the same seniority; (3) selling protection through a single-name credit default swap (CDS) written on the same issuer and for the same seniority; or (4) selling protection through a CDS written on an index that is a reasonable proxy to the issuer of the security being hedged. The use of a CDS ultimately has to be hedged by someone else going short of the underlying security or index and covering that short position by borrowing in the repo market.
**** A ‘buy-in’ is a process whereby a buyer of a security that has not been delivered by the seller, appoints an agent to buy in the security on his behalf or buys in directly from the market. Any cost over and above the original purchase price is charged to the failing seller.
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