Even though the panic of 2007 and 2008 occurred mainly on the repurchase market, the council says repo is critical to overall financial stability and any reforms should be taken carefully.
Going forward, repos will be particularly important as collateralized lending gains favor as a way to contain risk and as financial markets are asked to handle more debt transactions from governments and corporations, the council says.
From the council’s July 13 report, “A white paper on the operation of the European repo market, the role of short-selling, the problem of settlement failures and the need for reform of the market infrastructure”:
The repo market is at the core of the financial system. It is pivotal to the functioning of markets and a cornerstone of stability.
The report lists 14 ways the repurchase market is fundamentally important, including providing an efficient source of money market funding, providing a secure home for liquid investment, and allowing more efficient employment of capital.
Other experts have been less enthusiastic about repos. For example, Stanford University professor Anat Admati would like to see banks get more money from selling stock than from taking on repo debt, and economist Carolyn Sissoko would like to see less collateralized lending so lenders will be more careful about the loans they make.
The European Repo Council’s report comes out solidly in favor of short selling, which critics claim exaggerated the damage during the financial crisis.
In a short sale, a trader borrows a security and sells it, in hopes that he can buy it later at a cheaper price before he has to return it to the original owner.
The council’s report also supports naked short selling, in which the trader never borrows the security. In other words, he sells a security he doesn’t own, in hopes that he can buy it at a cheaper price before he has to deliver it to the buyer. Critics, including some central banks, have complained that naked short selling allows for the unlimited sale of a security, artificially driving down its value.
Short selling is a key component of the repurchase market. It’s an important way that traders get securities to use as repo collateral, and it’s an important way traders use the securities they acquire from a repo transaction.
From the report:
Short-selling is overwhelmingly a legitimate and desirable market activity. Regulatory restrictions such as limits on short positions mistakenly presuppose that short-selling is inherently undesirable.