Repurchase Agreements Research Articles

A Theory of Repurchase Agreements, Collateral Re-Use, and Repo Intermediation

We show that repurchase agreements (repos) arise as the instrument of choice to borrow in a competitive model with limited commitment. The repo contract traded in equilibrium provides insurance against fluctuations in the asset price in states where value is high and maximizes borrowing capacity when it is low. Haircuts increase both with counterparty risk and asset risk. In equilibrium, lenders choose to re-use collateral. This increases the circulation of the asset and generates a collateral multiplier effect. Finally, we show that intermediation by dealers may endogenously arise in equilibrium, with chains of repos among traders.

Lender Protection versus Risk Compensation: Evidence from the Bilateral Repo Market

We study secured lending contracts using a novel, loan-by-loan database of bilateral repurchase agreements in which borrower quality is fixed and collateral quality is known. Other things equal, lower-quality loans have longer maturities, indicating that borrowers’ concerns with refinancing risk override lenders’ incentives to engage in maturity rationing. Lower-quality loans also have higher spreads and margins, indicating that margin is lenders’ main risk management tool. As collateral quality drops, lenders take more risk and earn higher spread. Holding loan quality constant, one point of spread substitutes for approximately 9 points of margin.

Excess reserves and monetary policy implementation

In response to the Great Recession, the Federal Reserve resorted to several unconventional policies that drastically altered the landscape of the federal funds market. The current environment, in which depository institutions are flush with excess reserves, has forced policymakers to design a new operational framework for monetary policy implementation. We provide a parsimonious model that captures the key features of the current federal funds market, along with the instruments introduced by the Federal Reserve to implement its target for the federal funds rate. We use this model to analyze the factors that determine rates and volumes under the new implementation framework, and to study the effects of changes in the policy rates and other shocks to the economic environment. We also calibrate the model and use it as a quantitative benchmark for applied analysis, with a particular emphasis on understanding the role of the overnight reverse repurchase agreement facility in supporting the federal funds rate.

Central counterparties and sale and repurchase agreements: regulating financial markets in the light of yet another false dawn

ABSTRACTIn this article it is argued that the burgeoning faith of policymakers and regulators in the ability of central counterparties (‘CCPs’) to absorb both counterparty and collateral risk in ‘sale and repurchase agreements’ (otherwise known as ‘repos’) – and, in turn, in helping to forestall contagion in the form of so-called ‘repo runs’ – is misplaced. In developing this contention, three major claims are advanced. First, for all their benefits, CCPs exhibit a major design flaw in as much as they are unable to diversify away market-wide systemic risk when counterparty failures become correlated – as exemplified by the global financial crisis (‘GFC’). Second, this design flaw is remarkably similar to the flaw which the modern trend towards market-based finance exhibits, again, as revealed during the GFC, and as persists in its more recent ‘fund-based’ guise, and that this parallel cautions against viewing CCPs in an unduly favourable light. That is to say, in much the same way that market-based finance helped to neutralise systemic risk in good or moderately turbulent times pre-crisis, but amplified it in times of acute market turbulence, so too CCPs are liable to exhibit similar tendencies. Finally, although the UK’s new regulatory and supervisory regime applicable to CCPs has much to commend it, these measures are, in fact, likely to be of limited assistance in ensuing that CCPs are able to perform their mutualisation role, or that they do not disrupt financial markets, when things go seriously wrong.

The Liquidity Dilemma and the Repo Market: A Two-Step Policy Option to Address the Regulatory Void

A repurchase agreement (repo) is the sale of financial assets coupled with a promise to repurchase the same assets at a later date. With similar economic characteristics to secured loans and bank deposits, the repo market is one of the main sources of liquidity for financial markets and a vital segment of the US financial system. During the financial crisis of 2007-2009, when the markets crashed and the value of many assets dropped, repo lenders lost confidence in the repo market and massively withdrew their financing. Panic then ensued, drying up the liquidity in the markets. The over-reliance on short-term repo financing magnified the liquidity crunch, and financial institutions such as Lehman Brothers and Bear Stearns were brought to the brink of ruin. The crisis unveiled the deep opacity of the repo market, its proneness to runs, its structural weaknesses, the interconnectedness of its participants, the absence of stability buffers, and the lack of any comprehensive regulatory or supervisory framework. Astonishingly, however, the post-crisis regulatory agenda almost completely ignored the repo market. Though depicted as a reform intended to create a safer financial system, the Dodd-Frank Act essentially left untouched this important source of systemic risk. After outlining the repo market and shedding new light on its structural instability, this paper presents an alternative narrative of the crisis by arguing that the structurally weak repo market triggered a liquidity crunch that halted the engine of the financial system. In doing so, the paper challenges the assumption that the crisis was caused merely by over-the-counter derivatives, securitization, and too-big-to-fail institutions. This paper shows how the repo market has developed within the financial markets – free from the watchful eyes of regulators and capitalizing on regulatory arbitrage – and challenges the regulatory void of the Dodd-Frank Act vis-a-vis the repo market. Specifically, this paper presents an original two-step policy option for assessing the repo market, based on the lesson of the post-crisis reforms of over-the-counter derivatives market as well as the incremental role envisioned by lawmakers for “financial market infrastructure” and central clearing counterparties as stability mechanisms. This paper calls for the assessment of the necessity of a structural intervention in the repo market to fix the failures that currently characterize it, and suggests that more transparency, coupled with a strong financial market infrastructure, would make the repo market more transparent, stable, and resilient.

Evolution of collateral ‘management’ into collateral ‘optimisation’

New regulations have forced an unpresented change in banking and financial industries, following the Lehman crisis. One of the key areas impacted by this is the collateral management function. There has been a fundamental change of focus on key drivers of collateral management since introduction of Master Agreement and Credit Support Annexes. Post Lehman crisis Market behaviour in assessing creditworthiness and pricing, and monitoring risk has changed significantly, leading to an increase of risk parameters banks need to monitor and price overtime, introducing more complexity to managing available resources. As a result, banks require a new type of capability and framework to assess, quantify, control and optimise scarce resources. Collateral management is no longer a reactive post trade exercise, rather a key building block within the trade cycle to ensure resources are priced and used as efficiently as possible. This paper examines the building blocks of margining and collateralisation of derivative transactions and trends evolved to mitigate systemic risk in capital markets, and the increased complexity faced when optimising the need to collateralise derivative and repurchase agreement (repo) business post new regulations.

The Federal Reserve's Tools for Policy Normalization in a Preferred Habitat Model of Financial Markets

We develop a model to analyze monetary policy implementation with multiple Federal Reserve liabilities and superabundant reserves. The analysis demonstrates the Federal Reserve's tools including interest on excess reserves (IOER), overnight reverse repurchase agreements (ON RRP), and term deposits should allow the Federal Reserve to raise the short‐term interest rates to any desired level. We find the contribution of each the increase in the IOER and ON RRP offering rates in firming money market rates suggested by the data during the December 2015 policy tightening event is remarkably similar to the effect of each tool implied by the calibrated model.

The Economic Consequences of 'Market-Based' Lending

The growth of “market-based” lending is closely related to the growth of repurchase agreements and similar contracts that grant the lender the right to sell collateral on the market if a threshold level of over-collateralization is not maintained. This paper argues that this contractual structure relies so heavily on market liquidity that its ubiquitous use has the paradoxical effect of disrupting market liquidity itself. The paper takes a Keynesian view of market liquidity as prone to crises of confidence and thus fundamentally unstable. It develops an analytic framework that explains how the economic function of the traditional banking system is to act as a shock absorber for the liquidity crises that are inherent to markets. The growth of “market-based” lending and in particular its culmination in the development of a money market that is dominated by repurchase agreements and other collateralized instruments is analyzed using this framework.This paper argues that the growth of repurchase and margin contracts has created an environment where liquidity crises are endemic. In this environment even in normal times market participants seek to self-insure by holding “safe haven” assets that are unlikely to fall in value in a liquidity crisis. Thus, this structural shift in the financial system explains (i) the decline in real interest rates that started in the late 1990s, (ii) the increase in the spreads between “safe” and riskier assets, and (iii) the lackluster economic performance that has led to concerns about secular stagnation.

SPOE Plus TLAC = More Bailouts for Wall Street

SPOE Plus TLAC = More Bailouts for Wall Street

Exploring the Dynamic Relationship in the Shadow Banking System

In this paper, we study the dynamic relationship in the shadow banking system by examining the short-run and the long-run relationship among the financial assets of the money market fund, the commercial paper, and the repurchase agreement market. The evidence suggests that there exists a common long-term cointegrating trend among these three components of the shadow banking system for 1985-2013 sample period. Any disequilibrium in this long-run relationship among these variables is corrected by movement in the financial assets of the money market funds. The trend-cycle decomposition from the estimated cointegrating relationship shows that the cyclical component in the money market funds is large and captures the huge swings in these markets during the financial crisis. Our results are also robust to the exclusion of the financial crisis, and it reveals the changing role of the commercial paper and the repurchase agreement market in the shadow banking system.

Gap Risk KVA and Repo Pricing: An Economic Capital Approach in the Black-Scholes-Merton Framework

Although not a formal pricing consideration, gap risk or hedging errors are the norm of derivatives businesses. Starting with the gap risk during a margin period of risk of a repurchase agreement (repo), this article extends the Black-Scholes-Merton option pricing framework by introducing a reserve capital approach to the hedging error's irreducible variability. An extended partial differential equation is derived with two new terms for expected gap loss and economic capital charge, leading to the gap risk economic value adjustment and capital valuation adjustment (KVA) respectively. Practical repo pricing formulae is obtained showing that the break-even repo rate decomposes into cost of fund and economic capital charge in KVA. At zero haircut, a one-year term repo on main equities could command a capital charge as large as 50 basis points for a 'BBB' rated borrower.

Funding, Repo and Credit Inclusion in Option Pricing via Dividends

This paper specializes a number of earlier contributions to the theory of valuation of financial products in presence of credit risk, repurchase agreements and funding costs. Earlier works, including our own, pointed to the need of tools such as Backward Stochastic Differential Equations (BSDEs) or semi-linear Partial Differential Equations (PDEs), which in practice translate to ad-hoc numerical methods that are time-consuming and which render the full valuation and risk analysis difficult. We specialize here the valuation framework to benchmark derivatives and we show that, under a number of simplifying assumptions, the valuation paradigm can be recast as a Black-Scholes model with dividends. In turn, this allows for a detailed valuation analysis, stress testing and risk analysis via sensitivities. We refer to the full paper for a more complete mathematical treatment.

Money Market Reform in Korea and Its Effects on the Overnight Call–Repurchase Agreement Rate

ABSTRACTThe Korean government implemented money market reform after the global financial crisis, aiming to develop the repurchase agreement (RP, repo) market. In this article, I analyze the reform and its effects on money markets. Results show that the reform strengthened the functionality of the RP market and the monetary policy transmission channel to it. The error correction model indicates that although the adjustments to the equilibrium occurred through the call rate during the global financial crisis, they were processed through the RP rate in later periods. The ability of the RP rate to inform market liquidity conditions has improved.

MARKET RISK ESTIMATION IN (T+)-TRANSACTIONS

Market risk analysis and estimation are presentedin T+ transactionsas they are used within the Moscow Exchange. There is a need to do so as a result of the cut-off of a new REPO product with Central Counterpartner (CCP). Here repurchase agreement goes through the National Clearing Center (NCC), the last being a bank and a clearing structure within the Moscow Exchange group.NCC actsas an intermediary (so called “Central Counterpartner”) between trading participants.REPOs with CCP raisecontractor claims and commitments to the CCP which takes the risk of default on commitments from unfair contract side. The REPO with CCP cut-off made ready a technological platform to implement T+2 trades at the Moscow Exchange. As a result of it there appeared the possibility to enter security purchase/sell contracts partially collateralized. All these transactions (the REPO with CCP, T+) made it a must determining security market risks. The paper is aimed at presenting VaR-like risk estimates. The methods used are from the computer fi nance. Unusual TS rate of return indicator is proposed and applied to find optimal portfolios under the Markowitz approach and their VaRs (losses) forecasts given the real “big” share price data and various horizons. Portfolio extreme rate and loss forecasting is our goal. To this end the forecasts are computed for three horizons (2, 5 and 10 days) and for three significance levels.There were developed R-, Excel- and Bloomberg-basedsoftware tools as needed. The whole range of proposed computing steps and the tables with charts may be considered as candidates to be included in the future market risk standards.Paper results permit capital market participants to choose the correct (as to the required risk level) common stocks.

GE and the Shadow Banking Landscape

The case examines the rationale for why shadow banking exists, what role it plays in the financial system, and the risks that it may pose. In the case, an analyst in an investment fund is tasked to examine in greater detail the decision by GE to divest GE Capital. Understanding the rationale for this transaction, the role of GE Capital in the financial system, and the potential risks for the financial system would be important for the analyst's decision. This case would fit well in a second-year MBA elective course on Financial Institutions or Capital Markets. Excerpt UVA-F-1761 Oct. 3, 2016 GE and the Shadow Banking Landscape Well, my plan is more comprehensive. And frankly, it's tougher because of course we have to deal with the problem that the banks are still too big to fail…But we also have to worry about some of the other players—AIG, a big insurance company; Lehman Brothers, an investment bank. There's this whole area called “shadow banking.” That's where the experts tell me the next potential problem could come from. I want to make sure we're going to cover everybody, not what caused the problem last time, but what could cause it next time. —Hillary Clinton, Democratic presidential candidate Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions—but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies. Before the crisis, the shadow banking system had come to play a major role in global finance. . . .

Japanese repo and call markets before, during, and emerging from the financial crisis

We empirically investigate the relationship between the Japanese general collateral (GC) repurchase agreement (repo) and uncollateralized call rates before, during, and emerging from the recent financial crisis. Unlike the US and many other countries, the Japanese GC repo rate had been higher than the uncollateralized call rate, despite the former being secured by collateral. Moreover, during the financial crisis, the Japanese GC repo rate rose, whereas the US Treasury GC repo rate decreased. The results of our empirical analysis suggest that segmentation between the Japanese repo and call markets was an important factor in explaining these features. Our results also imply that the Bank of Japan’s policy actions during and after the financial crisis were effective to some extent in lowering both the repo and call rates, and stabilizing the relationship between them.

The Role of Margin and Spread in Secured Lending: Evidence from the Bilateral Repo Market

We study secured lending contracts using a novel, loan-by-loan database of bilateral repurchase agreements in which borrower quality is fixed and collateral quality is known. Holding all risk factors constant except collateral quality, we show that loans on riskier collateral have higher spreads, that is, they remain riskier even though lenders require higher margins. We also document that lower-quality loans have longer maturity, driven by borrower rollover concerns. Our results suggest that maturity is not lenders' primary risk management tool. Holding loan quality constant (including collateral), we show that one point of spread substitutes for approximately 9 points of margin.

Regulatory Arbitrage in Repo Markets

Non-U.S. banks with relatively low capital ratios appear to temporarily remove an average of $170 billion from the U.S. market for tri-party repurchase agreements (repo) before each quarter-end in order to appear safer and less levered. This amount is more than double the $76 billion market-wide drop in tri-party repo during the turmoil of the 2008 financial crisis and represents about 10% of the entire tri-party repo market. Such window dressing-induced deleveraging spills over into agency bond markets and money market funds and affects market liquidity each quarter.

Explaining Recent Modifications to the Treatment and Use of Repurchase Transactions

The research outlined in this article considers recent events that have transpired in the repurchase transaction market. In the United States, the Financial Accounting Standards Board (FASB) has changed the accounting treatment of repurchase transactions. Across the globe, regulators have changed the treatment and capital required for financial institutions to participate in repurchase transactions. The intended effect is clear: new rules treat repurchase agreements as debt and require participating institutions to provide additional financial statement disclosures about repurchase agreement activities. What impact will the stricter rules have on the repurchase transaction market? Federal Reserve data on the repurchase transaction market suggest that the recent changes have decreased repurchase market activity. Remaining questions for practitioners and theoreticians might include the effect that a smaller repo market might have on other credit markets as well as the financial markets as a whole.

SEC fines alternative mutual fund adviser for improper handling of fund assets

Purpose – To explain that the Securities and Exchange Commission (“SEC”) brought and settled charges against an investment adviser to several alternative mutual funds alleging, among other charges, failure to comply with the custody requirements of the Investment Company Act of 1940, as amended (the “1940 Act”). Design/methodology/approach – To explain that the Securities and Exchange Commission (“SEC”) brought and settled charges against an investment adviser to several alternative mutual funds alleging, among other charges, failure to comply with the custody requirements of the Investment Company Act of 1940, as amended (the “1940 Act”). Findings – The enforcement action serves as an important reminder for the growing number of advisers of alternative mutual funds to be mindful of specific restrictions and obligations when managing registered funds that do not apply to private funds and separate accounts. This action shows that the SEC will bring charges even when the alleged violations do not result in harm to investors. Practical implications – The 1940 Act, the rules thereunder, and SEC staff guidance relating to alternative investment strategies are complicated and not intuitive. These standards can constrain a registered fund’s ability to employ options, futures, swaps, prime brokerage, repurchase and reverse repurchase agreements, enhanced leverage through securities lending, and other facilities. As the SEC continues to examine alternative mutual funds, advisers to these funds should remain cognizant of the obligations arising under the 1940 Act and the implementation of fund policies and procedures. Originality/value – Practical guidance from experienced financial services lawyers.