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“Repos are the oil that greases the wheels of the financial system,” the Economist newspaper recently observed. Repurchase agreements allow money managers to obtain short-term financing from banks in the form of a collateralized loan. A Money manager lends a security, like a Treasury or corporate bond, to a bank in exchange for cash, agreeing to repurchase it at a later date with interest. Repo transactions usually last only a matter of days; an agreement extending more than three weeks is rare. A bank will not hold the security, but instead will lend the bond to another money manager. Connecting the two parties is how the bank makes money. When the repo agreement expires, the bank must find the specific bond to be delivered back to the original money manager, or else the trade “fails”. Lately, the failure rate for such trades has been increasing.
Global repo trading is estimated at around $1.6 trillion daily, and in the past heightened fails have coincided with financial turmoil. Broker-dealer divisions of large banks regularly use repo agreements themselves as sources of financing. In the wake of the financial crisis, however, additional scrutiny has been placed not only on banks’ capital positioning, but also on liquidity. The net stable funding ratio (NSFR) and the supplementary leverage ratio both discourage bank participation in repo agreements by making the transactions far more expensive (850% more expensive in the case of the NSFR). Banks like Goldman Sachs have been reducing their reliance on repo in response. A negative feedback loop appears to be forming: additional regulation discourages repo transactions, which decreases liquidity, which makes sourcing particular bonds for delivery tricky, which discourages trading, which further decreases liquidity. Sourcing bonds to complete the repo transaction is so difficult at times that dealers are opting to pay the fail charge of 3% (for Treasury bonds) rather than pay the going rate to retrieve the bond they need to deliver back to their money manager counterparties. Worse still, assuming the downward liquidity spiral continues, the 2010 Dodd-Frank Act makes it harder for the Federal Reserve to backstop the repo market like it did in 2008.
Broadly speaking, less emphasis on short-term financing is a credit-positive for banks like PNC, a name held in SNWAM client portfolios that has decreased repo activity. But adapting to this change may not be easy. Volatility in the repo markets, both due to pricing of transactions and availability, is expected to continue, and higher borrowing costs could eat away at bank margins. Eric Rosengren, president of the Boston Fed, recently described this volatility as one of the "financial stability issues that still really scares me." Regardless of how troublesome it appears in the present, additional regulation of repo is probably a good thing.