Repo: The heart of the global financial system and why the SEC took action

The US Securities and Exchange Commission (SEC) on 13 December approved new rules to mitigate the systemic risk in the repo market, a relatively obscure and arcane corner of the global financial system, yet its beating heart and home of up to USD 4 trillion in trades each day. Coming into effect in phases by June 2026, the rules will require cash and repo transactions in US Treasury securities to be centrally cleared

This volume alone would seem to vindicate the action. But what makes repo transactions important and leads to frayed nerves for markets and regulators when the system ceases to work properly?

Understanding repos and repo trading

A repo is essentially a short-term cash loan typically backed by high-quality government securities, such as US Treasuries, as collateral. It is a market where financial institutions and central banks borrow and lend money, often overnight. A reverse repo is the other side of the transaction, where a party sells securities, raising cash, with a pledge to repurchase them.

Repos are important for several reasons, two of which are:

1. They are a fundamental pillar of transmitting central banks’ monetary policy to the market and economy, providing a lever to control inflationary pressures and the money supply in the economy.
2. The collateralized nature of a repo transaction makes it a critical secured funding tool for banks, hedge funds, money market funds and brokers to raise cash more cheaply than they would otherwise be able to, as well as to diversify their borrowing and risk.

At the core of repo trading is the interest rate – this is the rate at which the central banks, such as the Bank of England, the Bank of Japan, ECB, and the US Federal Reserve, lend money to commercial banks.

Suppose authorities want to rein in inflation or reduce borrowing in the economy. They can raise the repo rate as a deterrent to make it more expensive for commercial banks to borrow money and thereby reduce the money supply in the system. Similarly, central banks can tweak the repo rate to encourage borrowing and stimulate demand.

Markets look to the repo rate as a reference for all other interest rates, including mortgages. US Treasuries play a unique role in repos, such that investor confidence in them is critical to the stability of the global financial system.

The other main function of repo transactions is as a secondary market where financial players can lend securities for short-term funding. For example, a commercial bank might have a shortfall of cash to fund its daily operations but hold securities that may be used to collateralize this cash need and reduce the interest rate it would pay otherwise for unsecured borrowing. It could sell those securities with an agreement to repurchase them at an agreed price. It also works the other way. A fund might have an excess of cash on its balance sheet and aims to generate additional revenue by exchanging the cash for collateral that it will sell back at a profit.

The key benefits of trading in repos are their relatively low-risk and highly liquid nature, together enabling financial market participants who require liquidity to move fast.

A smooth-running market with sporadic malfunctions

The recent volatility in the overnight repo rate of US Treasuries is pertinent in reminding regulators of the limitations inherent in a system underpinning global capital markets.

The “flash rally” of 2014, the US Treasury repo market stress of September 2019, and the COVID-19 shock of March 2020, collectively raised questions about the US Treasury market’s continued capacity to absorb shocks. “Although different in scope and magnitude, these events all generally involved dramatic increases in market price volatility and/or sharp decreases in available liquidity,” the Fed said this month.

A malfunction in the market can impact borrowing costs for governments and other financial players. And it can hinder the ability of central banks to use repos as an effective monetary tool. Given the size of the US repo market, with some USD 4trn traded daily, higher borrowing costs could force participants to sell securities at a loss or even default on obligations.

When financial institutions are reluctant to lend or struggle to raise cash in the repo markets to finance their daily operations, there is greater potential to create negative market sentiment and increase asset selloffs in the broader financial markets.

A spike in the overnight repo rate four years ago to 10% indicated a cash shortage in the market. The Fed pumped cash into the financial system through repo and reverse repo transactions, helping to bring down the rate and boost reserves in the system.

The event reminded authorities that the repo market needs to be more resilient and stable. Although the 2008 global financial crisis led to new supervisory and structural regulations for asset classes across the board, reform of the repo market has been slow. A lack of transparency and built-in systemic risk persists.

More clearing but risk shifted elsewhere

A concern long held by regulators is the number of transactions cleared by a central counterparty, who becomes the legal buyer to every seller and the legal seller to every buyer, and thus a guarantor of the transaction.

The scenario prompted the SEC’s recent adoption of new rules. The aim? A more efficient, competitive, and resilient market.

“The $26 trillion Treasury market — the deepest, most liquid market in the world — is the base upon which so much of our capital markets are built,” said SEC Chair Gary Gensler in a press release. “Having such a significant portion of the Treasury markets uncleared — 70 to 80% of the Treasury funding market and at least 80% of the cash markets — increases system-wide risk.”

Of particular concern is the increased role played by non-bank players, such as hedge funds, in the secondary repo market, who trade bilaterally over-the-counter (OTC) and are often highly leveraged, yet relatively lightly regulated in comparison to the larger inter-dealer market participants that traditionally have contributed to the core repo market.

New rules to regulate repos

This non-centrally cleared, bilateral segment of the US repo market, where there is no central source of data, has long been a blind spot for regulators, the US Office of Financial Research (OFR) said in a blog post in August 2022.

The SEC’s new rules aim to get more trades through a centrally cleared process.

According to a paper published by the OFR in May 2023, central clearing has two advantages for market participants.

‘’First, it can significantly reduce counterparty risk. Second, it allows a dealer to net their repo positions with one counterparty against reverse repo positions with another counterparty for the purpose of calculating certain regulatory ratios, thus reducing the balance sheet costs of participating in repo.’’ Given those two key benefits, ‘’the large volumes in non-centrally cleared bilateral repo something of a puzzle,’’ the OFR noted.

The SEC recognizes the criticism and concern that increasing central clearing and settlement can increase costs for participants and potentially reduce liquidity. In addition, systemic risk is not removed entirely, but potentially displaced, as mentioned in ION’s September blog, US Treasuries: Central Clearing Solutions.

While ‘’providing benefits to market participants, the concentration of these activities at a covered clearing agency implicitly exposes market participants to the risks faced by covered clearing agencies themselves, making risk management at covered clearing agencies a key element of systemic risk mitigation,” the Fed said.

Power dynamics, OTC blunt monetary tool

A peculiarity of the repo market is its traditional way of doing business.

According to a GreySpark/ION study last month, Global Repo Trading: Trends & E-Trading Report, the non-standardized nature of repo trading means that it historically was – and largely still is – a predominantly voice-traded market that “tended to lead to a manual, often disjointed process for all market participants, with little automation.’

However, several brokerage venues now frequently trade repo and other securities financing and money market products electronically, leading to cost-savings and greater efficiencies.

The market structure also impacts the efficiency of monetary policy as a tool.

A working paper in August 2022, issued under the auspices of the ECB, highlighted how dealer banks ̶ those entities authorized to buy and sell government securities ̶ have the market power to secure better prices than non-dealer banks and non-banks in repo markets.

‘’As a result of dealer market power, our estimates show that only 53.3% to 70.7% of the inter-dealer repo rate passed through to OTC customers during the ECB’s September 2019 rate cut,’’ according to the paper.

It said that allowing non-dealer banks and non-bank access to repo trading platforms may improve monetary transmission efficiency by 26% to 39% in different OTC repo markets.

Moreover, the paper suggested granting non-bank financial institutions access to a secured deposit facility like the Fed’s Reverse Repurchase Facility. Through this backstop facility, the Fed sells securities to cash-rich entities with the pledge to repurchase them at a set price, thereby helping to ensure the market functions smoothly and that monetary policy is implemented effectively.

Such measures could alleviate collateral scarcity or liquidity frictions, and improve stability and efficiency in times of market stress.

The overall effect of more regulatory oversight of the repo market and other industry trends in recent years has encouraged a gradual shift towards repo trade automation and electronification.