What drives repo haircuts? Evidence from the UK market

Summary

Focus

Contract terms are rarely disclosed in repo markets, except for repo financed by US Treasury securities. As a result, we still know relatively little about the market-wide relationships between haircuts, collateral and counterparty characteristics. This is especially true of the European repo market, where there is a shortage of high-quality collateral since government bonds are of heterogeneous quality. Our paper fills this gap in the literature by estimating these relationships using a transaction-level UK data set and, importantly, by showing what types of market friction (eg adverse selection) are relevant for repo haircuts in general.

Contribution

We focus on the factors that drive repo haircuts using a unique trade-level repo database. To our knowledge, this is the only database that covers transaction-level haircut information for collateral with a wide range of qualities and a rich set of counterparties. The dataset also allows us to gain a market-wide view of how UK banks use bilateral repo contracts to intermediate liquidity and to study how the supply of this liquidity is affected by collateral quality, counterparty characteristics, bilateral relationships and contract terms.

Findings

First, we find that only 60% of collateral used in the UK market can be categorised as high-quality cash-like securities. This is in contrast to the US repo market, where high-quality securities such as US Treasuries are predominately used as collateral. Second, we find that banks obtain liquidity from asset managers, while providing liquidity to hedge funds. We also show that central counterparty (CCP) trades are significantly different from non-CCP ones. Third, we find evidence for collateral rehypothecation – on average, about 30% of collaterals are rehypothecated. Fourth, we find that more than a third of bilateral contracts have zero haircut. We also show that counterparties matter in haircut determination. Hedge funds are charged significantly higher haircuts, whereas larger borrowers with higher ratings receive lower haircuts. We also find that borrower-lender relationships affect haircuts significantly.

Abstract

Using a unique transaction-level data, we document that only 60% of bilateral repos held by UK banks are backed by high-quality collateral. Banks intermediate repo liquidity among different counterparties and use central counterparties to reallocate high-quality collateral among themselves. Furthermore, maturity, collateral rating and asset liquidity have important effects on repo liquidity via haircuts. Counterparty types also matter: non-hedge funds, large borrowers, and borrowers with repeated bilateral relationships receive lower (or zero) haircuts. The evidence supports an adverse selection explanation of haircuts, but does not find significant roles for mechanisms related to lenders' liquidity position or default probabilities.

JEL classification: G01, G12, G21, G23.

Keywords: repurchase agreement, systemic risk, repo market, margin, haircut.