The Role and Importance of the Repo Market

Repos are a financing tool, and they serve many purposes. Through repos, market participants can obtain the necessary securities or cash to be deployed in other transactions, such as posting margin.

Alternatively, securities borrowed via repos can help market participants meet their settlement obligations. “Where an intermediary has sold securities to one party, which it has purchased from another, but the inward delivery fails to arrive on time, the intermediary can borrow those securities in the repo market to ensure that it can make timely delivery. Without the ability to borrow securities, delivery failures might propagate through the market,” according to a report by the International Capital Market Association (ICMA). ^[1] With more markets shortening their settlement cycles from T+2 to T+1, the role of repos will become increasingly important for companies, if they are to avoid trade fails.

Repos can also be used by financial institutions to hedge interest rate exposures, cover short sales and build up leveraged positions. A hedge fund, for example, might turn to the repo market to finance a trade designed to benefit from a mispricing of risk - which in turn will facilitate better price efficiency in the underlying cash markets. ^[2]

Central banks are major participants in repo markets too and make use of this financial tool in their daily activities.

ICMA notes that the collateralised nature of the repo market reduces Central bank’s credit risk, and also allows for the use of a wider range of assets beyond outright purchases.^[3] This lets Central Banks execute their monetary policies seamlessly during periods of calm, while simultaneously enabling them to respond more quickly to major crises.^[4]

Repos have played an invaluable role in insulating markets from recent bouts of turbulence (i.e. COVID, deteriorating geopolitical tensions, etc.) over the last few years. In particular, repos were a conduit for central banks to provide much-needed liquidity to financial markets during the early stages of the COVID pandemic, and following Russia’s invasion of Ukraine two years later.

During both crises, the European Central Bank (ECB) used repo lines to provide extensive euro liquidity to a number of non-euro area central banks, helping to prevent further market turmoil and contagion seeping into the euro-area. With markets looking increasingly unpredictable, repos will continue to be leveraged by central banks in the months and years ahead.

An Effective Investment Model

Reverse repos are widely seen as being a low risk and highly liquid investment tool for financial and non-financial institutions (i.e. money market funds, asset managers, financial market infrastructures, corporates, etc.), which are sitting on surplus cash piles. At a time when return generation is proving difficult, the repo market helps lenders net incremental income, while giving borrowers access to cheaper funding.