In the past few months, financial markets, market commentators and selected parts of the internet have been abuzz with talk of a crisis in the American repo market.
Such speculation has been rife given the unprecedented event which occurred in the ‘overnight repo market’ which principally operates from Wall Street on 17 September 2019.
In this article (which is part 1 in a two-part series about the ‘repo crisis’), we offer a technical explanation of what is the ‘repo market’ and how significant was it in causing the 2008 Global
Financial Crisis (GFC). This essential knowledge is critical to understanding:
what happened in the repo market in September 2019;
what has the response been by the Federal Reserve Bank of New York (NYFR); and
what is likely to come in the months to come in 2020.
What is the Repo Market?
The repo market is where dealers in low-risk liquid assets[1] are able to obtain short-term cash through selling their securities to counterparty buyers through a repurchasing agreement[2] before being required to purchase the securities back at a pre-agreed point in time[3][4].
Repurchasing agreements define:
the security (or collateral) which will be the basis of the ‘security-for-cash’ repurchase transaction; and
the interest rate which the seller is required to pay for the privilege of obtaining access to cash over the defined period[5].
Typically, the sellers into the repo market have been securities market intermediaries (market-makers and other securities dealers in firms called ‘broker-dealers’ or ‘investment banks’) and leveraged/other bond investors seeking funding.
Alternatively, the buyers’ have been cash investors seeking secure short-term investments including:
large commercial banks;
central banks investing foreign currency reserves;
international financial institutions;
money market mutual funds;
agents investing cash collateral received by their securities lending clients;
sovereign wealth funds;
asset managers with temporary cash surpluses; and
the treasuries of large non-financial corporates.
Repurchasing agreements were first developed in the United States of America in the 1920s and were subsequently adopted by Europe in the 1970s and in United Kingdom in the 1990s.
They now have become a vital instrument in financial systems across the world, especially in how they assist Central Banks transmit monetary policy throughout their relevant national or regional jurisdiction.
In modern financial systems, banks and dealers use repurchasing agreements to finance inventories, cover short positions, to create leverage and to hedge against interest rate movements.
Repurchasing agreements can be settled through direct bilateral arrangements between sellers and buyers of the underlying security (or collateral) or through 3rd party agents (known as tri-party agents) which is the most common method.
Repurchasing agreements are subject to three forms of risk, with them being: counterparty risk (i.e. default risk), market risk (i.e. risk of price volatility and the ease in which the value of the collateral can be realised in a sale) and operational risk (i.e. the risk of the market not operationally functioning).
Diagram 1 illustrates how a repurchasing agreement (or ‘repo’) works with Stage 1 showing the initial exchange of ‘security for cash’ (this is known as the ‘near leg’) and Stage 2 showing the return of the securities and cash at the conclusion of the repo market (this is known as the ‘far leg’).
Diagram 1: How ‘Repos’ operate in the US Financial System
Why does the Repo Market Exist?
In developed financial systems, national central banks require commercial banks to deposit a particular quantum of capital reserves with them which can be used to meet the demand for withdraws.
Typically, these reserve requirements require commercial banks to hold a particular amount of capital at the end of each trading day at the central bank[6].
For many financial institutions, it is difficult to predict whether they will have adequate funds at the end of any particular day, thus they require access to short term funds to ensure that they can meet their capital requirements.
Commercial banks access these short-term funds through the interbank overnight lending market via a repurchasing agreement[7].
The interbank overnight lending market is the most elementary description of why repurchasing agreements exist and what the repo market does, although repurchasing agreements are used for a much broader range of commercial reasons which some of them are described above.
The culmination of all these repurchasing agreements constitutes the ‘repo market’.
Central Banks Involvement in the Repo Market
Central banks play an important role within the repo market by directly participating in what are known as ‘repo operations’.
To implement its official interest rate policy throughout the economy (i.e. monetary policy), central banks rely on two markets to transmit its policy throughout the economy. These markets are:
the unsecure lending market – where the central bank helps set the interest rate in the market where borrowing for unsecure credit (i.e. without collateral)[8] occurs;
the general collateral (GC) repo market where the central bank sets the interest rate in the market where borrowing of low-risk secured credit (general collateral refers to government bonds which are deemed to be low risk) occurs.
The interest rate that central banks pay on repurchasing agreements is referred to as the ‘repo rate’.
The interest rates set by the central bank for unsecure and secure credit are used by financial markets to define the ‘risk-free rate’, which is an important interest rate benchmark that is used to determine the price of a whole host of financial instruments and assets such as shares (or equities), bonds, real estate and financial derivatives.
Beyond setting the repo rate, central banks conduct repo operations in order to:
resolve any funding or liquidity shortages which may occur at particular financial institutions or within a particular asset;
create facilities to exchange illiquid collateral for liquid government bonds; or
broaden the maturity duration of securities which may be used as collateral in the repo market.
In the context of the USA, the NYFR intervenes in the repo market through a series of repurchasing agreements (known as ‘repo operations’) between itself and 24 approved ‘primary dealers’[9].
In a ‘repo operation’, the NYFR lends cash to a primary dealer in exchange for government securities (i.e. the ‘near leg’) and then returns the government securities to the primary dealer at a lower price (i.e. the ‘far leg’), thus establishing the ‘repo rate’ between the price purchased and the price sold.
Alternatively, in a ‘reverse repo operation’, the NYFR borrows cash from primary dealers in exchange for government securities (i.e. the ‘near leg’) and then returns the government securities (i.e. the ‘far leg’) at a higher price than what was purchased initially during the ‘near leg’.
Diagram 2 illustrates how the NYFR conducts a ‘repo operation’ occurs between the NYFR and the primary dealers.
Diagram 2: How the NYFR conducts a ‘Repo Operation’
The Significance of the Repo Market
No matter the economic or financial market context, the repo market plays a significant role in:
determining and communicating one of the pivotal benchmark interest rates across the economy; as well as
highlighting problems which may be occurring within the financial system whether they be funding issues at particular major financial institutions or the level of trust that the market has in particular assets or between institutions.
In the context of the 2008 GFC, the repo market was central to how the crisis unfolded and spread throughout the financial system.
As noted by the National Bureau of Economic Research[10] and the Bank for International Settlements[11], the 2008 GFC which crystallised with the financial collapse in Lehmann Brothers in September 2008 stemmed from a ‘run’ on the USA repo market as cash investors lost confidence in mortgage backed securities and other collateralised debt obligations (or CDOs) (i.e. structured bonds which include mortgages of differing credit quality including subprime mortgages) which became the underlying collateral of many repurchasing agreements.
The securitised repo market in the USA was approximately $US 10 trillion in size during 2007[12].
In early 2007, cash lenders in the repo market grew anxious as concerns about subprime mortgages rose as defaults of sub-prime mortgages rose to a 7-year high (i.e. there was a perceived increase in counter‑party risk).
By August 2007, concerns within the repo market reached a point of critical mass with two hedge funds linked to investment bank Bear Stearns defaulting resulting in a ‘run’ in the repo market as cash investors were flocking to short dated maturities US Treasuries and no longer accepting securities of longer maturity or lesser credit quality as collateral which were previously deemed as safe.
This resulted in the repo market becoming more concentrated in only the highest-quality collateral given the collapse and closure of repos in corporate bonds and structured products. Hence, as a result credit lines were cut resulting in multiple institutions experiencing an inability to access sufficient quantities of liquidity.
By March 2008, the lack of market liquidity and the write down in securities underpinned by subprime mortgages resulted in investment bank Bear Stearns becoming insolvent and requiring a rapid takeover by JP Morgan. At this point, the repo market was not accepting repurchasing agreements which had a maturity of more than a week.
Also, in the same month, the same market factors which led to the collapse of Bear Stearns also led to the share price of Lehman Brothers collapsing by 48% given that in 2007 Lehman Brothers underwrote $US 85 billion in mortgage-backed securities (MBS), which was more than any major financial institution and was four times their shareholder’s equity.
Significant financial losses in the 1st and 2nd quarters of 2008 ($US 2.8 billion and $US 3.9 billion respectively), ongoing liquidity and confidence issues (especially within the subprime mortgage market) as well as the loss of funds as major hedge fund clients and short term creditors withdrew their capital resulted in the financial collapse of Lehman Brothers with its announced bankruptcy on 15 September 2008 and thus the GFC and all of its economic and social horrors commenced.
Conclusion
In this article, we offer an introductory explanation of:
what is the ‘repo market’;
its role and significance in the financial system; and
how central banks use the repo market to transmit its official interest rate policy.
The ‘repo market’ is a critical market within the financial system of an economy as it signals important information:
about the cost of borrowing secured credit across an economy (i.e. the risk-free rate); and
the health of the financial system – specifically whether banks and major financial institutions
have sufficient cash reserves and whether sufficient trust exists between institutions and in particular asset classes.
When unexplained dramatic movements occur in the repo market such as liquidity (i.e. cash) drying up, it is a sign that those entities who are cash investors do not want to lend their cash in exchange for securities because of a lack of trust in either:
the underlying security (or collateral) underpinning the repurchasing agreement; or
the financial institution who is offering the security and their capacity to repay.
Left alone and the lack of liquidity within the repo market can increase the interest rates offered in these markets thus raising the risk-free interest rate and hence lifting market lending rates.
This can then lead to higher interest servicing costs for those financial institutions (i.e. commercial banks, investment banks and hedge funds), especially for those who are carrying significant amounts of debt (including those institutions who use debt to make large bets through financial derivatives) which can ultimately result in insolvency and bankruptcy.
If the financial ramifications of an institution or institutions who declare financial difficulty or even bankruptcy spreads rapidly and uncontrollably (i.e. contagion), a financial crisis is likely to ensue as was the case with the 2008 GFC.
John Adams is the Chief Economist for As Good As Gold Australia
[1] These assets typically include government bonds, corporate bonds or mortgage‑backed securities (MBS).
[2] The standard legal documentation for repos trading, both in Australia and internationally, is a Global Master Repurchase Agreement (or GMRA).
[3] Note that repurchasing agreements typically operate on an overnight basis – that the repurchase of the securities occurs the following morning of when the securities were first sold. Repurchasing agreements can also include longer than overnight periods. These types of repos are called ‘term' repos. Repos without a pre‑defined maturity date are called ‘open repurchase agreements'.
[4] Note that a repurchasing agreement (or ‘repo’) is when a party sells the security and agrees to repurchase it in the future, whereas a reverse repurchasing agreement (or ‘reverse repo’) is the party on the other end of the transaction, that is they are buying the security and agreeing to sell the security into the future.
[5] The interest rate is the percentage price difference between what the seller sold the security for and how much the seller sold the security back for.
[6] In the Australian context, these reserves are called exchange settlement balances. For information about reserve requirements established by the NYFR in the American context, see the following link: https://www.newyorkfed.org/aboutthefed/whatwedo.html
[7] Note that legal title of the underlying collateral does not always transfer or exchange between counterparties as part of a repo agreement, in this instance the relationship between the counterparties is one of borrower and lender rather than that of a buyer and seller.
[8] In the USA, the interest rate on unsecured debt is called the ‘Federal Funds Rate’ and in Australia, this interest rate is called the ‘cash rate’. In both cases, the unsecure lending market is where commercial banks use their central bank reserves to provide unsecure overnight loans to other commercial banks.
[9] A primary dealer in the USA context is a major commercial bank or financial institution which has been approved to purchase US treasuries bonds with the intention of reselling them to other organisations, thus acting as a market maker of US treasury bonds.
[12] In 2007, the equivalent repo market in Europe and the United Kingdom was approximately $US 10 trillion and $US 1 trillion respectively.
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