Fixing the Repo Market: The Piece Regulators Missed When Reforming the Financial Markets

We all remember the hectic summer and fall of 2008, when the U.S. financial system was at the brink of collapse. Since then, policymakers have enacted structural reforms to the financial system but left the market in repurchase agreements largely untouched.

A repurchase agreement, or repo, is a sale of financial assets coupled with a promise to repurchase them later. Repos have economic characteristics similar to those of secured loans and bank deposits and are one of the main sources of liquidity for the U.S. financial system. Having developed free from the watchful eyes of regulators, the repo market has flourished. During the 2007-2008 financial crisis, however, that market ground to a halt, triggering a severe liquidity crunch. Financial institutions such as Lehman Brothers and Bear Stearns were brought to the brink of ruin because of their overreliance on repo financing. In the post-crisis regulatory agenda, however, the repo market was left at the periphery of the discussion. The Dodd-Frank Act, for example, though aimed at creating a safer financial system, essentially failed to address this important source of systemic risk.

In a forthcoming paper, I identify three weaknesses of the repo market that led to market failures: opacity, conflicts of interest and systemic risk. I challenge the currently passive regulatory approach to the repo market and propose a two-step reform that envisions a pivotal role for financial market infrastructure. I argue first for greater transparency through trade repositories and, second, for the reduction of conflicts of interests and the mitigation of systemic risk through the use of trading venues and central clearinghouses.

The American repo market developed into two main segments: bilateral and tri-party. In the former, parties agree on the terms and the performance of a bilateral contract. In the latter, parties set up a multi-party deal, where a clearing bank, acting as an agent, offers ancillary services in the management and transfer of the cash and the collateral. (A third, smaller segment is where repo transactions in fixed-income assets are centrally cleared by the Fixed Income Clearing Corporation).

The repo market’s first major weakness is opacity, which limits the capacity of regulators to oversee the market, assess its riskiness and intervene effectively in the event of a crisis. The lack of readily available and comprehensive information on market participants, trades and collateral used also reduces market efficiency by making the pricing of risk more expensive and potentially inaccurate.

The market’s second big weakness is the presence of conflicts of interest. It is a concentrated and closed market built around the operations of few dealers and two clearing banks.

The third weakness is that the repo market poses systemic risk. It is a major source of liquidity for the financial system, yet it lacks any stability buffer or safety net.

There is a strong case for regulating the repo market. The New York Federal Reserve took some steps to overhaul the tri-party repo market business, but further efforts are needed. They can best be made through changes in the role financial market infrastructure plays in the repo business.

First, mandate reporting of all repo transactions to trade repositories. That should create transparency, as the Financial Stability Board has argued.

Second, move repo trading to multilateral venues and have transactions cleared through clearinghouses. That should reduce conflicts of interest and produce efficiencies and stability. Trading venues can offer stable, non-discretionary and multilateral platforms that increase competition, reduce barriers to entry and keep transaction costs down, while promoting pre- and post-trade transparency. Clearinghouses operate as central counterparties and so can act as private stability buffers, mitigate systemic and liquidity risk, absorb and mutualize losses and cut conflicts of interest in the tri-party clearing market.

These structural reforms can help eliminate the repo market’s weaknesses, preserving an essential source of liquidity for the U.S. financial system.

This post comes to us from Paolo Saguato, a fellow in financial regulation at the London School of Economics. It is based on his article, “The Liquidity Dilemma and the Repo Market: A Two-Step Policy Option to Address the Regulatory Void,” which is available here. A previous version of this post was published on LSE Business Review.