In this piece I will explain the basics of how repos work, and give a shallow overview of the different repo markets. I hope this overview is broadly informative, as delving into the depths of the financial system is a foreboding challenge without understanding many things that are often brushed over and never explained.

Fundamentals

Repurchase agreements, or colloquially, repo agreements, undergird a large portion of interbank lending and funding that is crucial to the functioning of the modern financial system. Despite being a relatively niche topic, the importance of this form of transaction is paramount for forming a cohesive view of how banks operate.

Formally, repurchase agreements are a ‘sale and repurchase’ of an asset. Someone who requires dollars will sell the collateral and agree to repurchase it on a later date. However, it is much simpler to think of repos as collateralized loans. Where the repo borrower borrows dollars and the repo lender borrows collateral. When a borrower places an asset as collateral (think of a pawn shop where someone in need of money places something of value as collateral for a loan) to protect the lender against default risk, the loan becomes collateralized or securitized. Many of these repo transactions are overnight loans that are securitized (collateralized) by a U.S Treasury. This is illustrated in the abstract below.

Here a U.S Treasury (UST) is transferred from the borrower to the lender, and reserves (dollars) are transferred from the lender to the borrower.

Repo borrowers usually pay haircuts on their collateral, meaning that with a 2% haircut, a $100 UST may only be able to be used in a loan of 98 dollars, this is to cover fluctuations of the collateral’s price. Haircuts vary given the pristineness of collateral (UST vs. junk bond) as well as exogenous financial conditions.

At the end of night, these two parties could continue this deal and roll it over, or unwind it by repaying the loan and giving back the collateral. In the instance where the borrowing party cannot pay back the loan, the lender seizes ownership of the collateral.

Specialness

As an aside, sometimes certain collateral will become highly valuable due to supply and demand interactions and trade at a premium, making repo rates significantly less and often negative. This is called trading ‘special‘. It is formally defined as a repo rate that is distinctly below the General Collateral Repo rate. This happens quite often but is not very intuitive, as it postulates that someone is paying money for someone else to borrow it. A special trading repo can be thought of as a collateral driven repo, where it is the collateral that is being pursued, not necessarily the cash. This quirk fits in nicely with the larger post-GFC global collateral shortage theme, where these pristine assets are highly sought after.

Market Structure

While the commonly referred to ‘Repo Market’ implies there is one broad market, there are quite a few different markets that each are distinct.

Tri-Party Repo

The most observable repo market is the Tri-Party Repo market. This market is quite large, averaging $1.1 trillion dollars daily on average in volume. Here there is a 3rd party that facilitates repo settlement, called clearing banks (Bank of New York Mellon and JP Morgan Chase). They settle the transactions on their own balance sheets take custody over the collateral during the transaction. They also provide various services including daily evaluation of the collateral and daily remargining of the collateral among other things. The lenders in this market do not know the specific collateral that is pledged, which makes rehypothecation somewhat difficult.

The other participants in this market are cash investors and the security dealers. Cash investors are typically money market funds, securities lenders, and mutual funds, though they are much more diverse than the security dealers. These cash investors serve the role of the repo lender, lending cash and receiving collateral.

On the flip side, security dealers are typically large Primary Dealers. These dealers are banks that have permission to trade directly with the New York Fed, and compared to the cash lenders are much more concentrated in number.

Bilateral Repo

The other main type of repo is bilateral repo, where there is no third party involved in the transaction. Within the bilateral repo domain there are the uncleared bilateral repo market, the General Collateral Finance (GCF) repo market, and the Delivery-versus-Payment (DVP) repo market. The Fixed Income Clearing corporation (FICC) is the central counterparty for the GCF and DVP repo markets, and the GCF market additionally has tri-party custodian services. These markets are more opaque than the Tri-Party market, but arguably more important. Uncleared bilateral repos in particular have little to no official data, however there has been attempts to understand how this market functions. I will go over the differences of each of the markets without going into too much detail.

GCF Repo

The GCF Repo market is a blind interdealer market, wherein participants do not know who they are dealing with. Transactions are intermediated by an interdealer broker. This market also has tri-party custodian which offers collateral management services akin to the Bank of New York (BONY) Tri-Party Repo Market. Dealers use this market frequently to finance their inventories (assets being used as collateral), as well as using it for collateral upgrades. For example, they can obtain cash by posting a Mortgage-backed security, then use that cash to obtain a U.S Treasury. Only collateral that can be transferred using Fedwire, a real time settlement system used by the Fed, can be used in this market, which limits collateral to Treasuries, Agencies, and Agency MBS. This market is typically an inter-bank or inter-dealer market, where large dealers will lend cash to smaller dealers. Transaction volumes in this market was reported at $126 billion per day in 2020, making it noticeably smaller than the BONY Tri Party Repo Market.

DVP Bilateral Market

Similar to the GCF Repo Market, this market allows Treasuries and agency collaterals to be used over Fedwire, however unlike the GCF market, this market does not allow use of agency MBSs. This market primarily uses Treasuries as collateral, and repo lenders know the specific type of collateral being pledged, making collateral rehypothecation much more frequent in this market. There is also no tri-party custodian in this market unlike the GCF repo market. This market is much larger than the GCF Repo Market, averaging $1 trillion dollars in volume daily. On net, money market funds are primarily repo lenders in this market while Hedge Funds are overwhelming repo borrowers. However both dealers and banks make up the majority of the market on both sides.

Uncleared Bilateral

There is scant data or information on this market, so I will keep this section short, however this market is still vital to the financial system functioning efficiently. There is no central counterparty in this market nor tri-party intermediary. This market consists of individually negotiated contracts between borrower and lender. Thus trust is typically an important factor in this market as well as the usage of high quality collateral (U.S Treasuries). We do know hedge funds are the most prominent borrowers in this market.

Summary

Below are two figures which do a excellent job visually outlining this web of markets, and I do recommend reading the articles from which they came from as they are both very informative. The figure below shows the differences between the different repo markets.

Office of Financial Research

This figure outlines the web of markets and how they all relate to one another.

Monetary Mechanics

It is insightful to view repo as a form of money, as it supplies a medium of exchange for the financial system. By allowing the short term financing of securities, repo serve as the expedient form of exchange that our credit and market based system depends on. Banks are inherently funding constrained and thus rely on short term funding to meet marginal demand for loans. Repo serves as an incredibly dynamic role in the extension of liquidity in markets and credit to the real economy.