The Bank for International Settlements' Committee on the Global Financial System published a paper on, "Repo market functioning (CGFS Papers No 59)." The Executive Summary says, "Repo markets play a key role in facilitating the flow of cash and securities around the financial system. They offer a low-risk and liquid investment for cash, as well as the efficient management of liquidity and collateral by financial and non-financial firms. A well functioning repo market also supports liquidity and price discovery in cash markets, helping to improve the efficient allocation of capital and to reduce the funding costs of firms in the real economy. However, excessive use of repos can facilitate the build-up of leverage and encourage reliance on short-term funding." (Note: Thanks to Russ Ives from Ives Associates and Garret Sloan from Wells Fargo Securities for pointing out this paper.)

The BIS explains, "The CGFS Study Group on repo market functioning was established to analyse changes in the availability and cost of repo financing, and how these affect the ability of repo markets to support the financial system, in both normal and stressed conditions. The Group focused on repo transactions backed by government bonds."

The paper tells us, "Repo markets are in a state of transition and differ across jurisdictions in terms of both their structure and their functioning. In many jurisdictions, outstanding volumes of repos have declined significantly from their pre-crisis peaks but have stabilised in recent years. Changes in headline measures of price, such as the spread with risk-free rates, have differed across jurisdictions. In some jurisdictions, there are signs of banks being less willing or able to undertake repo market intermediation, compared with the period before the crisis, and seeking opportunities (including through greater netting) to minimise the use of their balance sheet in repo activity. An emerging pattern of volatility in both prices and volumes around balance sheet reporting dates can be associated with banks in some jurisdictions contracting their repo exposure in order to "window-dress" their regulatory ratios and reduce contributions to resolution funds, taxes and fees."

It continues, "The report identifies several drivers behind these changes. Exceptionally accommodative monetary policy has played a role in providing ample central bank liquidity to the market and reducing the need for banks to trade reserves through the repo market. At the same time, central bank asset purchases have increased the reserves seeking investment in the repo market, thus putting pressure on the balance sheets of repo intermediaries, but have also reduced the quantity of high-quality collateral in many jurisdictions. The experience of the crisis and subsequent regulatory reform have combined to render banks more cautious about engaging in repo market intermediation."

The BIS study comments, "The financial stability benefits of a potential decline in the availability of repo relate to moderating the vulnerabilities that emerged in the crisis through discouraging the future build-up of institutions' leverage and reliance on short-term funding. The maturity of repos is very short, which creates liquidity risks, and the value of repo collateral can be procyclical. In periods of stress, market participants become more sensitive to perceived counterparty risk and the value of the collateral can also be affected, thus amplifying the procyclical effects of leverage."

It adds, "The channel working through the collateral value is arguably weaker in the case of repos against government securities, and in particular in jurisdictions where government bonds appreciate in value during stress. Nevertheless, a reduction in the availability of repo and a better pricing of the intermediation costs may enhance financial system resilience by acting to limit excessive leverage, a key objective of the post-crisis regulatory reform."

The study also says, "These benefits, however, must be set against the costs of a reduction in repo availability. In a number of jurisdictions, some end users have already experienced difficulties (or increased costs) placing cash in repo markets, but the significance of these costs to the real economy is hard to gauge. A contraction in intermediation capacity may also reduce the degree to which repo markets can respond to demand during future periods of stress."

It adds, "A reduction in repo market functioning might create frictions in cash and derivatives markets, and reduce the ability of financial institutions to monetise assets. The scale of the resulting costs to financial stability and the real economy in times of stress might be significant altogether, although such situations have not materialised on a substantial scale in the most recent past. Repo market adaptations might mitigate the costs to some end users, but could also introduce new risks."

Finally, the BIS paper tells us, "Given the differences in repo markets across jurisdictions and the fact that repo markets are in a state of transition, it is too soon to establish strong links between the different drivers and the observed changes in markets, or to reach clear-cut conclusions on the need for policy measures. A further study undertaken within the next two years should be able to form a clearer view of how repo market functioning has been shaped by, and adapted in response to, the various drivers identified in this report, including for example, the impact of regulations that act on the size or composition of banks' balance sheets, the treatment of collateral, permissible netting and the effects of cross-jurisdictional differences in the way repo exposures are calculated for the purpose of regulation, taxes and fees."

They write, "To the extent necessary, the future study might provide a more informed assessment of the costs and benefits of any policy action. Any such assessment should consider the wider benefits or costs of these policies for the resilience of firms and the financial system as a whole, going beyond the narrow perspective of repo markets adopted in this study."

The summary concludes, "Prior to such a review, authorities in some jurisdictions might consider mitigating the adverse effects of a reduction in repo availability via more targeted and temporary measures. These include measures to reduce the scarcity of certain collateral, as well as other policies implemented in certain jurisdictions which, though initiated with the objective of facilitating monetary policy, have nonetheless improved repo market functioning."

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