What You Need To Know About The Repo Market 4
Collateral in the repo market isn’t limited to sovereign bonds.
A wide variety of fixed income instruments can, and are used as collateral, for example, asset backed securities (ABS), mortgage back securities (MBS), and corporate debt.
However, it is important to note that since the financial crisis in 2008, the use of ABS and MBS as collateral has declined. This is due to the fact that these markets seized up completely in the depths of the crisis, leaving holders of collateral facing massive mark-to-market losses.
The preference these days is for USTs, since ‘08 proved that even markets once thought to be highly liquid (ABS & MBS) can and will seize up in times of financial stress, simply because every participant is too fearful of every other participant going belly up.
Unfortunately, March of 2020 came along and even the UST market seized up.
The preference then became for On The Run (OTR) USTs, which are the most recently issued ones (because trading in them is more liquid); over Off The Run USTs.
As should be evident by now, liquidity is what truly matters in the repo market. When it dries up, all other financial markets fall into chaos, as ‘08 and ‘20 both demonstrated.
But how does this affect the broader economy?
At this point it just sounds like a financial system problem, and these days it is very difficult to garner sympathy for Wall Street’s problems.
Unfortunately, a repo market seizure affects a lot of markets. This is because collateral values are adjusted daily, and when a systemic event occurs, margin calls go out en masse.
This in turn leads to mass liquidations in all liquid markets; stocks, corporate bonds, precious metals, and even US Treasuries.
Naturally, such liquidations cause a lot of fear, which leads to market participants hoarding their capital and collateral.
As a result, funding costs rise by a lot, very quickly. This directly affects debt markets, starting with short term funding markets like commercial paper (CP).
The CP market was about $1 trillion in size in 2020, and is a short term unsecured funding market which companies tap in order to cover their myriad operating cash needs. As such, any sudden and significant rise in funding costs here directly results in corporations having problems obtaining cash to cover their short term needs.
This leads to desperate scrambles for cash, more fear, more hoarding of capital, and even higher rates.
Ultimately, this reverberates up the chain to higher funding costs in corporate debt markets like bonds and loans, pushing many vulnerable and already highly indebted firms into a liquidity crisis, and possible insolvency.
In other words, financial contagion, all starting from a market that most people haven’t even heard of!
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