Implications of repo markets for central banks

Executive summary

The purpose of this report is to enhance central banks' understanding of the economic and monetary policy role of repo markets and the policy issues surrounding the development of sound and efficient repo markets. The report is divided into three chapters. The first chapter, on the economics of repo markets, explains how they are used by private market participants for such activities as hedging and leverage. The second chapter focuses on the use of repos by central banks, both as a monetary policy instrument and as a source of information on market participants' near-term monetary policy expectations. In light of the benefits and the risks inherent in repo markets, the third chapter identifies those structural features (such as the legal framework and settlement systems) and market practices (such as adequate margining) that support sound and efficient repo markets.

In repo transactions, securities are exchanged for cash with an agreement to repurchase the securities at a future date. The securities serve as collateral for what is effectively a cash loan and, conversely, the cash serves as collateral for a securities loan. There are several types of transactions with essentially equivalent economic functions - standard repurchase agreements, sell/buy-backs and securities lending - that are defined as repos for the purposes of the report. A key distinguishing feature of repos is that they can be used either to obtain funds or to obtain securities. This latter feature is valuable to market participants because it allows them to obtain the securities they need to meet other contractual obligations, such as to make delivery for a futures contract. In addition, repos can be used for leverage, to fund long positions in securities and to fund short positions for hedging interest rate risks. As repos are short-maturity collateralised instruments, repo markets have strong linkages with securities markets, derivatives markets and other short-term markets such as interbank and money markets.

Repos are useful to central banks both as a monetary policy instrument and as a source of information on market expectations. Repos are attractive as a monetary policy instrument because they carry a low credit risk while serving as a flexible instrument for liquidity management. In addition, they can serve as an effective mechanism for signalling the stance of monetary policy. Repos have been widely used as a monetary policy instrument among European central banks and with the start of EMU in January 1999, the Eurosystem adopted repos as a key instrument. Repo markets can also provide central banks with information on very short-term interest rate expectations that is relatively accurate since the credit risk premium in repo rates is typically small. In this respect, they complement information on expectations over a longer horizon derived from securities with longer maturities.

An assessment of the risks faced by repo market participants can help identify the conditions necessary for sound repo markets. Like other financial markets, repo markets are subject to some credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralised instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralisation of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default. Leverage that is built up using repos can increase these risks. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.

Repo markets have offsetting effects on systemic risk. They are likely to be more resilient than uncollateralised markets to shocks that increase uncertainty about the credit standing of counterparties, limiting the transmission of shocks. However, this benefit could be somewhat reduced by the fact that the use of collateral in repos withdraws securities from the pool of assets that would be available to unsecured creditors in the event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means they may help transmit shocks originating from this source. Finally, repos allow institutions to use leverage to take larger positions in financial markets, which could add to systemic risk.

There are a number of structural features and market practices that support sound and efficient repo markets. Some, such as an adequate legal framework and settlement system and good margining practices, are essential to limit risks and to ensure the efficient and sound operation of markets, while others are probably less crucial. In addition to promoting these features and practices, authorities may want to conduct market surveillance of repo markets to help ensure that such practices are respected and to help detect instances of market manipulation or abuse. A number of features and market practices are especially important for sound and efficient repo markets:

• An adequate and efficient legal framework.There should be a clear legal definition of the repo contract (including buy/sell-back and securities lending agreements), an essential feature being unambiguous certainty as to legal rights vis-à-vis the counterparty in the event of a default. The legal framework should be complemented by well-structured legal documentation, such as master agreements.
• Secure and efficient settlement systems.Since the securities leg of a repo serves as collateral for the cash leg, the failure to settle simultaneously opens up a credit exposure. This risk can be contained using safe settlement procedures based on delivery-versus-payment (DVP) arrangements.
• Appropriate haircuts and margin call practices.While the use of collateral reduces credit risk, market participants remain exposed to credit risk arising from volatility in the value of collateral, counterparty default and liquidity risk. Haircuts and margin call practices limit these risks provided they are set at levels commensurate with risks and adjustments are implemented promptly when appropriate.
• Adequate transparency. To effectively manage their risk in repo markets, creditors need to have sufficient comprehensive and relevant information to assess the risks they face on an ongoing basis. However, provision of such information need not compromise proprietary information.

The work on this report was initiated in December 1997 when the Euro-currency Standing Committee decided that interested member central banks should form a working group on repo markets based on a proposal in a pilot study by the National Bank of Belgium. The working group, under the chairmanship of the National Bank of Belgium, included the Bank of Canada, Bank of England, Bank of France, Bank of Italy, Bank of Japan, Deutsche Bundesbank, European Central Bank, Federal Reserve Bank of New York, Netherlands Bank and the Bank of Sweden. In preparing its report, the working group obtained information from repo market participants using a questionnaire (in cooperation with IOSCO and the CPSS), through bilateral contacts and as a group during meetings in London and New York.