The Repo Market

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The Repo Market

Background
The repo market – from “sale and repurchase” agreement – was introduced by the US Federal Reserve in 1918 as the main tool of the Federal Reserve’s Money Market Operations. Repos were used to drain liquidity from the US banking system and to add liquidity as required.

The size of the Repo Market: Gross amounts outstanding at year end 2007 of roughly $10 trillion (double counting of repos and reverse repos) in the US (70% of US GDP) and €6 trillion in the Euro Repo Markets (65% of Euro-area GDP) and another $1 trillion in the UK Repo Market (Hordal and King, 2008).

The Euro Repo market has grown in size to reach €6 trillion Euros. Two thirds of the collateral is Central Government bonds from Euro area countries. In terms of country of issuance, Germany makes up ¼ of the market followed by Italy at 13%, France at 11% and other Euro area at 15%. Two thirds of repos have a maturity of one month or shorter with the rest up to one year (ECB, 2010).

US Primary Dealers are the most active participants in the US market and have used repos to finance most of the growth of their balance sheets, creating pro-cyclical leverage and an exposure to refinancing risk. In particular the top US Investment banks funded roughly half of their assets using repo markets. While the US repo market is dominated by trading in US Treasuries, there are also active markets in bonds issued by US government sponsored agencies (agencies), agency mortgage backed securities and corporate bonds (Please note that the argument by Gorton 2009, of declining haircuts on Repo transactions related only to structured products). Prior to the crisis, non-governmental collateral contributed significantly to the growth of the market.

Primary dealers are the primary suppliers of collateral in the Repo market. Other suppliers include hedge funds and institutional investors with long investment horizons e.g. pension funds etc.. e.g. in the tri-party repo market in the US (which accounts for $2.3trillion, the top 5 collateral providers from July 2008- Jan 2010, accounted for 57% of borrowing (Copeland et al, 2010).

Copeland et al (2010) provide reasons for why dealers (as in primary dealers) hold securities e.g. Dealers provide cash to their clients, such as hedge funds, usually through a bilateral repo transaction in which the client is the collateral provider. Dealers can also rehypothecate the collateral to a cash investor through a tri-party repo and make money on the different interest rates. If the hair cut on the tri-party repo is less than on the bilateral repo, then they can make money on the extra cash obtained (Copeland et al, 2010:5). They also give the example of how dealers use repos to finance their securities purchase, enabling them to economise on the use of their capital.

An alternative way of funding for these dealers is bilateral repos. However these are not considered to be as flexible and are considered to be too costly. Unsecured funding, using Commercial Paper or Medium Term Notes also became less attractive as it was thought to be less stable and more affected by market sentiment than repos (Copeland et al, 2010).

Cash investors or lenders of cash include financial intermediaries, money market mutual funds etc. They are willing to lend for short durations. They are more numerous than the collateral providers. An important group here are securities lenders, who use the repo market to invest the cash that they receive when they lend securities.

Cash providers, may provide cash for short periods because they need cash at short notice e.g. money market funds need cash to accommodate redemption requests.

Some cash investors may use DvP (bilateral repos). However they require the investor to take possession of the collateral and to perform other functions that the clearing banks provide in the tri-party repo. Cash investors can also invest in unsecured instruments such as CP or certificates of...
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