Since Repo rates spiked on 16th September, the US Federal Reserve has pumped upwards of $500 bn into the Repo market. However, any discussion about Repo seems a bit like looking at a twig in a river, a different perspective can be had depending on the angle you look from.
Discussion since rates spiked on September 16th has included the characteristics of repo, banks LCR ratios and what this technically means regarding their engagement in the repo market. The position of dealers in terms of liquidity and possession of treasuries/collateral and sponsored repo, the players involved and what the rules enable actors to do.
But these aspects although crucial to understanding the market, don’t really explain the full picture. Repo is a useful tool, a mechanism financial entities can use, but if it does not prove useful, it can be circumvented or disregarded and other transactions can be utilised, such as Total Return Swaps (TRS) employed by Goldman. The bank sought to replicate repo with TRS which reduce the capital standards required for straightforward trading in repo. Goldman deployed TRS to exchange a return from US Treasuries between itself and Hedge Funds. One entity makes payments based on a set rate while the other party makes returns based on the total return of the underlying Treasury.
The utilisisation of TRS by Goldman raises the question of whether Repo itself, what it is and how it functions should be the focus or whether the activities of financial entities within and outside repo that should be of interest. A mechanical approach that seeks to *fix* repo doesn’t begin to analyse the different angles and depths of entities transactions and funding needs.
If we briefly consider two theories. The first one being Complexity Theory, as argued by Anderson. This asserts the decisions of economic entities are determined by a cognitive function which determines behaviour from a set of rules. Order is seen in complex situations which is useful for considering how financial entities might adapt in complex environments. The second theory is a model conceived by this blog, The Financial Innovation Model (FIM). The FIM possesses a rational maximizing function which ultilises and manipulates financial markets. A self-interest function evolves to prevent regulatory or institutional limits obstructing the pursuit of goals.
Complexity theory might consider the approach of the Financial Stability Board in 2012 which advocated applying numerical floors on haircuts at a transactions level for Security against Cash Transactions. It is suggested that regarding TRS, proposed haircuts should take into account proposed haircut schedules for non-centrally cleared derivatives when formulating numerical floors for Security against Cash Transactions.
However, whilst it is useful to examine detailed transaction types and risk areas, the FIM would liken this approach to trying to catch a deluge in a paper cup. There are so many transactions and the structures, and the features of shadow banking are complex and multi layered. Opportunities are always present to evade and manoeuvre to securitise and intermediate to gain value from collateral. However, such processes can create complex, fragile feedback loops. Arbitrage and innovation are different processes that are intrinsic to financial markets. In regards to repo, rather than Treasuries being an asset dealers got backed up with, they seem to have become a new opportunity to evade regulation and enhance potential for gain.
This makes suggestions that the Fed effectively establish a standing repo facility as rather besides the point. Does this mean it oversees a market that might have outlived its usefulness, whilst failing to comprehend potentially damaging activities on the margins. JP Morgan’s use of Sponsored Repo might circumvent Liquidity Capital Ratios and make transactions nettable, but this could create problems as Sponsored Repo is only available overnight, so should a Hedge Fund need to roll a position they can only do this overnight, if dealers don’t have balance sheet, there might not be liquidity available.
Hedge Funds have also utilised an innovation that exploits differences between comparable securities in the Treasuries market. Relative Value Trading uses price differences between two almost identical assets. A Hedge Fund would buy Treasuries and sell a derivative contract like interest rate futures and extract a small price difference. To make this worthwhile, to compensate for the small price difference, the Treasury that is purchased, is bought and exchanged in the repo market for more cash which is used to improve the trade and duplicated to build up leverage and increase returns. It is said to fuel this trade, Hedge Funds submitted increased demands for cash in September which contributed to September’s repo rate spike. Trades that hinged on the ability to secure large amounts of cash from banks became problematic when the supply ran out.
To go back to the earlier analogy, solutions to the repo madness have seemed to stay on the bank of the river looking from one angle, claiming to know how things work. Utilising this approach many months later, we are no closer to gaining an understanding.
Rather than looking at repo as a market in isolation, it might be more useful to examine the complex web of non-bank entities engaged in structures that seek to carry out off-balance sheet credit intermediation, maturity and liquidity transformation in capital and money markets. It is these processes that drive needs for funding, the actions and consequences of which then transmit into financial markets. Repo is simply the twig at the surface of the river, the layers and depths underneath are what sustain and redefine the many angles it represents.
actionsandconsequences 