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 
Anonymous Qunat’s comment leads me to the following thought:
Are there really two separate theories of repo: my #2 transactions costs; my #3 risk shifting?
Suppose there were zero transactions costs. Would we still do repos to shift risk? I don’t think we would. Because instead of doing a repo, I could just as easily do two separate transactions: sell my Tbill to Tom; buy a Tbill forward from Dick. It would be a total concidence (the same coincidence of wants that is invoked to explain money vs barter) if Tom and dick were the same person, i.e. if the person who wanted to buy my Tbill also wanted to sell me a Tbill forward.
So the #3 risk shifting argument also requires transactions costs. Or else some reason why that coincidence of wants isn’t really a coincidence.
wh10: Thanks! Definitely some of the best comments on any WCI post (definitely not the best post, except insofar as it lead to the best comments). I expect the “accounting” theory might explain some repos. But the comments here from the people who know the market better give explanations that have nothing to do with accounting. And the accounting theory does seem to rest on fooling people. And if an activity were so widely known you would have thought that people would have gotten wise to it by now.
“And the accounting theory does seem to rest on fooling people”. People (investors, perhaps?), maybe, but not accountants.
Possible opening lines for my next post on this subject?:
“The central puzzle of monetary economics is why people use two transactions when one would serve the same purpose. (Why do I sell apples for money, then turn right around and sell that money to buy bananas? Why don’t I just swap my apples for bananas?) The central puzzle of repos is why people use one transaction when two would serve the same purpose. (Why don’t I sell my TBill to one person, then buy a Tbill forward from another person?). The answer to both questions must be “transactions costs”. But why are two transactions cheaper than one in the first case, and one transaction cheaper than two in the second?”
“But why are two transactions cheaper than one in the first case, and one transaction cheaper than two in the second?”
Just to be clear, in each case there are two transactions, in the apple and banana world there are two transactions with three people, whereas in the repo world there are two transactions with two people.
Surely the distinction is that in your apples and bananas world there are two goods and money, while in your (hypothetical) repo world there’s really only one good and money. You’re not repo-ing your t-bills to buy bananas, you’re repo-ing your t-bills today to buy t-bills tommorow (and have cash on hand in the meantime), and the lender is buying t-bills today to sell them tommorow. In the repo world there is always a double co-incidence of want, because there’s only one good and the difference between the buyers and sellers is simply one of time preference. Sure, you could sell the t-bills to one person and repurchase them from another, but why bother, when your friendly neighbourhood banker has developed a a package deal.
Going out on a limb here because this is not my area of highest expertise.
Repos are done because they are two transactions that get treated like one. Sell a long dated asset, with an agreement to repurchase, and it gets treated as a short term loan.
That makes a lot of difference for how the repo transaction is treated for: GAAP and Regulatory accounting, regulatory capital, Asset-Liability testing, and bankruptcy. Since the repo gets treated as a short collateralized loan:
1) It gets favorable capital treatment
2) It gets treated as a cash-like borrowing for interest-rate testing purposes, rather than a short-dated financing of a long-dated asset. Trouble is, in a crisis, with mark-to-market and falling collateral values, there is both liquidity and credit risk.
3) It doesn’t get caught in bankruptcy.
4) It’s cheaper than borrowing directly to hold onto the long dated asset.
5) the asset gets to stay on the balance sheet, with a corresponding entry on the liability side for repurchase transactions.
6) you have the flexibility to end the repo financing if the terms are no longer desirable, or if you want to sell the asset outright.
My main problems are the capital treatment of repos, and asset-liability treatment for financial institutions. Even safe assets being repoed are subject to low-frequency, high-severity events akin to a run on the bank, where no one wants collateral, everyone wants cash, and no one wants counterparty risk. It would be nice for the financial regulators to make the banks do a stress test to makes sure banks have enough capital, such that if the repo haircut went up by a factor of 5-10x during a general credit/liquidity crisis, the bank survives.
Aleph: “3) It doesn’t get caught in bankruptcy”
Just to be clear, that a repo doesn’t get caught in bankrupty isn’t a function ofthe fact that it’s treated as a short term collateralized loan. That’s a function of the fact that it ISN’T a short-term collateralized loan, notwithstanding that it’s treated as such.
It’s about trading, mostly, and financing trading inventory.
And it’s about risk management, which means hedging costs as you go along. You know the original cost of the bonds, and the repo cost, so you know what your accrued cost will be at your chosen point in the future (repo maturity). You pick the future point that you want to free up your flexibility (often just overnight) to make a decision to sell outright rather than repo again.
“The future is uncertain. We usually wait to get as much information as possible before deciding what to do.”
I’ve seen that before here. That’s wrong. That’s not how risk management works. You don’t wait. You make term financing decisions now. If the world worked as you describe, there’s be no bonds or no term structure on anything in finance. Everybody would “wait” and never decide, while all interest rates clocked in continuous time.
Nick,
To follow-up on my point, let’s imagine and apple and banana world with no cash. So that’s equivalent to our repo world with t-bills and cash. And let’s suppose that this is a world where the banana holders want apples today, but not tommorow, while the apple holders want apples tommorow, but not today. In this case, wouldn’t you expect to see reciprical transactions between apple holders and banana holders? Heck, even in the absence of any meaningful transaction cost, that’s the world that will arise since one agreement will always be easier to enter into than two.
JKH: “You know the original cost of the bonds, and the repo cost, so you know what your accrued cost will be at your chosen point in the future (repo maturity). You pick the future point that you want to free up your flexibility (often just overnight) to make a decision to sell outright rather than repo again.”
Just to play devil’s advocate here, surely that would also be true if you sold the bonds to one person and simultaneously entered into a forward purchase agreement for bonds with another person (I concede the point that, in practice, that isn’t likely to be feasible). I think Nick’s point is that economically (and legally) that isn’t really much different from a repo transction, except that it’s with two counter-parties rather than one. But maybe the answer is that, sure, but isn’tthe counter-party to the forward agreement going to want to hedge his position? He could do that by entering into a forward with the person to whom you sold the bonds (or some other bond holder). But if he wants to do that, why not just hedge his position with you in the first instance by offering you a repo transaction.
Bob: “Just to be clear, in each case there are two transactions, in the apple and banana world there are two transactions with three people, whereas in the repo world there are two transactions with two people.”
I disagree.
Suppose I go to Tom, and swap a basket of my apples plus carrots, for a basket of his bananas plus dates. That’s one transaction (contract), with 2 people and 4 goods.
Now suppose I go to Tom, and swap a basket of my current TBill plus my $84 next month, for a basket of his $80 today plus his Tbill next month. That’s one transaction (contract), with 2 people and 4 goods. (I’m adopting the Arrow-Debreu “dated goods” approach, in which an apple to be delivered next month is not the same good as an apple to be delivered today).
“In the repo world there is always a double co-incidence of want, because there’s only one good and the difference between the buyers and sellers is simply one of time preference.”
The fact that trade is in dated versions of the same two goods, and that one of those goods is the medium of exchange, must indeed be part of the answer. But even then it’s not obvious there will be a coincidence of wants if there are differences in time-preference. Yes, it would be obvious if there were only two time periods; just as a coincidence of wants would be obvious if there were only two goods — apples and bananas. (In a barter economy with n goods there are (n-1)n/2 markets; in a monetary exchange economy there are (n-1) markets; and when n=2 you get the same number of markets (one) in both.)
And somehow (but I’m not yet sure how) this money/barter stuff must be tied in with the idea of shadow banking.
Oh, I really do find this stuff fascinating! I can’t help it!
Hmm, slightly unconvinced. Not by hte argument, but by the examle.
Pawning something includes an option value: I can decide not to redeem my pawn.
Repo doesn’t.
To really stretch things, a bit like the difference between a future and an option. “Must” and “May”.
Bob Smith,
Supply and demand.
The counterparty to the repo has the reverse repo.
There’s all sorts of institutional demand for outlets through which to invest cash on a short term basis. It’s part of institutional liquidity management. Reverses are very liquid because they can be contracted to as short maturity as desired – overnight is most common. And reverse repos pay a contracted interest rate for a contracted term, so interest rate risk is taken out of the equation.
A lot of it is about the most efficient way of managing liquidity risk and interest rate risk together.
The repo borrower just has to come up with the collateral to satisfy the credit risk – but in a way that’s secondary to the main purpose from either a supply or demand perspective.
The repo borrower is motivated to finance inventory.
The reverse repo lender is motivated to deploy liquidity.
Both are interested in hedging interest rate risk for those two different purposes.
Sorry I’m not responding to all comments. It doesn’t mean they aren’t good comments (they are). It just means my brain can’t keep up.
Tim: fair point. I suppose it doesn’t matter much if the haircut is big enough. (And I don’t think you are stretching things at all when you talk about options. The pawn ticket is an option, not an obligation, to repurchase my watch.)
I thought i showed there are n^2 markets if you allow, people to trade everything for everything. 2 dogs plus some corn for a sheep. Etc. What you are saying is accurate if you only exchange single goods with each other.
Slightly off topic: … is there any difference between these two sequence of events for a Tsy repo:
(1) repo shadow banking: i.e. simple collateralized loan where no vertical money is created, and
(2) leveraged purchase of a Tsy financed by a bank, then repo
d as in (1), i.e. vertical money creations comment on the relation of (Tsy) repo`s to monetary policy.This maybe similar to a previous comment on rehypothecation, but I wonder whether it also has a bearing on Nick
Or 2^n. I’m out of here.
Edeast: “What you are saying is accurate if you only exchange single goods with each other.”
Correct. I had forgotten. But your n^2 can’t be quite right either. E.g. if n=1 there should be 0 markets, and if n=2 there should be 1. Maybe (1/2)(n-1)^2 ??? (My bad math strikes again).
jt: what is “vertical money”?
JKH: “That’s wrong. That’s not how risk management works. You don’t wait.”
Agreed. That was (roughly) my explanation #3. I buy my watch forward because I want to insure against the risk that watch prices will rise.
Sorry, I meant horizontal … bank money.
Just wanted it to be the powerset (2^n) to make my proof of uncomputability accurate. But what you are saying makes sense, so dunno.
Alephblog: and it’s certainly not my area of expertise either 😉 (but I’m much farther ahead now than I was yesterday).
Your explanation for repo seems based on regulations. I always have a methodological problem with theories based on regulation. I’m never quite sure how to state the counterfactual. “If instead of the existing set of regulations, the regulations were X, then we wouldn’t see repos.” But how would we define X in such a way that the theory was both true and interesting? Sometimes it’s obvious, and sometimes it isn’t.
Edeast: once we allow baskets (weighted averages) of goods to count as goods, I think there is an infinite number of goods. There is an infinite number of weighted averages of apples and bananas (like price indices).
jt: the terminology with which I am familiar is: outside money (central bank money); inside money (commercial bank money, that is redeemable on demand at a fixed exchange rate for outside money).
Horizontal = inside money. Cheers.
Ashwin: “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.”
What does “cash” mean in this context? Does it mean “demand deposit at the bank”? If it does, then is it any different from my simply selling the bond to the bank, with no repurchase agreement? (Unless the repo has no required reserves and the simple sale does.) This looks like the standard loans create deposits story, except that the loan is collateralised.
Nick,
First, I suppose that there’s a farfetched answer, it may well that there isn’t a double coincidence of wants in the Repo market, but we don’t observe the unfulfilled wants. How would we know if Repo “borrowers” enter into “synthetic” repo transactions by selling their t-bills to one party and entering into a forward with another? Maybe the repo market is just the subset of a broader group of transactions where there is a double co-incidence of wants.
More seriously, is the difference that one party (the “lender”) doesn’t have a time preference? Or, at least, is willing to enter into repos over a range of time periods. The double coincidence of wants, in that case, isn’t all that remarkable, given that one party (the “lender”) is willing to enter into transactions over a range of time periods. In that sense, we really do live in an environment with two periods, now, and any time in the future. That surely isn’t that remarkable a suggestion – we see the same thing in the loan market, where lenders are prepared to enter into loans over a range of terms.
The other point is that the lender doesn’t really want the t-bill, so does “double” coincidence of wants really matter? As long as it would hold it’s value and is reasonably liquid, the t-bill could be anything – indeed, in practice, I don’t think the “lenderL much cares about the characteristics of the particular t-bill so long as it’s worth at least 102% (or whatever) of the repurchase price. The T-bill is just a means of ensuring cash tomorrow. In that sense, the repo is really a cash-today vs. cash-tomorrow transaction, indistinguishable from a secured loan (subject, to possible application of bankruptcy law).
In that sense, it isn’t that different from the pawnbroker. No one wonders about the remarkable double coincidence of wants which causes pawnbrokers to be willing to acquire watches and boomboxes and what have you in the event that you fail to repay your loan. The pawnbroker doesn’t want his collateral, he just wants the cash he can sell them for. Obviously, the market for his collateral isn’t that liquid and is riskier, which is reflected in his interest rate, but it’s conceptually the same.
Ashwin: “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.”
But if there were no repos, I could also have sold it to convert it into money, by selling it. But I didn’t, until the central bank did something to persuade me to sell it to the central bank and convert it into money.
Josh: ” I will choose the latter option [repo NR] 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).”
Yep, but aren’t there transactions costs of doing a repo too? Why does a repo have lower transactions cost then the separate sale and purchase?
“To take an example, govt issues T-bonds, I buy them and repo them with bank for cash -> increase in money supply.”
That’s not correct.
That transaction alone only uses bank reserves.
It doesn’t increase the money supply – i.e. doesn’t increase bank deposit liabilities.
Conside a bond dealer. They have inventory. This inventory is over a variety of terms, and exposes them to interest rate risk. This risk is large compared to the expected profit in the retail bond business. If they structure their repos to match the durations, they will hedge that risk via the repo ‘shorts’.
Note: I didn’t make it clear when I was pecking my answer away… but I’m convinced that the CB purchasing tbills is a problem. I think currency/bank reserves can substitute for the asset creation done through repos–its just more costly and not preferred.
I’m open to a discussion about CBs negative interacting with the repo market… but mostly in my first comment this morning I was mostly trying to explain the point of view that I think motivated Nick’s inquiry–I don’t advertise that as my own fast opinion.
Michael: So bond dealers “borrow” their inventory of bonds? OK, that makes sense. But the stock of bonds in dealers’ inventory must be a very small percentage of the total stock of bonds, no? And if this were the only source of the repo market, we presumably couldn’t talk about a ‘shortage of safe assets for repos”. Because presumably if the total stock of bonds shrank, dealers’ desired inventories would shrink too, roughly in proportion.
JKH: I think that when Ashwin said “cash” he didn’t literally mean currency or reserves.
Jon: “I think currency/bank reserves can substitute for the asset creation done through repos–its just more costly and not preferred.”
And that is because they are treated differently by regulation? Would it be too crude an interpretation of your view to say that the whole repo market is just a way to avoid regulations on banks?
Sorry if this is redundant; I did not read the whole thread through. Traders generally “repo out” a bond as a source of finance for the bond itself. I buy bonds and simulataneously borrow the money for the purchase by means of repo. I get a “good” rate since government securities (“govvys”) are good collateral. T-bill collateral is both high credit quality and short dated, so there is small default risk and limited price volatility. Therfore, the “haircut” will be small and I can borrow almost the entire amount needed to fund the purchase. Further, certain “bonds”, at least in the days before massive government deficits deficits and enormous issuance sizes, were systematically scarce. For example, traders shorted the US 10 year note as a hedge to MBS inventory, corporate bond inventory, and many other products. So these shorts always needed to borrow the govvy collateral and it was always in short supply. As incentive to owners/ potential lenders of these “special” (to use the jargon) bonds, the shorts would offer to lend money at a cut rate. So if I wanted to buy the systematically scarce bonds, I could borrow the money at very low rates, sometimes zero (even back when money market rates were above 6%. That alone would e strong incentive to use the bonds as collateral for funding. If one needed or wanted to short those bonds, one always had to count on the pain of the “special” borrowing rate. Speculating on the ebb and flow of specialness, through term repo trades divorced from outright purchases and sales, was a big business. The repo business has a richly deserved reputation as a rough corner of the bond business.
“And somehow (but I’m not yet sure how) this money/barter stuff must be tied in with the idea of shadow banking.”
Yes. http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf
JKH- I don’t follow your reasoning. If someone trades a Tbond with a bank, the bank gains an asset an a deposit liability. That increases the money supply. If the person withdraws the cash, the deposit turns into currency, which is still an increase in the money supply.
Also- I was going to say, is this not something that could be answered by asking smart, informed market participants? Some might have commented on this thread already…
Gosh, a better answer to the question: Generally, traders sell bonds they do not own. They may sell them for speculation, hedging , or spread trading (buy bond x, sell bond y). They must deliver the bonds they sell short the next day at least by US convention), and so must borrow them back. That is why they do (reverse) repo. Old saying that works if the sayer is from Tennessee: “He who sells what isn’t his’n buys it back or goes to prison.” But he can borrow it for a while 🙂
wh,
“govt issues T-bonds, I buy them”
Nick,
“govt issues T-bonds, I buy them”
that alone uses reserves; that’s how bonds are settled
Ah right, I skipped the first step.
wh10: “Also- I was going to say, is this not something that could be answered by asking smart, informed market participants? Some might have commented on this thread already…”
yes and no. Take insurance for example. Why do I bet that my house will burn down? Because at the market price, it’s a good deal for me. Why does the insurance company bet that my house will not burn down? Because at the market price it’s a good deal for the insurance company. That’s all the market participants need to know. But it doesn’t really answer the question of why the market exists — why it makes sense for two people to take opposite sides of the same bet. Under what conditions will the same deal be a good deal for both? You can’t just ask one side of the market. Are they both risk-loving? Do they have different beliefs about the probability of my house burning down? These are all conceivable answers to why the market exists. But a better answer is risk-pooling.
But if we assume the govt sells bonds to spend, and they do, then repoing with a bank would be a net add to the money supply.
There are a lot of comments here, but if you want to get at the motivations of the main agents for participating in the markets, I’d reread the comments by Michael, JKH, Ashwin, and myself above (we’re all basically saying the same thing). The main issue that was missed in your post is that bonds are not risk-free instruments, and for whatever reason (different future income/consumption streams, different preferences and expectations) some people want to be short and some people want to be long. Also, repo is almost 100% overnight.
The classical portfolio theory view is simply that as well as choosing some appropriate asset mix, some agents who are relatively less risk averse will increase their total portfolio size beyond their total wealth by borrowing a the risk free short rate from agents who are relatively more risk averse and therefore choose to hold some of their wealth as risk free short rate loans. The loans are risk free by virtue of the fact that they are at the short rate and collateralized by a liquid portfolio of assets.
K,
” The loans are risk free by virtue of the fact that they are at the short rate and collateralized by a liquid portfolio of assets.”
If the central bank was not ready to discount bills, what do you think the repo market would look like? I think there is still risk in being short an overnight liability and long a 90 day liability; there is an institutional key to why the repo market is less risky.
Didn’t lehman brothers use repo to “hide” assets off balance sheet?
rsj: ” I think there is still risk in being short an overnight liability and long a 90 day liability”
Absolutely. But the the risk is almost entirely in the 90 day liability. But if we just look at GC type trades where the motivation is purely lending, then let’s just look at the risk in the repo trade. (In a GC trade the bond borrower doesn’t generally sell the collateral – they just hold it to give it back tomorrow). The only risk then is that the collateral loses more value than the haircut (and the counterparty defaults) which is extremely unlikely if the collateral is treasuries, the loan is overnight, and the haircut is adequate. So I don’t see why the repo market would depend on government support.
The main risk, I guess, is liquidity in the treasury market. If the market breaks down like post 9/11 then overnight risk can suddenly turn into multi-day risk just as the volatility of the collateral is spiking. So I guess government could have a role in providing emergency liquidity in the bond market but it’s not obvious why the same function can’t be provided by the private sector.
There was a large repo market for asset-backed paper, none of which could be discounted by the CB under then prevailing rules. In the repo market, there are haircuts depending on risk–just like the pawn broker will lend you less than your watch is worth. So the question remains: why lend when you can sell.
For an answer, see my previous posts…