People know to talk about repo, but don’t actually know what it is about. What is repo? Why does it matter?
What is money? This is not as simple a question as it may seem at first glance.
Consider the following example: You find yourself in possession of a piece of paper that has a number written on it.
You bring it to the supermarket and try to use it to pay for food, but the cashier thinks you’re insane and calls security to escort you out.
However, when you bring it to a certain, very specialized, type of merchant, the same piece of paper can be used to immediately obtain a cash loan (the paper is used as collateral). And, at an amount almost equal to the number written on it too!
So the piece of paper cannot be used to buy food, but it can very quickly get you access to cash with which to buy food.
Furthermore, you notice that the number written on the paper is slightly more than what you paid for it. Plus, you were told that if you returned it to the place you bought it from after 3 months, you would receive that amount back in cash.
It’s an almost magical piece of paper!
So, is your piece of magic paper money?
Obviously, it depends on whom you ask. The supermarket cashier does not, and will not, think it is, but the specialized merchant definitely does.
Why is that?
Simple – the merchant has use for the piece of paper, and the supermarket does not.
The magical piece of paper is actually a US Treasury 3 month Bill (T Bill), and the specialized merchant a repo trading desk at a big Wall Street bank.
Repo desks have multiple uses for T Bills, but almost all involve using them as collateral – where they are pledged as security against default when taking loans or trading financial securities.
It is important to note that all tenors of US Treasuries can, and are, used in the repo market as collateral, simply because USTs are considered to be the “risk free” asset.
Consequently, USTs are the bedrock on which repo desks and their counterparties from all over the world secure their transactions with each other.
Furthermore, the market for USTs (by virtue of their “risk free” status, or not) is also one of the most, if not the most, liquid market on the planet.
This means collateral can be immediately liquidated by traders with minimal adverse price movements. (In less liquid markets, assets sold quickly and in bulk will push prices lower, causing sellers to get less than they would otherwise have gotten)
Lastly, and arguably most importantly, USTs are denominated in USD. This means sellers do not have to (overly) worry about the value of their collateral fluctuating wildly due to currency movements.
Additionally, upon liquidation, the seller will, by virtue of the USD being the world’s reserve currency, be able to easily swap their holdings into other currencies or assets.
No other financial asset can provide this combination of flexibility, security, and liquidity, which makes US Treasuries the premiere form of collateral in the global financial system.
As such, their role as an interest bearing instrument takes a back seat to their low price volatility and their ability to be quickly converted into some other asset.
Store of value – check, and medium of exchange – check.
USTs are money.
To be continued…
While all Treasuries can be used as collateral, they are not all made equal.
At least from the perspective of what serves as the best, and most widely accepted forms of collateral.
Bearing in mind the preference repo counterparties have for liquidity, and the ability to recover some amount close to the loan value in the event of default, shorter maturity Treasuries, that is T Bills, are considered to be “better” forms of collateral.
“Better” in this case because, by being of shorter tenor, they have lower duration.
Duration is a measure of how sensitive a bond’s price is to changes in interest rates (mathematically, the first derivative of the curve). Longer tenor bonds are more sensitive to changes in rates (have higher duration) because the bulk of a bond’s cash flows come at the end, where the principal amount is repaid.
As such, this large lump sum payment is what affects the present value of the bond the most when interest rates change.
Since the primary purpose of collateral is to ensure that, in the event of default, lenders can recover as much of their loan values as possible, assets which trade with relatively higher levels of volatility are not that good forms of collateral.
Consequently, while UST 10 year notes and 30 year bonds offer similar liquidity and flexibility characteristics, their longer durations ultimately put them at a disadvantage to T Bills, which are considered to be the most pristine form of collateral in the financial system.
But how exactly do these collateralized repo transactions work?
Firstly, “repo” is short for repurchase agreement, which is a sale of securities (the collateral), with the simultaneous obligation to buy them back on a certain date.
Repos allow institutions which hold large stocks of financial securities to use them as a way to obtain quick funding without having to sell them.
Examples of such institutions include Wall Street trading desks, brokerage houses, hedge funds, asset managers, and even pension funds.
The repo rate is the interest rate paid by the borrower, and in general, the lower quality the collateral, based on the factors discussed in Part 1, the higher the repo rate, more colloquially (and affectionately) known as the “haircut”.
It is important to note that the party selling the securities (and buying them back later) is the one engaging in the repo.
The counterparty, that is, the one purchasing the securities (and selling them back later) is said to be engaging in a reverse repurchase agreement.
Reverse repos are used by parties that require the securities pledged as collateral for use in their own financial transactions. This could be a hedge fund lending cash to receive UST Bills, which they in turn use as collateral in another financial transaction.
This is possible because repo transactions can be rolled over.
That is, when the specified date is reached, instead of going through with the repurchase leg of the transaction (refer to the diagram above), both parties agree to extend the transaction to a future date, and re-negotiate terms as necessary.
This brings us to another important aspect of repo transactions, which is that collateral values are recalculated daily based on price fluctuations. This recalculation results in securities or money being delivered in one direction or the other, depending on how prices change.
As such, repos are considered to be “safe” transactions as levels of collateral are adjusted according to market moves on a daily basis.
The exception to this is of course systemic events, where everyone scrambles for collateral at the same time, resulting in mass liquidations across global markets.
To be continued…
If you have heard the term “shadow banking system” being bandied about in the past few years, the repo market is a big part of it.
There are (and will be) those who conceive of the shadow banking system as hedge funds and/or private equity firms using their own balance sheets to extend loans.
While this kind of lending definitely counts as unregulated shadow banking activity, the amounts involved there are dwarfed by the amounts flowing through the repo market.
According to IMF research , at the end of 2017, the amount of collateral pledged was approximately $7.5 trillion. This was collateral that could be re-pledged.
In 2007, pre-Great Financial Crisis, this number was even higher, at $10 trillion. Post crisis, it dropped to $6 trillion, and stayed at this number for about a decade.
The “could be re-pledged” part is important, because this means collateral can, like money in the economy, have velocity. In 2007, this came in at approximately 3, dropping to about 2 at the end of 2017.
Unfortunately, we do not have more up-to-date figures, given that the repo market is extremely opaque, and comprehensive reviews or overviews of its data and activity are very difficult to compile (hence the moniker shadow banking).
While 2017 is a long time ago in financial terms, the data from this report is the best we have at this point in time.
But, even with 2017 figures, it is quite clear that the repo market is very, very big; $7.5 trillion with a velocity of 2 puts the size of the market at $15 trillion ($30 trillion in 2007).
That’s a $15 trillion market that the majority of people do not even know exists!
Why is it so large, and what are the implications of its size?
The important thing to remember about the repo market is that it is international.
Different types of collateral are pledged for cash loans, and vice versa, all over the globe. This is done for a wide variety of purposes, not least the examples given in Part 2.
Repo transactions are also not confined to a certain currency or type of collateral.
For instance, Indonesian sovereign bonds can be pledged as collateral to obtain a USD loan.
Obviously, the haircut on the transaction would be quite a bit higher than if USTs were used as collateral, but different repo desks have different risk tolerances, and in normal times, there will be traders willing to transact against riskier collateral.
To be concluded…
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!
The financial media has begun reporting on liquidity problems in the Treasury market, which means that the problem is reaching a phase where it is acute.
Is this due to recent narratives focused on inflation?
Or is there something more going on, like say in that global market that no one seems to know much about – repo?
The 10 year Note has been making waves (at least in the places where people know just how much repo matters) recently for trading “special” at a negative repo rate of around -4% in the first week of March.
All this means is that it is trading at a repo rate that is unusual. When a particular financial instrument is in high demand in the repo market, it can trade “special”.
What does a negative repo rate for the 10 year Note mean?
Firstly, a positive rate is the norm, and is the amount that a cash lender charges for lending their cash in exchange for receiving collateral (in this case the 10y Note).
In normal times, rates should be positive because lenders demand a return on the cash that they loan out, which is represented by the interest rate they charge.
With this as a reference point, negative rates mean the opposite. That is, cash lenders are paying counterparties to borrow money from them. This means that borrowers are getting paid to borrow.
Clearly lenders are desperate if they are resorting to this.
Which begs the question: desperate for what?
Simple. 10 year Notes.
Here, the picture gets a lot more muddled. Why would some parties be so desperate for 10y Notes?
A simple and easy answer is that demand for 10y Notes are through the roof because so many are looking to borrow them in order to sell them short.
Of course, this is part of the “boom times” narrative, which has caused a mad scramble of people betting on higher inflation. The result of this has been heavy selling in the 10 and 30 year Treasuries, leading to the much talked about spike higher in their yields.
However, we all know that simple/easy answers rarely tell the full story in complex systems like financial markets.
In this instance, the rush to borrow 10y Notes in repo has actually exacerbated a much broader problem – that of repo collateral shortages.
While many may not be aware of it, USTs serve a more vital purpose in the financial system than simply funding the US government. They also serve as collateral in the very large global repo and Eurodollar markets.
Unfortunately, QE has removed, and continues to remove, large amounts of USTs from the system, leading to a shortage in repo collateral.
Shortages naturally lead to hoarding (the liquidity problems reported in the media), which means lower supply and availability in repo. Throw into this a spike in borrowing demand for the 10y from frenzied short sellers, and all of a sudden folks are willing to pay to lend cash just so they can get hold of 10y Notes.
Ultimately, repo is one of the most opaque markets in the financial universe, and it is always difficult to know with any certainty what currents are flowing through it.
It is even harder to ascertain how these currents will spill out into more observable markets, such as USTs.
As such, one can never be fully certain of any narrative’s explanatory power. What one can be certain of, however, is that problems in the repo market tend to blow up in large and unexpected ways.
Hence, the real problem today isn’t “boom times” and the assumed incoming inflationary storm, it is collateral shortages at the heart of the world’s financial system!