Repo markets play a vital role in providing short-term financing and liquidity to financial institutions and corporations. However, they tend to operate in the shadows and are not well understood by those outside the financial industry.
This article aims to shed light on what repo markets are, how they function, and why they are important to the broader financial system.
Why Do Financial Institutions Use Repo Markets?
There are several key reasons why banks, hedge funds, money market mutual funds and other institutions use the repo market:
- Access to short-term cash – The repo market allows institutions to borrow cash on-demand to cover short-term needs. Banks may use it to help finance trading activities, lend to customers, or meet withdrawal obligations. Money market funds may borrow in the repo market to meet investor redemptions.
- Earn interest on excess securities – Institutions with surplus securities they don’t intend to sell use repo markets to earn interest income in the short run. Rather than sitting idle, securities are lent out for a period of time to earn incremental yield.
- Cheap source of financing – The interest rates paid to access cash in the repo market are typically quite favorable and lower than other money markets. Large Wall Street firms can access financing at rates close to the risk-free Fed Funds rate.
- Flexible maturity terms – Repos can be structured with various maturities, the bulk being overnight loans that are paid back the next day. But other common terms include 2-day, 1-week or 1-month repos tailored to the borrower’s needs.
The Unique Role of the Tri-Party Repo Market
The tri-party repo market funds a significant amount of activity in the U.S. financial system due to the collateral mitigation it provides. It funds over $1.5 trillion of activity at its daily peak and allows dealers to efficiently finance their securities inventories. This market played a central role in exacerbating liquidity issues during the 2008 financial crisis when participants lost confidence in the quality of certain types of repo collateral.
The Role of Repo Markets in the Global Financial Crisis
The onset of the global financial crisis in 2007-08 highlighted how strains in the repo financing markets can spill over to the wider financial system. As concerns mounted over the credit quality of mortgage-backed securities being used as collateral in repo agreements, participants became wary of accepting them.
Haircuts rose dramatically on risky asset-backed collateral, getting up to 50% in some cases by late 2008. This sucked liquidity out of critical repo funding markets for investment banks and other institutions. Unable to roll-over repo financing day-to-day, Bear Stearns saw its liquidity evaporate in early 2008 and required Federal Reserve intervention to avoid collapse.
The crisis illuminated how excessive leverage combined with fragile short-term funding can leave financial institutions acutely vulnerable when market confidence evaporates. The repo run was akin to a depositor run on banks but in the context of capital markets reliance on overnight collateralized lending. Ultimately extensive Federal Reserve liquidity support was required to stabilize repo markets and avoid a systemic liquidity crisis.
Post-Crisis Repo Market Reforms
In the aftermath of the financial crisis, regulators introduced reforms aimed at mitigating systemic risks originating from short-term wholesale funding markets including:
- Higher capital and liquidity requirements to make banks more resilient to sudden loss of short-term financing
- Reduced allowable leverage across shadow banking system to curb build-up of excessive risks outside the banking sector
- Improved collateral valuation and management procedures by tri-party clearing banks to reduce fire sale risks
- Expanded collection of market data to enhance regulatory oversight over opaque short-term funding markets
- Creation of stress testing scenarios measuring financial firm resilience to runs or seizing up in repo and money markets
While appetite for sweeping structural changes was limited, policymakers hope that increasing the overall stability and capitalization of the financial system will reduce the system’s vulnerability to future repo market shocks.
The Repo Market’s Response to the Pandemic Crisis
The onset of the Covid-19 crisis in early 2020 created major liquidity strains across fixed income markets including repo markets. As investors dumped risky assets and rushed to safety, prices plummeted, and haircuts spiked similar to 2008 albeit on an accelerated timeline measured in days rather than months.
On March 17th, 2020, the Fed announced extensive new repo facilities aimed at shoring up liquidity and functioning in Treasury and mortgage-backed repo markets. This flooding of liquidity into the financial system calmed markets and allowed conditions to normalize across key short-term funding markets over subsequent weeks.
The crisis demonstrated how the Fed has become acutely sensitive to stresses in these obscure but vital plumbing elements of the financial system and is now much quicker to intervene to provide liquidity during periods of market turbulence. While repo markets were front and center early on in the pandemic crisis, the Federal Reserve’s quick actions averted a 2008-style systemic liquidity crunch.
Conclusion
While the intricacies of collateral practices and interest rate benchmarks that underpin these markets seem esoteric, they provide an indispensable source of financing to the broker-dealers and financial institutions that access public debt and equity markets for corporations. During periods of market volatility and declining asset prices, strains can rapidly develop within the opaque but critical repo financing markets sparking liquidity crises. As such, regulators monitor repo market dynamics closely for signs of rising systemic risks.
The repo and other short-term money markets exemplify the interconnected nature of the financial system. Often unseen by the general public, disruptions in these obscure corners of fixed income markets can have an outsized influence on overall financial conditions. As former Fed Chair Ben Bernanke noted, the 2007-2009 financial crisis underscored how “a relatively obscure corner of the financial system can end up posing a threat to financial stability and the economy”.
