Repo Market Basics
By Linda Zuo on The Capital
As we know, the financial market facilitates the identification and transfer of resources — moving capital into the right hands at any given moment. Businesses and individuals all operate at different stages, following their own plans and making rational decisions accordingly. Capital, therefore, flows through the financial system from a party with excess resources to a party requiring funding for its operation. That is how the repo market (repurchase agreement) comes into play.
Modern corporates are complicated systems. They generate revenues by selling products; the profits netted from their expenses are used to expand operations or reward the owners. Not all revenues and expenses are realized in cash instantaneously so in the meantime, they need to manage their cash carefully so they won’t keep too much cash in their accounts that bear little interest income but they must also reserve a sufficient amount to meet any matured liability requirements. It is natural to think sometimes these corporates may screw up. They are likely to run out of cash one day and cry for more cash to pay their creditors the next day. The repo market emerges in this context and allows these companies to agree on short-term lending contracts with lenders. The borrowers will send financial securities that are trade-able and generate future payments as collateral to lenders; they will receive cash from lenders in return and promise to repurchase the securities the next day with a bit of a premium. With the trade-able collateral, lenders feel more secure about lending out money and they are able to earn a small amount of interest while taking negligible risk. Investment banks and hedge funds normally hold large amounts of securities and are willing to post them out for cash to fund their operations; asset managers and money market funds will sit on the other side of the table and function as cash providers.
The repo market does not only serve private sectors. In fact, government may also step in to monitor and intervene in the market movement. Central banks have statutory powers to create money or reserve and when needed, they could lend the in-hold reserve to the repo market and therefore boost money supply. As previously mentioned, corporates need cash to keep their daily operations running and they may turn to banks asking for overnight loans. By law, banks are also required to maintain a certain level of funds to ensure that they can meet liabilities in case of sudden withdrawals. Once the money in their account falls below the bottom line, banks face the risk of breach and they will seek money elsewhere such as other banks, federal reserves or the repo market. That’s why the reserve available in our financial system is essential in determining the power shift between money supply and demand, which shows how easy it is to access funding and therefore influences the ‘price’ of money as reflected in interest rates. If the repo rates goes up, it indicates the current money demand outweighs the amount available. This does not apply to the repo market only. In fact, this reflects investor sentiment in the whole short-term cash funding system and repo is only a part of it.
Governments and other market players all constantly monitor the repo market. Any unusual movement could be an indicator of severe issues. During the 2008 financial crisis, repos played an important role in Lehman’s demise. Lehman Brothers relied heavily on a substantial amount of overnight cash loans by posting ‘junk’ collateral rather than traditional high-quality assets. This discouraged lenders from further releasing liquidity to the market; the whole system quickly seized up, which resulted in the final collapse of these big names. A few weeks ago, the repo rate spiked to 10%; this upheaval drew significant attention worldwide and the Federal Reserve quickly stepped in to bring the rate down to its normal level. The cause is still unclear though people have speculated whether this could be the signal of the next crisis. No one knows, but we will see.
