February 15, 2020
What is this ‘Repo Market’ that Everyone is Concerned About?
The repo market is often referred to as the plumbing of the financial system, and just like the plumbing in your home, you’re unlikely to think about how it operates each day until something goes wrong with it.
So you’d be forgiven if you had no idea just how vital the repo market was until you started hearing about all the issues with it in the financial news over the past six months. However, this is a market that has a turnover of $1–2 trillion per day, so...it’s pretty big!
Repo stands for repurchase agreement and is a form of short-term borrowing where securities, and especially government securities, are used as collateral. It’s called a repurchase agreement rather than simply a collateralised loan due to the way the transaction is done.
Essentially, the repo market is like a huge pawn shop.
Let’s say you have Bank A, which is holding a lot of cash, more than they need, and you have Bank B that has some treasury bonds but needs to raise some money.
In a repurchase agreement, Bank B will sell its treasury bonds to Bank A, but the agreement will state that Bank B will repurchase the treasury bonds back from Bank A at a later point in time for a higher price. This is usually overnight or within 48 hours, but it can sometimes be longer.
Since Bank B is repurchasing the treasurys for a higher price, the difference between the price it sold them for and the price it buys them back for is the equivalent of paying interest for borrowing the money. This implied interest is known as the repo rate.
In situations where there is demand for borrowing in the repo market, but not enough lending available, the repo rate will increase. This, in very basic terms, is what happened in September 2019.
The party that’s lending the money (in this case, Bank A) will be institutions such as banks and money market funds, the borrowers (Bank B) will be institutions like investment banks, hedge funds and brokers. The Federal Reserve will also be involved in the repo market to help regulate bank reserves and the money supply.
Typically, the lender’s motivation for taking part in this deal is to make a relatively risk-free short-term return on its money. The reason this is relatively risk-free is that the securities are held as collateral. This means, if the borrower institution can’t repurchase the securities as agreed, the lender can sell the securities in the market to make its money back.
With this in mind, the value of the securities will always be higher than the amount of money they are being bought for. The difference between the value of the securities and the money exchanged is known as the haircut. If there is greater risk involved, the lender may ask for a larger haircut and a higher repo rate.
It’s these transactions at a huge scale that allows the market to function smoothly. It allows financial institutions to obtain liquidity for their day to day needs and facilitates all kinds of trading.