What Is the Repo Market? Why Does It Matter?

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1 Introduction

Repurchase agreements, or 'repos', are a form of secured borrowing and lending. In the New Zealand context, repos are predominantly used by banks for managing short-term fluctuations in their cash holdings, rather than for general balance sheet funding. However, in many offshore markets, there are entities that use repo markets to fund leveraged position-taking in securities. Some major securities Arms, such as Lehman Brothers and Bear Stearns, funded a substantial portion of their balance sheets in this way.

The repo market was a key channel through which the Global Financial Crisis (GFC) was transmitted. (1) As asset prices declined during the crisis, repo lenders increased the amount of collateral required for a given level of cash lending. This meant that investors holding leveraged portfolios of securities were not able to undertake the same level of secured borrowing via repo markets as they had previously. The ensuing funding shortfall forced investors to lower their leverage by selling assets, which contributed to even lower asset valuations that fed back into further asset sales, creating a 'vicious cycle'. Stresses also appeared in repo markets backed by government securities, as exceptional demand for these safe-haven assets led to shortages.

Overseas regulators have since been seeking to increase the resilience of repo markets so that they become a more stable source of funding during periods of market stress. (2) In this way, regulators hope to avoid a repeat of the events that exacerbated the crisis. More recently, the focus on repo markets has intensified, given signs of revival in some markets, which had been in steady decline since the crisis.

Activity in New Zealand's repo market has also recovered, with turnover in repos that use government securities as collateral hitting record highs in late 2011. However, New Zealand's repo market is different from those offshore because domestic banks, which are the main market participants, do not typically rely on repos for funding. The resulting low level of leverage limits the sensitivity of the market to swings in risk appetite. Furthermore, the small size of our repo market and the dominance of low-risk collateral means that it is much less likely to transmit shocks to other markets. As a result, we do not believe that the New Zealand repo market poses a systemic risk to the wider financial system. However, we will continue to monitor developments in this market.

2 Repurchase agreements

A repurchase agreement is a contract in which a seller of securities agrees to buy them back at a later date at a predetermined price (see figure 1, overleaf). A reverse repurchase agreement, or 'reverse repo', is a contract in which a buyer of securities agrees to sell them back at a later date at a predetermined price. The two agreements are the opposite sides of the same transaction. The buyer of the securities is the lender, while the seller of the securities is the borrower, using the securities as collateral for a loan at a fixed rate of interest.

[FIGURE 1 OMITTED]

A key distinction between repo lending and a collateralised loan is that legal ownership of the security is transferred, providing the repo lender with stronger control over the collateral, as well as quick access to collateral if the counterparty defaults. Other key features (3) of repo agreements include:

* At the termination date, when the borrower repays the lender, the repurchase price for the collateral will include an interest payment, sometimes called the repo rate. A repo that uses a mixture of non-specific government securities as collateral is known as a general collateral (GC) repo, and the repo rate in this case is known as the GC rate. The relative safety of government securities allows the GC rate to be lower than other repo rates.

* The lender is only exposed to changes in the value of collateral if the borrower defaults, because the forward contract sets the price in advance at which the lender resells the collateral. …