Today's dumb question from the back of the Finance class. (But I would guess some other students might not know the answer either, and some maybe hadn't even thought of the question).
[Update: just to be explicit, I am not asking why lenders want security for loans. I am asking why I don't sell my watch instead of pawning my watch.]
I want to borrow $80 for one month. I have a watch worth $100. I go to the pawnbroker, hand over my watch as security, and borrow $80. I promise to repay the $80 plus interest next month, and the pawnbroker promises to give me back my watch if I do this.
That's like a "repo", which is short for "sale and repurchase agreement". It is as if I had sold my watch for $80, and the pawnbroker had promised to sell it back to me, and I had promised to buy it back from him, for $80 plus agreed-on interest next month. If I borrow $80 on a watch worth $100 there's a 20% "haircut". (The difference is that in a repo I get to keep wearing the watch for the month (I get the coupons on the bond) even though the pawnbroker legally owns it.)
Why don't I just sell my watch instead, then wait till next month before deciding whether to buy it back?
Why do I and the Pawnbroker choose to agree in advance on what we will do next month? Why don't we just wait and see what we will want to do next month? The future is uncertain. We usually wait to get as much information as possible before deciding what to do. We might change our minds when we get new information. If we do make promises about what we will do in the future, there must be some reason that outweighs the benefits of making that decision with better information when next month arrives.
Three possible explanations that come to my mind:
1. Maybe this particular watch has sentimental value, because it used to belong to my grandfather. It's worth $150 to me but only $100 to anyone else. So there's not a competitive market in this particular watch. If I sold it, and then wanted to buy it back, the repurchase market would be a market with bilateral monopoly. The new owner would have monopoly power, and I would have monopsony power. We would haggle over the distribution of the $50 gains to trade. That haggling would be costly, and the outcome would be uncertain. So to avoid those costs and risks, the pawnbroker and I agree on the repurchase price beforehand. By bundling the sale and repurchase together, the price doesn't matter, as long as the haircut is big enough so the pawnbroker has sufficient security.
Or maybe there's a Market for Lemons problem. Any particular watch might be a lemon (have some hidden defect). The owner will have better information than a prospective purchaser on whether the watch is a lemon. If I offer to sell my watch to the pawnbroker, because I need temporarily need cash to buy something else, he doesn't know if i really need cash or if I'm trying to get rid of a lemon. The repo eliminates the Market for Lemons problem (as long as the haircut is big enough). If I'm selling a lemon watch I'm also buying a lemon watch, because I agree to buy back the exact same watch.
Those explanations make perfect sense if I'm pawning my watch. They don't make sense if I'm pawning a Canadian or US government Treasury Bill. Tbills, for a given issuer, maturity, and "run", are fungible. They are all the same.
2. Maybe there are transactions costs of buying and selling watches. There's a spread between the bid and ask price, even though all watches are (by assumption) the same. The market-maker in watches, who quotes bid and ask prices, always puts a spread between bid and ask prices for fear he might make losses when informed traders, who have better and quicker news about things affecting the future demand or supply of watches, decide whether to buy or sell from him.
By pawning the watch, rather than selling it and buying another watch next month, both I and the pawnbroker eliminate the risk that the other is better informed than we are about whether the market price of watches represents a good buying or selling opportunity.
That explanation might conceivably work for Tbills too. Bid-ask spreads are very small, but not zero. But it's not obvious whether it works empirically. Are the transactions costs of a repo lower than on two separate trades?
3. The future price of watches is uncertain. If I know I will want to have a watch again next month, it is as if I have a short position in one future watch. If I sell my watch, I face the risk that the price of watches will be higher next month, when I buy a replacement. If I am risk-averse, I will want to cover my short position by agreeing now on a price at which I will buy a watch next month. I buy a future watch, Cash On Delivery (because I don't have the spare cash now), to cover my short position. Pawning the watch covers my short position, and eliminates the risk.
That explanation too might conceivably work for Tbills. If I have a portfolio full of Tbills, for safe income in my retirement, but I need cash now for a month, I might borrow rather than selling my Tbills. Because if I sold my Tbills there's a risk the price might be higher next month, so I would be able to buy back fewer and my retirement income would be lower. I have short position in safe retirement income that I initially have covered by my ownership of Tbills. When I sell my Tbills I now am net short again. But if I repurchase at the same time I immediately re-cover my short position.
But it's not obvious whether it works empirically. Do the people pawning their Tbills have a future need for those same Tbills for some other purpose? Are they pawning Tbills that have a considerably longer maturity than the loan, and then hanging onto those Tbill after the loan is repaid?
Those three explanations are all I can come up with. Which one of those three explanations (presumably not the first) applies to repos of Tbills? Or are there other explanations I've missed?
Why do I ask? Well partly just out of interest. But also because I think that the answer to the question "why does repo exist?" might matter for monetary policy.
1. Sometimes central banks do repos (and reverse repos, which are exactly the same only with the central bank on the other side of the deal), and sometimes they do Open Market Operations (either sales or purchases of bonds). Whether it matters whether central banks use repos or OMOs, and how it matters, might depend on why repos exist.
2. Some economists have said that there is a shortage of safe assets for repos. And some (I think) have said that central bank OMO purchases worsen that shortage of safe assets for repos. I would understand these questions better if I understood better why repos exist. (If the central bank buys bonds for cash, why do people need the bonds for repos, when they already have the cash?)
Worthwhile Canadian Initiative 
Nick
Perhaps you already understand this, but at the risk of stating the obvious.
If I lend money to RBC short term, say via commercial paper (or a demand deposit) and it goes bust tomorrow, then I am unlikely to get much back: Lehmans creditors perhaps 10 cents on the dollar?
By contrast, if I take security over a particular asset from their vault, with a haircut (the degree of overcollateralization) then if they go bust, I have claim to a specific asset and can sell it.
Thus Repos are key to liquidity in interbank markets, because of this high level of asset protection for any short term liquidity loan.
#3
Repo is nothing other than secured borrowing, a loan of cash secured by relatively risk-free securities securities.
If your question is “why do people do so much secured short-term borrowing,” the answer I think roughly has to do with the preferences for leverage in the financial industry: returns on equity are higher when there’s a cheap way to lever your portfolio.
If your question is “why do people denominate their short-term borrowing as repo” I think the answers begin with worries about the perfection of security interests and the bankrupty treatment of secured lending denominated as lending, though they also shade into things like “Repo 105” where you can for accounting purposes sometimes disguise this lending as something other than lendign.
was this post inspired by this Felix Salmon blog – if so, well you’ve already seen his answer, if not, he suggests repo exists because of the “desire on the part of people with money to lend out money but to take no credit risk while doing so”.
Matt: but if you’ve got a T-bill, why not “borrow” by selling the T-bill? If buying a T-bill is lending, selling one is borrowing, and “risk-free” borrowing at that. What does a repurchase agreement add to this?
For stocks, etc. it makes sense to me; you are gaining creditworthiness by securing your loan with them. For risk-free assets it seems like an outright sale is best.
Nick: point 3 makes sense for risky assets, if you want to borrow but still want your portfolio to have exposure to that asset (as speculation, as a hedge, or just for the higher expected return). I agree it doesn’t make much sense for a risk-free asset.
“Maybe this particular watch has sentimental value, because it used to belong to my grandfather. It’s worth $150 to me but only $100 to anyone else. So there’s not a competitive market in this particular watch. If I sold it, and then wanted to buy it back, the repurchase market would be a market with bilateral monopoly. The new owner would have monopoly power, and I would have monopsony power.”
To have monopsony power, don’t you also have to be able to afford to buy the watch for more than $100?
Did you see Tomura’s BoC 2012 working paper on this?
[link here pdf NR]
…or the Monnet and Narajabad paper? [link here pdf NR]
valuethinker and Luis: Yep. I get that. (I’ve just updated the post to make it more explicit earlier). Lenders want security for a loan. But why does the borrower borrow against that security? Why not just sell the asset instead of using it as security?
Luis: yes, that Felix Salmon post did trigger my writing this. But I’m asking a different question, and it’s one he doesn’t ask.
Matt: “If your question is “why do people do so much secured short-term borrowing,” the answer I think roughly has to do with the preferences for leverage in the financial industry: returns on equity are higher when there’s a cheap way to lever your portfolio.”
I think that’s maybe a fourth explanation? In my #3, I pawn my watch rather than selling it because I want to reduce my risk. You are saying I want to increase my risk.
Suppose I sell my watch to buy a bike. I have sold one risky asset and bought a different risky asset.
Suppose I pawn my watch to buy a bike. I now own two risky assets — the watch and the bike (strictly, in a true repo, I don’t own the watch, but I do own the right to buy a watch at a cheap price, and that right is a risky asset.)
At least some people in the industry [link here NR] seem to like explanation #3, which makes sense to me.
Repo will be attractive if you want to short a particular security (i.e. speculate that its price will fall.) Repo allows me to buy the security now and sell it later at a fixed price. That allows me to turn around and resell the security at a spot price today, hoping to buy it back at a lower spot price in the future, just in time to turn around and resell it to my repo counterparty.
Because repo is often short-term, it is great for short-term speculative short positions. Interest rates are also very competitive and the market is typically liquid for major players.
Sounds like a good way to speculate against indebted european government bonds.
Min: “To have monopsony power, don’t you also have to be able to afford to buy the watch for more than $100?”
Yep, but next month (if all goes as planned) I will be able to afford to pay $150 to buy back my watch.
Alex: good points (I think). We must be careful to define “riskiness” relative to the other risks faced by an individual. If you need to be able to tell the time for the next 10 years, then owning a watch that will last 10 years eliminates that risk, even if watch prices fluctuate. Because you have covered your “real” short position. (I’m using “real” by analogy to “real option theory”.)
Simon: Thanks. No I haven’t. I will do so.
Nick,
aha, I see.
Say I own a $100 T-bill, maybe I want to borrow to buy more T-bills. So selling my T-bill to buy a T-bill doesn’t get me anywhere. If I borrow against it, I use the money I borrow to buy another T-bill, which I borrow against, use the money to buy another T-bill … so I end up with highly leveraged exposure to T-bills. Is that right? I may be embarrassing myself in public, never having taken any finance classes.
Would help to clarify where repo rates are vs. t-bill rates and other sources of funding for the banks.
At the long end of the curve, there will be a clear difference between the yield of the security and the cost of money to finance it in the repo market. So the question “why repo” is not very different from the question “why lend money for term and borrow daily to fund” – and the answer is to capture the term premium.
If the securities used as collateral are of similar maturities to the terms of the repo, this argument doesn’t hold as well, unless:
1) the borrowing rate on repo is less than what the mkt makes the gov’t pay on t-bills (hard to see why this could be so, except that the haircut makes repo loan a senior claim on the security, and so marginally safer than the security itself (only works in theory if there is perceived to be some risk to the security).
2) The mkt for t-bills is not as liquid as you would imagine, esp for off-the-run stuff. It is easier to just borrow against the value of the portfolio than to dump in onto the market and hope not to move prices against you in the individual securities.
This is a very good question. I don’t have the answer.
Somewhat OT, but it seems to me that the other question raised by the shift from unsecured lending to repo is, why do we have private banks?
Historically, the reason we have a system of private credit money is that economic actors prefer to hold the liabilities of banks to the liabilities of ultimate borrowers, both because they safer and — even more — because they are liquid, they can be transferred to third parties. But if banks themselves now prefer to hold government liabilities to other banks’ liabilities, it’s not clear what purpose the bank-based payments system is serving.
Regulation. This about is rehypothetication and leverage rules.
We all know the story about how banks create money, but in the real world (futures trading OTC derivatives etc) we don’t need money we need to point to an asset to secure our contracts. Repo and rehypothetication is how we create assets to do this without interacting with those monetary policy rules like reserve ratios and the monetary base..
So if you think back to the old story: ten dollars of base is deposited. Then the bank lends 9 dollars to someone else, leaves their promissory note in the vault and gives them the 9 in cash which is then deposited and so forth. Now all the bank customers go to the stock exchange and pledge the value of their accounts as collateral. Yum, we’re all making money.
Now someone decides that since banks are insured by the government, this is too risky and bans the use of these accounts as collateral….
This is where repo and rehypothetication come in. In the language of repo, that banking situation is the same as taking a ten percent hair cut and having unlimited rehypothetication–except we don’t need banks. And we all still get to claim we have assets when meeting our collateral requirements when really it is all the same asset. (indeed what’s happened is that the piece of paper which says we can get the asset back tomorrow is itself the collateral).
The reason there was a financial panic and shortage of tbills is that the haircuts went up–which is e same as raising the reserve ratio:
[link here pdf NR]
The result was a collapse in an important money aggregate and a sudden surge in demand for base money, but the base of the pyramid is the asset like tbills. So when the CB buy tbills to expand their monetary base, they deplete the asset. Why does this matter because the currency of financial markets is not the national currency. So this is more like a devaluation game. Okay, why don’t they just switch to using real base money instead of tbills? Because that’s illegal, you’re now in the realm of banking regulation intended to curtail speculation..
Yes, the purpose of repo is to increase risk.
“Some economists have said that there is a shortage of safe assets for repos. And some (I think) have said that central bank OMO purchases worsen that shortage of safe assets for repos. ”
This is small potatoes. It is like printing money in a denominations not accepted in casinos. A tiny AS shock.
Simon (and Louis S): I have skimmed the first two papers you linked to. They look really good and interesting. But they raise an empirical puzzle: if the reason for repos is some variant of my #2 (transactions costs of buying and selling bonds quickly) why is it that some of the most liquid assets seem (am I wrong?) to be most widely used in repos? Why do people repo US Tbills, which are some of the most liquid assets that exist? Why isn’t the repo market dominated by illiquid assets instead of US Tbills?
Louis S: “1) the borrowing rate on repo is less than what the mkt makes the gov’t pay on t-bills (hard to see why this could be so, except that the haircut makes repo loan a senior claim on the security, and so marginally safer than the security itself (only works in theory if there is perceived to be some risk to the security).”
OK, so a repo is doubly safe for the lender. If the borrower goes bust, you can still sell the watch. If the watch goes bust, you can still go after the borrower.
Excellent question! I’ve thought about this too, and a few years ago I did a brief research proposal for a class attempting to suggest some answers. I don’t remember all my conclusions too well, but I was similarly puzzled by the “repo a T-bill” phenomenon, and I eventually decided:
(1) As Louis S says, the market for Treasury securities is not as liquid as you would think. There is not a single source of good evidence for this, but you can look at this paper by Griffiths, Lindley, and Winters, who find that the average bid-ask spread for off-the-run one month T-bills never fell below 4 basis points from 1991 to 2001. This doesn’t sound like much as a one-off expense, but if your liquidity requirements are changing, it would cost an extraordinary amount of money to simply buy and sell the T-bills. If your average turnover is once a month, you’re coughing up 48 basis points per year, which is extremely unfavorable compared to the cost of raising liquidity in the form of repo, which is basically zero.
Other sources offer similar conclusions, though unfortunately all the data seems somewhat old. Fleming and Mizrach (2009) report that the average bid-ask spread for on-the-run 2-year Treasury notes is about 1/128 of 1% of par. This is very low (slightly below one basis point), but even so it’s enough to render frequent turnover completely uneconomical. And the bid-ask spread for on-the-run notes is generally far lower than the spread for off-the-run notes, which comprise the vast majority of notes outstanding at any given time.
(2) But this leaves the question of why transactions costs are so high for Treasury securities compared to repo. How can daily repo transactions cost almost nothing, while buying and selling a similarly sized portfolio of Treasuries every day would be completely ruinous? I think the answer is that the bid-ask spread on Treasury securities, like pretty much all spreads in financial markets, arises from asymmetric information. You might think that asymmetric information is pretty minor issue when it comes to a quasi-guaranteed, relatively short-term nominal asset like a T-bill or 2 year T-note… and it is, but it’s not quite minor enough to eliminate the last couple basis points of spread. (The spread for a 1 month T-bill seems particularly baffling, and I’m sure it has to do with details of market microstructure far too arcane for any of us to have a clue. But after some thought it’s possible to imagine some reasons for asymmetric information; key rates like LIBOR or the effective federal funds rate fluctuate somewhat from day to day based on the short-term liquidity needs of financial institutions (with the federal funds rate often going haywire on the Wednesday end of the 2-week reserve settlement period), and the clever person on the other side of the trade could be taking advantage of you. This adverse selection equilibrium is self-perpetuating, since with cheap alternatives like repo there is no particular reason for banks to be moving T-bills in massive volume every day, raising the chance that your trading partner is out to screw you.
The advantage of repo is that it is doubly, or arguably triply secured: there’s the value of the security itself, the haircut, and then the creditworthiness of the repo borrower. For someone to lose money on repo, the value of the security needs to fall by more than the haircut and the repo borrower needs to fail, all within the term of the agreement. The nice thing about repo-ing Treasuries is that, barring a fiscal crisis, their prices are negatively correlated with the probability of borrower failure. A world where banks are failing is a world where there is a flight to liquidity, and anticipated short rates fall. This makes repo pretty much as close to riskless as you can imagine, with truly negligible frictions from asymmetric information.
The picture isn’t so pretty when we have other, sketchier securities being used as repo collateral. There, asymmetric information might still be a problem for repo. But it is evidently even more of a problem for the securities themselves (much worse bid-ask spreads), meaning that repo is far preferable to buying and selling the securities for liquidity.
Matt Rognlie: Hey, it’s great to see you are still alive! I miss your blogging! (I will actually read your actual comment later!)
Nick,
Perhaps it has something to do with mismatch between receipts and payments. For example, suppose that I am a firm. I need to make some type of purchase today (say because of payroll or a contract), but I will not receive the income receipts necessary to make that purchase until tomorrow. I hold little or no cash in my portfolio because of its zero nominal rate of return. One thing that I could do is sell my Treasuries today, make my purchase, and use the income received tomorrow to purchase Treasuries. On the other hand, I could pledge the Treasuries that I have as collateral and borrow money from another firm overnight — i.e. a repo. I will choose the latter option when the transaction costs associated with selling and buying Treasuries exceeds the overnight interest payment on bonds (which I have to believe would be almost always).
Matt Rognlie: Very good comment. But it raises another question: if I would be buying and selling Tbills frequently enough that the transactions costs matter, why don’t banks take over and replace the repo market? I sell my Tbills to a bank, and the bank holds the Tbill as an asset and my deposit as a liability, and pays me interest. That way I can get a 0% haircut.
Are the transactions costs of banks greater than the transactions costs of repos? Or is it regulation?
Now I need to re-read Jon’s comment.
Money demand, Nick. Repos exist to meet the money demand. Repos are used to expand the liabilities of the shadow banking system. There is a huge demand for banking (and hence ‘safe’)liabilities that also bear interest.
Repos expand the money supply/ velocity of money without the central bank needing to. Pledged collateral is the best deal that portfolio demanders of money can get.
Without repos, the developed world would have faced the deflationary pressure of this increased money demand long ago.
“Suppose I pawn my watch to buy a bike. I now own two risky assets”
Yes! That is one of the most important reasons for “borrowing” using repo: leverage. Suppose you spot an anomaly in the bond market: if the bond is priced too low, it is usually only by a handful of basis points – not worth getting out of bed for on a cash basis. But if you can lever up 20:1, that’s a different story. This is possible because haircuts for government bonds are small. And of course, if the bond is priced too high, you want to short it and then a cash transaction is impossible. A more liquid security is better-suited for this application than a less liquid one because it has a lower haircut and smaller bid-ask: anomalies are easier to spot and to trade.
The plain old-fashioned “positive carry” – borrowing short and lending long in a rising yield curve environment – mentioned by some commentators is also an important motivation.
Ritwik: OK, but why not regular banks? Sell your Tbills to the bank, and the bank credits your account and you make payment by cheque?
“why don’t banks take over and replace the repo market”
Now you are talking from the lender’s perspective again. For corporate depositors in the US, the repo market is the bank deposit market. Corporate deposits are not insured and therefore such depositors demand collateral. Despite this, the haircuts demanded by corporate depositors vary according to the perceived creditworthiness of the repo counterparty; repo is not in practice “informationally-insensitive.” That is because corporations do not actually want to have to deal with the legal and market costs of counterparty bankruptcy.
Here is a related example – loosely a “repo” – where borrowing a security is much more efficient than an outright sale and repurchase.
Suppose that a small Canadian hedge fund wants to put on a US equity position; that requires USD cash. Of course, the fund could buy the USD outright with CAD to fund the position, but then it would be exposed to FX risk when the position is liquidated. This could be hedged with an FX forward (or other instrument) but the hedge would be expensive, particularly in small volume and for an unknown notional amount. It is much cheaper to borrow the USD and post CAD as collateral.
There is also an opportunity cost motivation. A bank that makes a market in bonds necessarily holds inventory, and this consumes appreciable funding capacity. The return earned by this inventory is generally not particularly attractive compared to the cost of funding. However, since bond transactions do not settle same-day, it is not necessary to have actual possession of a bond when it is sold. But the market maker would like to know the P&L of a transaction with certainty. So it can buy a bond, repo it out to recover the funding, and unwind the repo when it sells the bond.
a lot of repo activity is used for hedging (related to #3). If a corporation plans to issue debt, then while you cannot short bonds, you can enter into a reverse repo which has the same P/L profile as the underlying treasury.
Also, there are transaction costs – but there can also be tax and accounting related issues with selling a position and recognizing a gain or loss (and then re-entering it within 30 days).
banks not only don’t want to shut the market down, they make money as intermediaries.
someone may have mentioned it, but another issue is that many bonds settle (“T+3”) – three days from now whereas via FEDWIRE you can settle treasuries overnight. So theoretically you can have money that you only need to invest for say 2 days thereupon you need to guarantee that there is cash in your account when the other bonds settle (or vie versa: you may have sold bonds but the deal has not settled, so you can lend them out for a few days).
there are various types of repo: there is general collateral (which can be just about any high-grade liquid corporate bond or asset backed), but sometimes specific bonds trade “special” meaning there is specific demand to borrow a particular bond/note (hence you make more if you lend it out). bonds can be scarce for many reasons (its been parked away in a portfolio that does not want to sell for tax reasons, someone is short it, or there is a lot a corporate debt being issued whose reference price is that particular bond (think a large corporation issuing debt at the on-the-run ten year treasury + 100 bps).
dig out Fabozzi’s handbook of fixed income (a tome) i am pretty sure it has many sections on repo.
As others have said, I think the primary motivation for the borrower is leverage. I’ve never done a repo on T-Bills, but I have on much riskier assets. And the reason, every time, was to get leverage in a relatively painless way.
Nick, thanks. I am very much alive, though following a few comments I need to get back to work. : )
Matt Rognlie: Very good comment. But it raises another question: if I would be buying and selling Tbills frequently enough that the transactions costs matter, why don’t banks take over and replace the repo market? I sell my Tbills to a bank, and the bank holds the Tbill as an asset and my deposit as a liability, and pays me interest. That way I can get a 0% haircut.
Are the transactions costs of banks greater than the transactions costs of repos? Or is it regulation?
Isn’t this essentially what repo is, except that in your example it’s restricted to being between banks? Assuming that bank A and bank B reverse this transaction at the end of some predetermined period (which might just be a day, especially if the bank selling the Tbill and then repurchasing it thinks of this as a deposit), it’s repo. If there is no commitment to reverse by the end of a predetermined period, and instead (for instance) bank A is just selling the T-bill to bank B for a deposit in bank B, then you have all the usual adverse selection problems of trading, which imply a bid-ask spread?
By the way, I didn’t mean to dismiss the other function of repo, which is basically to serve as a convenient form of collateralized borrowing. (Many, many others have mentioned this.) This may well be the main purpose of repo, and there is a definite (though not precise) analogy to other forms of collateralized lending. You borrow to buy a house rather than pay rent because there are economic reasons that make it efficient for you to own it. (Alignment of ownership and occupancy mitigates agency problems, etc.)
Similarly, you borrow to own an asset (or borrow against that asset rather than selling it when you need money) because there is something about that asset that jibes with the overall design of your portfolio. Maybe you’re using it as a hedge, maybe you have good reasons to speculate on it, etc. It makes more sense for you to own that asset than for your creditor to own it (where “ownership” is meant in the sense of being the ultimate claimant to its returns; of course, part of the definition of repo is that formal ownership passes temporarily to your creditor, but this isn’t the kind of ownership that usually matters for financial assets). My guess is that repo is just a convenient, regulation-friendly way to arrange a securitized lending transaction that has (from the perspective of a creditor) many of the features of a bank deposit.
What puzzled Nick and I is the use of securities with extremely stable values (e.g. short-term Treasuries) as collateral in repo transactions, because aside from maybe a few hypertechnical considerations, there isn’t much reason to incur a debt in order to buy an asset with almost identical characteristics. This is where all the stuff about repo being more liquid than T-bills comes in.
This reasoning doesn’t seem like it should be very relevant right now for banks, since most of them are sitting on massive piles of excess reserves, which from a bank’s perspective are the most liquid asset of all. (Pretty much every transaction, if you look closely enough, is ultimately settled via Fedwire; even the alternative clearinghouses/payment networks are just mechanisms to more efficiently net out payments before eventually settling whatever remains with Fedwire.) There is an interesting implication here: if the “collateralized deposit” rationale for repo is now all that matters, we should see short-term Treasuries being used as collateral far less than before.
Hm, you think too theoretically about the “problem”. Repos exist because there are normally balance sheet and/or accounting constraints which do not allow for outright selling of assets. If you take liquidity book of a bank it is 99.9% booked as HtM and not 0% as you hypothesize. HtM means hold to maturity and this accounting treatment allows banks to avoid mark-to-market volatility of their holdings in the p&l statement (also on sales you do not want to show p&l). However it is still a liquidity book and therefore should be able to provide liquidity. This is where repo comes in because it is a secured lending from those who is long liquidity to those who is short liquidity, it does not require balance sheet sales of assets, can be used to liquidity management operations and allows to eliminate counterparty credit risk because lending is secured and assets are therefore ring-fenced.
Nick, are you asking:
1. Why do short term collateralized loans exist? Why are not all loans either long term loans or uncollateralized loans?
I think it shouldn’t be hard to imagine the answer.
2. Given that there is a market for short term collateralized loans, why don’t banks monopolize this market and squeeze out, for example, private sector non-financial corporate lenders? What competitive advantage would banks have to do this?
Or perhaps the real question is
3) Given that there is a market for short term collateralized loans, why would the loans be structured so that failure to pay allows the counterparty to “keep” the collateral (because failure to pay is equivalent to failure to buy back the collateral) as opposed to requiring the lender to undergo a foreclosure proceeding?
IIRC, muslim banking is similar to a repo, in that the lender buys the house and the borrower has a contract to gradually buy it from them for a certain price at a later date.
@rsj
I took Nick’s question to be, “why would anyone secure a loan of money with collateral that is similar to money?” The point of my CAD/USD example is that sometimes it is convenient to collateralize a loan with something that literally is money!
There are other examples where money is used as collateral, but the asset being collateralized is not liquid. I presume that Nick would not be puzzled by that – he would just invert the terms as say that the asset is the “true” collateral.
“why would anyone secure a loan of money with collateral that is similar to money?”
Ahh.
I would say that Treasury Bills are similar to money because they can be repo-ed so easily. Or less extreme, the ease with which they can be repo-ed is a function of how “money”-like they are.
Nick,
First, I think you underestimate what constitutes risk to a bond trader. While a 3-month t-bill might look like a riskless instrument to you, to the trader on a bank’s short term funding desk, it represents an arbitrage between her funding costs and the yield on the t-bill. All her profits come from trading the spread between short term instruments. While you see a yield of 5%+/-0.25%, depending on Fed actions over the next couple of meetings, the traders p&l and and entire job is just the +/-0.25%. So to the people who are trading t-bills, there is nothing risk free about it. As you move out the term structure, it should be clear that there is nothing riskless about bonds for almost anyone.
Second, when a trader in a bank, broker/dealer or hedge fund (or other leveraged player) buys a bond, she will finance that purchase in whatever way is cheapest. A straightforward way is just to borrow at the institutions internal funding cost, typically libor based. Typically that is not the cheapest, though. If another trader wants to short a bill, bond or whatever, she has to reverse repo it and then sell it. But when you are short selling e.g. a 5-year bond, you really want to sell the most liquid 5-year around for the simple reason that you need to buy that same issue back when you want to close your short position. Particular issues can get “parked” in large portfolios and be near impossible to find, in which case a short seller could find it extremely expensive to close out their position. For this reason, short sellers strongly prefer the most liquid, “on-the-run” bond issues, and therefore the repo rates on those securities are significantly lower than the risk free (fed funds) rate. So if you buy such a liquid treasury bond, you don’t want to fund your purchase at the general risk free rate; you want to repo it to someone who wants to short sell it and who therefore wants to lend you money against it at a very low rate.
I think that explains a lot of the repo market. There’s also a “general collateral” (GC) market which is a repo market where the collateral is determined buy the borrower after the deal is made. So it’s not useful for getting particular bonds to short sell, and for that reason the rate is more of a pure risk free interest rate. This is the market the Bank of Canada manipulates in OMO repos.
GC is a very important market for clearing interbank balances. I.e. if I write you a check, then your bank takes on a liability to you and my bank no longer has a liability to me. So my bank has to compensate your bank with a payment of some reserves. Seeing as my bank doesn’t have excess reserves (in fact, since we’re Canadian, my bank doesn’t have reserves at all), it borrows those reserves from your bank (who doesn’t want to hold excess reserves anyways). But, since your bank doesn’t want to have credit exposure to my bank, it extends the loan against GC.
rsj: there’s Phil’s and Matt Rognlie’s answer, as to what the puzzle is. But you can also think of it more abstractly: a repo is two transactions bundled into one. Which is puzzling. Why would we bundle the two transactions into one? And one of those transactions is a forward transaction.
I can understand why I might sell a watch. It’s because I want the cash more than the watch, and the buyer wants the watch more than the cash. Gains from trade.
I can understand why I would buy a watch next month. It’s because I will want a watch more than the cash, and the seller will want the cash more than the watch. Gains from trade again.
1. But why don’t I wait until next month before buying the watch? Why do the repurchase now?
2. Why bundle the two transactions together? Why do I sell a watch and buy a future watch from the same person at the same time in one double-transaction?
If we are talking about real assets like watches, the puzzle is easily resolved. Transactions costs, and hedging against the uncertainty of future prices. Can those same things also resolve the puzzle when we are talking about short term bonds?
Actually, though my head is still not clear on this, there’s a parallel here to barter vs monetary exchange. In a barter exchange I do one transaction: I swap an apple for a banana. In a monetary economy I need to do two transactions to do the same thing. First I sell my apple for money; then I sell my money for a banana. We normally explain monetary exchange by explaining why the sum of the transactions costs of those two transactions is actually less than the transactions cost of the one barter trade. Because of coincidence of wants, etc.
Sergei: “Hm, you think too theoretically about the “problem”.”
Nah, the trouble is that other people aren’t thinking theoretically (abstractly) enough! So they can’t see the puzzle! 😉
So your theory is that repo exists in order to fool the accountants? That’s actually a theory that has some merit in some cases. Like that Greek swap thingy? But it can’t explain all or even most repos, can it? The accountants ought to have figured it out by now. And when I pawn my watch I don’t care what my accountant says about it.
Nick @5:09,
Why do people borrow? It is two transactions — first borrow, then repay.
Let’s assume that we are not puzzled by why people borrow.
Then there is a need to borrow against collateral because risk is reduced.
Without including risk, there is no reason to require collateral. But even if you borrow against collateral, what happens to your collateral when your borrower goes bankrupt? You have to wait in line with all the other creditors. What happens if your borrower refuses to pay? You have to sue them to get the collateral. Banks are finding out that it is not easy to part households from their homes, even though those homes are collateral. It can take a year of litigation.
With a repo, the borrower gives (or rather sells) you the collateral for less than its market value, and he buys it back later on. He is repaying a loan, but because you own the collateral outright, there is no need to charge a premium for the risk of litigation or bankruptcy. If the borrower runs away, you keep the collateral without needing to sue them for it.
Nick, sorry, it is a puzzle for you and other people because you are more interested in abstract theory than in real world. So what I said is not a theory. It is real world. And it is not about fooling accountants because accountants created these rules because accountants are interested in the real world. You can theoretically out-think yourself but the point of repos is not to opportunistically trade assets but to reduce unnecessary volatility of p&l statements. And volatility of p&l statements is BAD. There is no theory about it, it is just for all practical purposes BAD. If you sell an asset, you have to book a p&l gain on it. Full point. But repos are not about trading, they are about short term liquidity management. Liquidity has a price and this price is different from prices and their changes of any other asset in the world be it financial or real.
Nick – you asked “Are they pawning Tbills that have a considerably longer maturity than the loan, and then hanging onto those Tbill after the loan is repaid?” They are – the overwhelming majority of repo transactions in the private market have a maturity between overnight and three months and the assets involved have a longer maturity. The case when both the repo and the asset expire on the same date is a much rarer product known as repo-to-maturity which is traded for entirely different reasons (usually accounting-driven).
Obviously this links in with the transaction cost argument as well – if I have a 5-year T-bond and keep buying and selling it on an overnight basis, it can get expensive quickly. But this is also a matter of flexibility – I can decide to roll my overnight repo today, not roll it tomorrow if I have some extraordinary requirements, again roll it day after and so on.
If you want the gory details and all the other reasons why the repo market exists, try Moorad Choudhry’s book ‘The Repo Handbook’ – chapters 5,6,7 and 13 should be sufficient to put you to sleep. Worth noting that from the lender’s perspective, it is more than a secured loan in that legal title actually passes over to the lender. So it is in fact better than a secured loan – as a lender, the asset belongs to you and is in your possession and can be liquidated by you. Repo of riskier assets can also carry not only an initial haircut but also a variation margining process where changes in MtM are exchanged on a regular basis. So again not just a secured loan by any means. In fact the legal docs go out of their way to ensure that the first leg is treated as a genuine sale so as to avoid getting caught up in bankruptcy proceedings.
The implications for monetary policy partly arise from the fact that they subvert reserve requirements even in normal times when we don’t have excess reserves and interest on excess reserves etc – quoting from page 22 here :
“The ECB for instance applies a zero reserve requirement to repos, regardless of counterparty, whereas the Bank of England only excludes repo transactions with other banks (equating them with interbank loans). Since the United States reserve requirements impact only on transactions accounts, repo liabilities are not included.”
To take an example, govt issues T-bonds, I buy them and repo them with bank for cash -> increase in money supply.
To take a more typical pre-2008 example, party A tranches some MBS into a large AAA super-senior tranche, I buy this tranche and repo them with bank for cash -> increase in money supply.
Neither case has any impact on reserves even if they were binding. Also illustrates why the textbook credit-money distinction is increasingly redundant.
The corollary for the current situation is that when the CB buys assets that are already repoable with negligible haircut, it has no impact on money supply. As a holder of the T-bond, I could have converted it to money anyway if I had so desired.
On the whole reduction in safe assets via QE argument, the logic depends upon the bonds supporting a larger quantity of repo-money via the process of rehypothecation and this ladder being taken away via QE. Absolutely possible but I’m not convinced.
GC is a very important market for clearing interbank balances. I.e. if I write you a check, then your bank takes on a liability to you and my bank no longer has a liability to me. So my bank has to compensate your bank with a payment of some reserves. Seeing as my bank doesn’t have excess reserves (in fact, since we’re Canadian, my bank doesn’t have reserves at all), it borrows those reserves from your bank (who doesn’t want to hold excess reserves anyways). But, since your bank doesn’t want to have credit exposure to my bank, it extends the loan against GC.
That’s not the way the Canadian Payments Association works, AIUI. Cheques generally are cleared in ACSS by netting transactions at the end of the day; the balance gets made up at 10AM the next day through overnight loans. In the far more important and far larger Large Value Transfer System, payments are secured through either Bank of Canada balances (Tier1 1) or against a pledged pool of assets from the banks involved (Tier 2). Still, transactions are netted and settled at the end of the day, not instantaneously. LVTS is a deferred net settlement system, not a real-time gross settlement system.
The US and Canada use different payment models due to the fact that there are much fewer players and the players are larger in proportion to the economy in Canada.
Nick, I don’t think the issue is to so much fool accountants, rather its to engage in transactions which are consistent with a particular accounting characterization. The accountants know about repos, but they don’t care, because the economic reality is consistent with the accounting characterization, notwithstanding the fact that, legally, they’re a sale and repurchase. You might not care about the accounting characterization of pawning your watch, but if had to preparing financial statements for your investors, you might. It also might matter if the tax results follow the accounting treatment (I believe, but stand to be corrected, that the US characterizes repos as secured loans for tax purposes).
Another explanation that was given to me(by someone who is knowledgeable about the sector – infinitely more so than I am) was that from the “lender’s” perspective, a repo is perceived as being safer than a collateralized loan. In your pawnbroker example, he may have a security interest in your watch, he may have possession of the watch, but the watch isn’t his. If you go bankrupt and don’t repay your loan, he will probably be able to acquire title to the watch and sell it, but its potentially messy and it may take time (I don’t pretend to be a finance lawyer, but intuitively that makes sense – that’s why creditors, even secured creditors, spend a lot of money in bankrupcty proceedings). In contrast, if you repo your watch and if you don’t repurchase it from the pawnbroker, hey, legally it’s already his. If you go bankrupt, and get a stay against your creditors, not his problem, he’s not a creditor (unless the value of the collateral has declined, but then only to the extent of the shortfall), he’s the proud purchaser of a watch, he can sell it off the minute you fail to fulfill your obligation (in fact, he can sell it off before that time if he wants). The additional security for the creditor may be marginal, but all else being equal it might mean that you can carve a basis point or three off your cost of capital. In that case, you can see why a market for repos would emerge.
The forward market for tbills is not as liquid as the spot market or the repo market. Gains from trade on the spot and in the repo market.
“3) Given that there is a market for short term collateralized loans, why would the loans be structured so that failure to pay allows the counterparty to “keep” the collateral (because failure to pay is equivalent to failure to buy back the collateral) as opposed to requiring the lender to undergo a foreclosure proceeding?”
Following up on my last point, I think (though I don’t pretend to be a bankruptcy expert either) the answer is that, the loan agreement would be subject to the applicable bankruptcy law, and the possibility of a stay of proceedings against creditors, in the event that the borrower declares bankruptcy. So long as the collateral is the property of the borrower, it would be subject (or at least potentially subject to that stay). With a repo, the creditor doesn’t have to worry about the bankruptcy of the borrower, because the collateral is his property, not the borrower’s.
Ashwin: very useful comment.
rsj: “Let’s assume that we are not puzzled by why people borrow.”
If I own a real asset, like a farm, it is no puzzle why I should borrow rather than selling my farm. High transactions costs of selling and buying, and I’m the best manager of that asset. But if I own a financial asset like a bond, it’s more of a puzzle. Why should I be a borrower and a lender at the same time? A puzzle, not a contradiction. We are exploring the possible answers to the puzzle. Transactions costs, and different risks, and accountants, and government regulations.
Thanks for all the good comments everyone. I’m still mulling them over. There seems to be more than one possible explanation, and not mutually exclusive. I’m thinking of how to categorise them, and their implications for monetary policy.
At the moment, I’m still thinking in terms of two broad categories: transactions cost explanations (my #2); and risk-shifting explanations (my #3, only broader). I see the first as more “money”, and the second as more “finance”.
“So they can’t see the puzzle! ;-)”
Yes, I must confess that’s true: I can’t see the puzzle. Phil the philistine once again.
Fixed terms of redemption are necessary condition of the leverage argument. When I take a position expecting to “buy low and sell high”, I can never be sure about that selling high part. But at least I can be sure of my buying price – so long as there is a repurchase agreement. If I had to buy my bond back at market price, then I could never profit from my position.
Great post and great comments. But Nick, I don’t understand your resistance to the idea of repos allowing firms to minimize earnings volatility. Do you doubt that firms like to minimize their earnings volatility?
It seems the only reason for a Tsy repo market to exist (i.e. that resolves Nick’s puzzles) is to speculate (long/short) on future interest rates.