Repo Market Research Articles

The Importance of Being Special: Repo Markets During the Crisis

We study how the Italian sovereign bond scarcity premia, specialness, in the repo market were affected by the European Central Bank (ECB)'s purchases during the euro area sovereign debt crisis. We propose and calibrate a search-based dynamic model with a central bank acting as a buy-and-hold investor. Consistent with model predictions, ECB purchases drive specialness of targeted securities in combination with short-selling. Special benchmark bonds entail a positive cash premium, but their market liquidity decreases when purchased by the ECB. Short-sellers were more likely to fail-to-deliver very special bonds, while holders of these bonds were less inclined to pledge them as collateral to the ECB liquidity operations.

Endogenous Repo Cycles

This paper presents a simple and tractable equilibrium model of repos, where collateralized credit emerges under limited commitment. We show that even if there is no time variation in fundamentals, repo markets can fluctuate endogenously over time. In our theory, repo market fragilities are associated with endogenous fluctuations in trade probabilities, collateral values, and debt limits. We show that the collateral premium of a durable asset will become the lowest right before a recession and the highest right after the recession, and that secured credit is acyclical.

Securitized banking, procyclical bank leverage, and financial instability

This paper provides a theoretical explanation of procyclical leverage of the broker-dealer sector and examines its macroeconomic consequences within the context of the securitized banking system characterized by loan securitization and collateralized short-term borrowing. First, from a model of repo transaction, it is shown that a broker–dealer (repo borrower)'s optimal leverage is positively related to asset prices. The main mechanism underlying this relation is a movement of repo rate, which reflects counter-party risks and collateral value risks repo lenders are facing. Second, based on this result, I develop a macroeconomic model with a securitized banking system characterized by procyclical bank leverage and identify conditions under which the model exhibits a limit cycle behavior. A vulnerability of the repo market to asset price fluctuations leads to procyclical bank leverage, which aggravates asset price cycles driven by the supply-led credit expansion and collapse. It is also found that as the procyclicality of bank leverage becomes stronger the financial cycles also get more intense and severe.

The dynamic relationship among the money market mutual funds, the commercial paper market, and the repo market

ABSTRACTIn this paper, we present the short-run and the long-run relationships among the financial assets of the money market funds, the commercial paper market, and the repurchase agreement market by undertaking a cointegration analysis of quarterly data over the 1985–2017 period. This was based on the empirical observation that the commercial paper and repo markets account for 50 percent of the assets of money market funds. The evidence suggests that there exists a common long-term cointegrating trend among these three components of the shadow banking system. Any disequilibrium in this long-run relationship among these variables is corrected by movement in the financial assets of money market funds. The Beveridge-Nelson decomposition from the estimated cointegrating relationship shows that the cyclical component of money market funds is large and captures huge swings in these markets during the financial crisis. We also find evidence of change in these dynamic relationships in the post-crisis period, where in addition to the money market funds, the commercial paper market also exhibits a tendency to correct for the disequilbrium.

The Clearing of Euro OTC Derivatives Post Brexit – Why a Uniform Regulation and Supervision of CCPs is Essential for European Financial Stability

With a notional amount outstanding of more than USD 500 trillion, the market for OTC derivatives is of vital importance for global financial stability. A growing proportion of these contracts are cleared via central counterparties (CCPs), which means that CCPs are gaining in importance as critical financial market infrastructures. At the same time, there is growing concern that a new too big to fail problem could arise, as the CCP industry is highly concentrated due to economies of scale. From a European perspective, it should be noted that the clearing of euro-denominated OTC derivatives mainly takes place in London, hence outside the EU in the foreseeable future. For some time there has been a controversial discussion as to whether this can remain the case post Brexit. CCPs, which clear a significant proportion of euro OTC derivatives and are systemically relevant from an EU perspective, should be subject to direct supervision by EU authorities and should be established in the EU. This would represent an important building block for a future Capital Markets Union in Europe, as regulatory or supervisory arbitrage in favour of systemically important third-country CCPs could be prevented. In addition, if a systemically relevant CCP handling a considerable portion of the euro OTC derivatives business were to run into serious difficulties, this may impact ECB monetary policy. This applies both to demand for central bank money and to the transmission of monetary policy measures, which can be significantly impaired, particularly in the event that the repo market or payment systems are disrupted. It is therefore essential for the ECB to be closely involved in the supervision of CCPs. Against this background, the draft amendment of EMIR (European Market Infrastructure Regulation) presented on 13 June 2017 is a step in the right direction. In addition, there is an urgent need to introduce a recovery and resolution mechanism for CCPs in the EU to complement the existing single resolution mechanism (SRM) for banks in the eurozone. Only then can the diverse interdependencies between banks and CCPs be adequately taken into account in the recovery and resolution programmes required in a financial crisis.

Pricing Total Return Swap

Total return swap (TRS) involves a pricing dilemma: Libor discounting of its premium leg forces upfront payment of future funding premium, and yet replacing Libor with a firm’s own funding rate falls into the well-known FVA debate trap. We consider TRS hedge financing from a repo market perspective and apply post-crisis derivatives valuation with collateralization and funding to TRS. We find that the financing cost of the TRS hedge should be reflected on the security leg, and the funding premium can only be discounted in conjunction with the TRS as a whole, depending on margining schemes. An easy to implement, recursive tree model is developed to value TRS with repo-style margining or defaultable underlying, together with any value adjustments.

Belief Mismatch and Banks’ Risk Taking: Evidence from the Repo Market in Mexico

Belief mismatches can trigger endogenous credit constraints in short-term funding markets (Simsek (2013)), and if banks rely on the latter their risk taking can also be affected through different balance sheet channels (Dell’Ariccia et al. (2014)). Using proprietary data we propose a proxy for belief mismatches, between banks and open-ended funds in the repo market, and study the effect on the determination of the repo pricing, on different metrics of banks’ risk taking, and on loan prices. We show that optimistic banks attain collateral prices on average 16 basis points higher. In addition, they have leverage ratios an average of 11.4 basis points higher, and z-scores an average of 0.82 points lower. Finally, we find that the effect on banks of the monetary policy’s risk-taking channel is dampened when they are more optimistic than open-ended funds.

The Pricing Implications of the Oligopolistic Securities Lending Market: A Beneficial Owner Perspective

In the last decade, central bank interventions, flights to safety, and the shift in derivatives clearing resulted in exceptionally high demand for high quality liquid assets, such as German treasuries, in the securities lending market besides the traditional repo market activities. Despite the high demand, the realizable securities lending income has remained economically negligible for most beneficial owners. We provide empirical evidence of pricing inefficiencies in the non-transparent, oligopolistic securities lending market for German treasuries from 2006 to 2015. Consistent with Duffie, Gârleanu and Pedersen (2005)’s theory, we find that the less connected market participants’ interests are underrepresented, evident in the longer maturity segment, where lenders are more likely to be conservative passive investors, such as pension funds and insurance firms. The low price elasticity in this segment hinders these beneficial owners to fully capitalize on the additional income from securities lending, giving rise to important negative welfare implications.

Repo Market Functioning: The Role of Capital Regulation

This paper shows that the leverage ratio affects repo intermediation for banks and non-bank financial institutions. We exploit a novel regulatory change in the UK to identify an exogenous intensification of the leverage ratio and combine this with supervisory transaction-level data capturing the near-universe of gilt repo trading. Studying adjustments at the dealer-client level and controlling for demand and confounding factors, we find that dealers subject to a more binding leverage ratio reduced liquidity in the repo market. This affected their small but not their large clients. We further document a reduction in frequency of transactions and a worsening of repo pricing, but no adjustment in haircuts or maturities. Finally, we find evidence of market resilience, based on existing, rather than new repo relationships, with foreign, non-constrained dealers stepping in. Overall, our findings help shed light on the impact of Basel III capital regulation on repo markets.

The Clearing of Euro OTC Derivatives Post Brexit Why a Uniform Regulation and Supervision of CCPs Is Essential for European Financial Stability

With a notional amount outstanding of more than USD 500 trillion, the market for OTC derivatives is of vital importance for global financial stability. A growing proportion of these contracts are cleared via central counterparties (CCPs), which means that CCPs are gaining in importance as critical financial market infrastructures. At the same time, there is growing concern that a new too big to fail problem could arise, as the CCP industry is highly concentrated due to economies of scale. From a European perspective, it should be noted that the clearing of euro-denominated OTC derivatives mainly takes place in London, hence outside the EU in the foreseeable future. For some time there has been a controversial discussion as to whether this can remain the case post Brexit. CCPs, which clear a significant proportion of euro OTC derivatives and are systemically relevant from an EU perspective, should be subject to direct supervision by EU authorities and should be established in the EU. This would represent an important building block for a future Capital Markets Union in Europe, as regulatory or supervisory arbitrage in favour of systemically important third- ountry CCPs could be prevented. In addition, if a systemically relevant CCP handling a considerable portion of the euro OTC derivatives business were to run into serious difficulties, this may impact ECB monetary policy. This applies both to demand for central bank money and to the transmission of monetary policy measures, which can be significantly impaired, particularly in the event that the repo market or payment systems are disrupted. It is therefore essential for the ECB to be closely involved in the supervision of CCPs. Against this background, the draft amendment of EMIR (European Market Infrastructure Regulation) presented on 13 June 2017 is a step in the right direction. In addition, there is an urgent need to introduce a recovery and resolution mechanism for CCPs in the EU to complement the existing single resolution mechanism (SRM) for banks in the eurozone. Only then can the diverse interdependencies between banks and CCPs be adequately taken into account in the recovery and resolution programmes required in a financial crisis.

The Regulatory and Monetary Policy Nexus in the Repo Market

We examine the interaction of regulatory reforms and changes in monetary policy in the U.S. repo market. Using a proprietary data set of repo transactions, we find that differences in regional implementation of Basel III capital reforms intensified European dealers' window-dressing by 80%. Money funds eligible to use the Fed's reverse repo (RRP) facility cut their private lending almost by half and instead lent to the Fed when European dealers withdraw, contributing to smooth implementation of Basel III. In a difference-in-differences setting, we show that ineligible funds lent 15% less to European dealers as they find their withdrawal for reporting purposes inconvenient. We find that intermediation through the RRP led to quantity and not pricing adjustments in the market, which is consistent with the RRP facility anchoring market rates.

Do higher capital standards always reduce bank risk? The impact of the Basel leverage ratio on the U.S. triparty repo market

Abstract While simpler than risk-based capital requirements, the leverage ratio may encourage bank risk-taking. This paper examines the activity of broker-dealers affiliated with bank holding companies (BHCs) and broker-dealers not affiliated with BHCs in the repurchase agreement (repo) market to test whether this may be occurring. Using data on the triparty repo market, the paper arrives at three findings. First, following the 2012 introduction of the supplementary leverage ratio (SLR), broker-dealer affiliates of BHCs decreased their repo borrowing but increased their use of repo backed by more price-volatile collateral. Second, the paper finds that regardless of whether a U.S. BHC-affiliated broker-dealer parent is above or below the SLR requirement, the announcement of the SLR rule has disincentivized those dealers affiliated with BHCs from borrowing in triparty repo. Finally, the paper finds an increase in the number of active nonbank-affiliated dealers in certain asset classes of triparty repo since the 2012 introduction of the supplementary leverage ratio. This illustrates how regulation can have competitive effects on the financial sector and may result in activities shifting among financial firms.

Supplementary Leverage Ratio and Repo Supply

While simpler than risk-based capital requirements, the leverage ratio may encourage bank risk-taking. This paper examines the activity of broker-dealers affiliated with bank holding companies (BHCs) and broker-dealers not affiliated with BHCs in the repurchase agreement (repo) market to test whether this may be occurring. Using data on the triparty repo market, the paper arrives at three findings. First, following the 2012 introduction of the supplementary leverage ratio (SLR), broker-dealer affiliates of BHCs decreased their repo borrowing but increased their use of repo backed by more price-volatile collateral. Second, the paper finds that regardless of whether a U.S. BHC-affiliated broker-dealer parent is above or below the SLR requirement, the announcement of the SLR rule has disincentivized those dealers affiliated with BHCs from borrowing in triparty repo. Finally, the paper finds an increase in the number of active nonbank-affiliated dealers in certain asset classes of triparty repo since the 2012 introduction of the supplementary leverage ratio. This illustrates how regulation can have competitive effects on the financial sector and may result in activities shifting among financial firms.

Liquidity in the repo market

This paper examines liquidity in the Swiss franc repurchase (repo) market and assesses its determinants using a proprietary dataset ranging from 2006 to 2016. I find that repo market liquidity has a distinct intraday pattern, with low liquidity in early and late trading hours. Moreover, repo market liquidity is negatively affected by stress in the global financial system and the end of the minimum reserve requirement period if central bank reserves are scarce. Furthermore, I show that with excess central bank reserves in the financial system, quoted volumes in the interbank market become imbalanced towards more cash provider quotes relative to cash taker quotes, and the trading volume declines. By estimating liquidity in an interbank repo market and explaining its drivers, this paper contributes to the ongoing debate on repo market functioning.

Do Higher Capital Standards Always Reduce Bank Risk? The Impact of the Basel Leverage Ratio on the U.S. Triparty Repo Market

While simpler than risk-based capital requirements, the leverage ratio may encourage bank risk-taking. This paper examines the activity of broker-dealers affiliated with bank holding companies (BHCs) and broker-dealers not affiliated with BHCs in the repurchase agreement (repo) market to test whether this may be occurring. Using data on the triparty repo market, the paper arrives at three findings. First, following the 2012 introduction of the supplementary leverage ratio (SLR), broker-dealer affiliates of BHCs decreased their repo borrowing but increased their use of repo backed by more price-volatile collateral. Second, the paper finds that regardless of whether a U.S. BHC-affiliated broker-dealer parent is above or below the SLR requirement, the announcement of the SLR rule has disincentivized those dealers affiliated with BHCs from borrowing in triparty repo. Finally, the paper finds an increase in the number of active nonbank-affiliated dealers in certain asset classes of triparty repo since the 2012 introduction of the supplementary leverage ratio. This suggests risks may be shifting outside the banking sector.

Identifying Repo Market Microstructure from Securities Transactions Data

Interbank repo markets are arguably just as important as unsecured markets. Despite this, the global research community has not analysed the microstructure of interbank repo markets in the same detail as unsecured markets, because loan-level repo data have not been available. This paper provides and assesses an algorithm for extracting loan-level repo data from over-the-counter securities transactions data, and it applies to securities transactions data from Austraclear. This approach is similar to how loan-level unsecured data are typically obtained from payments data. False detection and false omission rates are estimated to be 3 per cent or less. While separate prudential data indicate a larger repo market than the algorithm data, likely reflecting repos transacted through foreign (i.e. non-Austraclear) infrastructure, the two datasets have a robust positive relationship. The algorithm data, capturing non-RBA repos of up to 14-days maturity from several 2-month data samples between 2006 and 2015, reveal various market features. From 2006 to 2015, the distribution of repo-rate spreads (to the cash rate) drifted up and tightened, and the market shifted towards overnight maturities. Loan-level repo rates depend on the loan size and the types of counterparties, but not how long the repo is open. In 2015, the market's network structure comprises a tightly integrated core, and a segmented periphery with few counterparties. Repo haircuts do not display obvious patterns, appearing randomly distributed around zero.

An equilibrium pricing for OTC derivatives with non-cash collateralisation

In this study, we propose an equilibrium pricing rule for contingent claims traded in over-the-counter (OTC) markets with non-cash collateralisation. Owing to counterparty risks in OTC markets, collateral is required to create a derivative contract. In 2017, Osaka Exchange decided to expand the type of collateral asset, while cash has always been used as a collateral. In this study, we consider a market model in which the required collateral is not cash, and is instead assets with a senior credit class, such as a US Government bond. We further assume that market participants source collateral from the repurchase market (SC repo), where investors can borrow assets. Therefore, we provide an equilibrium pricing model that includes the repo market under counterparty risk. Our pricing rule also determines an equilibrium volume for the derivative contract. This enables us to examine the effects of the repo market on the price and volume for OTC derivative transactions.

Liquidity Risk and its Impact on Financial Performance of Financial Institutions in Pakistan

The recent financial crisis has highlighted the significance of sound liquidity management. Liquidity risk is one of the key issue for financial institutions. An organization with a strong asset base, adequate capital and earning may fail if not sustained good liquidity positions. This study attempts to empirically examine the impact of liquidity risk on the performance of selected banks operating in Pakistan. The panel data over a period of 2006-2015 was collected from the yearly published financial statements of banks working in Pakistan. The data was examined through the panel data regression model. Bank size, nonperforming loan ratio and capital adequacy ratio were used as surrogate variable for liquidity risk. The profitability of the selected banks was measured by taking the ratio of return on assets. The results of the regression model show a major impact of liquidity risk on the performance of Banking Institutions. The influence of the capital adequacy ratio and bank size was found significant and positive, while the influence of the nonperforming loan ratio proved insignificant. This study helps to understand the important parameters of liquidity risk and their influence on bank profitability. This study is valuable for risk managers to alleviate liquidity risk by having satisfactory liquid assets. This minimizes the liquidity gap and dependency of the financial institutions on the repo market.

Monetary Policy Implementation and Financial Vulnerability: Evidence from the Overnight Reverse Repurchase Facility

In this paper, we examine the Federal Reserve’s newest policy tool, known as the overnight reverse repo (ONRRP) facility, to understand its effects on the repo market. Using exogenous variation in the parameters of the ONRRP, we show that private repo activity is crowded out when money funds invest in the ONRRP. Additionally, we find that the ONRRP increases lenders’ bargaining power, thereby raising borrower funding costs. Lastly, we show that repo borrowers reallocate to repo backed by riskier collateral and borrow more from ONRRP-ineligible asset managers, both of which could increase financial vulnerability due to instability in dealer funding. Received April 27, 2017; editorial decision October 19, 2017 by Editor Stijn Van Nieuwerburgh.

Eurosystem's Asset Purchases and Money Market Rates

Some Euro area money market rates have been standing below the deposit facility rate since 2015, which coincided with the start of the Eurosystem’s public sector purchase program (PSPP). In this paper, we explore empirically the interactions between the PSPP and short term secured money market rates (repo rates). We document different channels through which asset purchases may affect the various segments of the Euro area repo market. Using proprietary data from the PSPP purchases and transactions made on the repo market for specific securities (“special”), our results show that the PSPP has contributed to push down repo rate, in particular prior to January 2017. On average, purchasing 1% of a bond outstanding is associated with a decline in its repo rate of -0.78 bps.