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REPO AND SECURITIES LENDING
Working Paper 18549
NATIONAL BUREAU OF ECONOMIC RESEARCH
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This paper was prepared for the NBER Systemic Risk Measurement Initiative meeting on October 27, 2010. The authors thank Markus Brunnermeier, Michael Fleming, Ken Garbade, Frank Keane, Jamie McAndrews, and Arvind Krishnamurthy for constructive comments on earlier versions of this paper. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York, the Federal Reserve System, or the National Bureau of Economic Research.
NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.
© 2012 by Tobias Adrian, Brian Begalle, Adam Copeland, and Antoine Martin. All rights reserved.
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Repo and Securities Lending Tobias Adrian, Brian Begalle, Adam Copeland, and Antoine Martin NBER Working Paper No. 18549 November 2012 JEL No. G18,G23,G28,G38
ABSTRACTWe provide an overview of the data required to monitor repo and securities lending markets for the purposes of informing policymakers and researchers about firm-level and systemic risk. We start by explaining the functioning of these markets and argue that it is crucial to understand the institutional arrangements. Data collection is currently incomplete. A comprehensive collection would include, at a minimum, six characteristics of repo and securities lending trades at the firm level: principal amount, interest rate, collateral type, haircut, tenor, and counterparty.
Tobias Adrian Adam Copeland Federal Reserve Bank of New York Federal Reserve Bank of New York Capital Market Research email@example.com 33 Liberty Street New York, NY 10045 Antoine Martin firstname.lastname@example.org Federal Reserve Bank of New York Antoine.Martin@ny.frb.org Brian Begalle Federal Reserve Bank of New York email@example.com Introduction The markets for repurchase agreements (repos) and securities lending (sec lending) are part of the collateralized U.S.-dollar-denominated money markets. The markets for repos and sec lending are crucial for the trading of fixed-income securities and equities.3 Repos are especially important for allowing arbitrage in the Treasury, agency, and agency mortgage-backed securities markets, thus enhancing price discovery and market liquidity. Securities lending markets play key roles in allowing shorting, both in fixed-income and equity markets. Given the essential role of these markets to the functioning and efficiency of the financial system, it is important to better understand and monitor repo and sec lending.
The key question addressed in this paper is, what are the data requirements for monitoring repo and sec lending markets so as to inform policymakers and researchers about firm-level and systemic risk?
One conclusion emerging from the paper is the need to better understand the institutional arrangements in these markets. To that end, we find that existing data sources are incomplete.
More comprehensive data collection would both deepen our understanding of the repo and sec lending markets and facilitate monitoring firm-level and systemic risk in these markets.
Specifically, we argue that, at a minimum, six shared characteristics of repo and sec lending trades would need to be collected at the firm level: 1) principal amount, 2) interest rate (or lending fee for certain securities loan transactions), 3) collateral type, 4) haircut, 5) tenor, and 6) counterparty.
In addition, we believe there would be value in collecting data at the firm level on the instruments in which securities lending cash collateral is invested. The reinvestment of cash collateral as practiced by securities lending agents potentially introduces a source of risk in addition to the “run” risk that also exists in repo markets.
These data would create a complete picture of the repo and sec lending trades in the market, allowing for a deeper understanding of the institutional arrangements in these markets and for accurate measurement of firm-level risk. Further, these data would allow for measures of the interconnectedness of the repo and sec lending markets, which would allow for better gauges Krishnamurthy, Nagel, and Orlov (2011) offer a detailed comparison of these collateralized money markets. See Covitz, Liang, and Suarez (2009) for an excellent overview of the market for asset-backed commercial paper, which constitutes another important secured money market.
of the systemic risk in these markets. The involvements of custodians, sec lending agents, and tri-party repo banks contribute to the riskiness of each transaction.
Background on Repurchase Agreements and Securities Lending A repurchase agreement is the sale of securities coupled with an agreement to repurchase the securities, at a specified price, at a later date (see Duffie (1996) and Garbade (2006)). Securities lending agreements are economically similar to repo agreements.4 Both agreements resemble a collateralized loan, but their treatment under the U.S. bankruptcy law is more beneficial to cash lenders: In the event of bankruptcy, cash lenders can typically sell their collateral, rather than be subject to an automatic stay as would be the case for a collateralized loan.
A repo or sec lending trade consists of six key variables: the size of the transaction, the interest rate, the type of eligible collateral, the haircut, the maturity date, and the counterparties.
The haircut corresponds to the difference between the value of the cash and the value of the collateral and is generally expressed as a percentage. For example, if $100 of securities collateralizes a loan of $98, the haircut is 2 percent. The level of haircut will typically reflect the quality of the collateral but may also vary by counterparty, reflecting the collateral provider’s creditworthiness. The haircut can thus limit the counterparty credit risk exposure in secured borrowing transactions.
Repo and sec lending trades are conducted in over-the-counter markets that intermediate between borrowers and lenders, facilitating the exchange of securities and cash.5 Given that these are collateralized money markets, each transaction features a collateral provider and a cash lender. The motivation behind a specific repo or sec lending transaction can be either cash or security driven. A cash-driven transaction is one where the collateral provider is seeking to borrow cash, while a security-driven transaction is one where the cash lender is seeking to borrow securities.
Among the financial intermediaries that participate in repo and sec lending markets, two sets of institutions are crucial. First, clearing banks and custodial agents are primarily involved in For a detailed comparison of repo and sec lending agreements from a legal perspective, see Ruchin (2011). In practice, repos are used more often to finance fixed-income securities, while securities lending is used more often to obtain equities.
Sec lending agreements can accommodate the exchange of securities for securities. In the United States, however, most sec lending transactions exchange securities and cash. This article focuses on this more common case.
the operations of the repo and sec lending markets. Second, security dealers are both lenders and borrowers owing to their role as market makers. In contrast to the repo market, custodians play a unique role in sec lending transactions.
Source: Copeland, Duffie, Martin, and McLaughlin (forthcoming).
Note: MMFs are money market mutual funds and PB is prime brokerage.
A schematic of the U.S. repo markets, provided in Figure 1,6 illustrates the extensive intermediation role played by securities dealers. For example, securities dealers intermediate between financial institutions that are long in cash, such as money market mutual funds, corporate treasuries, and custodial agents, and those institutions that are short in cash, such as hedge funds and other dealers. Repo markets are also used to reallocate securities both among securities dealers (e.g., the GCF repo market) and between securities dealers and hedge funds, asset managers, and other financial institutions. The role of the clearing banks is hidden in Figure 1—they provide the operational support for the tri-party repo market (see the following section for details on that market).
See also Copeland, Davis, LeSueur, and Martin (2012).
Securities dealers also intermediate in the sec lending markets. In these markets, securities dealers are often borrowing securities from custodial agents and lending these same securities to hedge funds and other financial institutions. Part of the cash collateral that custodial agents acquire in the sec lending market is typically invested in the repo markets, creating an important link between the two markets. The custodial business is fairly concentrated: A few large players dominate the market as suppliers of general collateral and specific securities.
Consequently, custodial agents are also large cash lenders in the market for repos.
While repo and securities loans may be open or term, most sec lending transactions are open. An open loan has an overnight tenor, but continues until one of the counterparties decides to cancel it. In particular, if the borrower returns the securities, the lender must return the cash collateral.
The U.S. Repo Markets Overview
It is useful to separate two broad classes of repos, distinguished by the way they are settled:
bilateral and tri-party. Bilateral repos are repurchase agreements between two institutions where settlement typically occurs on a “delivery versus payment” basis. More specifically, the transfer of the collateral to the cash lender occurs simultaneously with the transfer of the cash to the collateral provider. Hence, the cash lender must have back-office capabilities to receive, track, value, and account for the securities.7 In a tri-party repo transaction, a third party provides a suite of collateral management and settlement services, such as settling the repos on its book, valuing the collateral, and making sure that the collateral adheres to the lender’s eligibility requirements. Because settlement occurs on the books of a third party to whom collateral management has been outsourced, the cash lender does not need the back-office capability to take possession of the collateral. Currently, the U.S.
tri-party repo market is set up to facilitate cash-driven repos. In contrast, bilateral repos are used to obtain both specific securities and cash. In addition, the tri-party repo market is currently exposed to intraday credit risk by the clearing banks, while the bilateral repo market does not have such exposures.
The cash lender can also hire its custodial bank to perform these services.
The Bilateral Repo Market The bilateral repo market provides for the exchange of cash and securities directly between collateral and cash providers. Use of this market may be preferable to other repo markets when two parties want to interact directly with each other, rather than through an agent, or if specific collateral is desired. Dealers use bilateral repos to provide cash to hedge funds, real estate investment trusts, banks, and other institutions, primarily through their prime brokerage activities. The collateral that dealers obtain in this fashion can in some cases be rehypothecated in other repo markets, notably the tri-party repo market. Bilateral repos are also common in the interdealer market, either as a source of funding or as a way to obtain specific securities.
Dealers often serve as the custodian for their prime brokerage clients. In such cases, they settle bilateral repos through which they provide cash to these clients on their books. Interdealer bilateral repos are typically settled on the Fedwire Securities Service or through the Fixed Income Clearing Corporation (FICC).8 One of the benefits of settling with FICC is that the settlement of a dealer’s repos, reverse repos, buy-sell transactions, and auction awards are netted (see Garbade and Ingber (2005)).
The Tri-party Repo Market The U.S. tri-party repo market is set up to facilitate cash-driven transactions and serves as a key source of funding for securities dealers. Hence, the main collateral providers in the tri-party repo market are securities dealers—in particular, primary dealers. Some large hedge funds and other institutions with large portfolios of securities also borrow in the tri-party repo market, but they represent a small share of the total volume.
The cash lenders are more numerous and diverse than collateral providers. More than 4,000 individual firms are active as cash lenders. However, despite this large number, there is some concentration among cash lender types as money market mutual funds represent between a quarter and a third of the cash invested in the tri-party repo market and securities lenders represent an additional quarter of cash invested. Securities lenders use the tri-party repo market to reinvest some of the cash collateral received from lending securities.
For more information on the FICC, see http://www.dtcc.com/about/subs/ficc.php.
In the United States, the role of the third party is played by the two government securities clearing banks: JPMorgan Chase and the Bank of New York Mellon, which we also call tri-party agents.