To spot the build-up of systemic risk in the financial markets, regulators need to collect six bits of information about every repo and securities lending transaction, according to a report from four economists at the Federal Reserve Bank of New York.
From the four economists:
Better data is particularly important for understanding repo and securities lending markets and monitoring developments that may be indicative of stress. Such early warning signals can be the basis for policy decisions that aim at stabilizing the financial system.
These are the money markets at the heart of the market based financial system.*
These four economists should talk to the Office of Financial Research, which has no plans to collect any of this information, even though Congress created the Office specifically to collect the data that regulators need in order to be able to spot systemic risk.
The six bits of information are:
1. The principal amount of the repo or securities loan
2. The interest rate
3. The type of collateral
4. The haircut (the amount that the market value of the collateral exceeds the loan)
5. The term
6. The parties
In addition, the economists recommended a further step. When securities lenders get cash as collateral, they usually reinvest it, often using it to make a repo loan. The economists recommended tracking the reinvestment of this cash, noting the type of instrument, its credit rating and its term.
From Fed economists Tobias Adrian, Brian Begalle, Adam Copeland, and Antoine Martin in their January 2012 paper “Repo and Securities Lending“:
These data would create a complete picture of the repo and sec lending trades in the market, and so allow 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 allow for better gauges of the systemic risk in these markets.
(Editor’s Note: See accompanying story about the Office of Financial Research, its plans and its progress. See below for information about where some of the repo and securities lending information is already reported.)
That these recommendations are being made now, more than three years after the financial crisis of 2007-2008, is a measure of how little has changed since then. Meanwhile, the dangers caused by this information gap are growing, as collateralized lending becomes increasingly important in today’s uncertain financial markets.
Experts still don’t even know for sure how big the repurchase market is. RepoWatch estimates the U.S. market at $5 trillion in daily volume, based on a 2004 study and partial 2012 data, and the European Repo Council estimates the European market at $8 trillion, based on a 2011 voluntary survey. There’s probably overlap between the two.
But some analysts disagree with these estimates and with each other.
International Monetary Fund economist Laura Valderrama wrote in September 2010 that the repurchase market is the largest financial market.
The use of collateral has become one of the most widespread risk mitigation techniques in global ﬁnancial markets.
-Central banks require collateral in most of their reﬁnancing operations.
-Banking regulation fosters the use of collateral as an instrument to reduce capital requirements.
-Financial institutions extensively employ collateral in lending transactions, including reverse repos and securities lending programs.
-Securities lending programs provide yield to their beneﬁcial owners, including central banks and institutional investors, by reinvesting the collateralized cash in the repo market.
These practices have contributed to turn the repo market into the largest ﬁnancial market today.
Nine months later, in June 2011, three U.S. economists challenged that view. In their “Sizing Up Repo” paper, Arvind Krishnamurthy of Northwestern University and Stefan Nagel and Dmitry Orlov of Stanford University argued that repo is overrated. The withdrawal of repo lenders in 2007-2008 “particularly affected” the large investment banks, but the collapse of the asset-backed commercial paper market was more damaging to the economy, they propose.
Much of the discussion of the repo market has run ahead of our measurement of the repo market. Because of a lack of data, we know little about basic questions: How big is the repo market? How much did it contract during the crisis? What type of collateral is most commonly financed in the repo market? How did this change over the crisis? As a consequence, it is difficult to evaluate how much of a factor the repo market run was in contributing to the financial crisis.
Adding to the confusion is the similarity between repos and securities lending and their interconnectedness.
Securities lending, with an estimated $2 trillion outstanding, is often thought of as a smaller cousin to the repo market. It’s where financial institutions and other businesses earn a fee by lending out their securities, sometimes receiving cash or other securities as collateral. (Companies borrow securities mostly for short selling but also to use as collateral for loans and for hedging derivatives.)
Until recently, financial institutions mainly used repos to borrow cash so they could buy fixed-income securities. They mainly used securities lending to borrow stocks so they could short them. But increasingly the lines are blurring.
Repo and securities lending are often conducted on different trading desks and they require a different contract, but terms are usually identical in the deals where one party gives cash and the other gives securities, according to attorney Andre Ruchin, writing in the May 2011 issue of The Banking Law Journal, “Can Securities Lending Transactions Substitute for Repurchase Agreement Transactions?”
(Deals are not identical in two other types of securities lending, said Ruchin: Where each party gives securities, or where one party gives securities and the other gives nothing.)
Here’s how Financial Times reporter Isabella Kaminska described the difference between repo-ing a bond and lending a bond in the Alphaville blog January 16:
Just like Schrödinger’s cat, a fixed income security can be in two states at any one time.
Until tested in the market the bond can be considered both repo-able or lend-able.
The condition is decided upon by the observer, or to be more specific the bond holder.
When the bond is in a lend-able state the owner earns an interest for parting ways with the security for a given duration. When it’s repo-able, the owner pays out an interest rate for the same act. In both cases he receives cash collateral.
Of course, when the bond is in a repo-able state, that cash is seen as more valuable to the owner of the bond than the bond itself. When the bond is in a lend-able state, meanwhile, that cash is seen as less valuable to the owner of the bond than the bond itself.
Which state the bond finds itself depends entirely on the perspective and preferences of the market.
The main lenders of securities are entities that have a lot of them, like pension plans, mutual funds, hedge funds, banks, foundations, insurance companies, or the large custodian banks like JP Morgan, Bank of New York and State Street that hold securities for these organizations and others.
The main borrowers of securities are hedge funds, asset managers, option traders, and market makers. Wall Street broker-dealers are also involved in most trades, as borrowers, lenders, clearing banks or market makers.
Perhaps the best known securities lender is American International Group. Leading up to the financial crisis, AIG lent out securities that were owned by several of its insurance companies. It received cash as collateral, and it repo-ed out or reinvested that cash. During the panic in 2008, the securities borrowers suddenly wanted to return the securities and get their cash back.
According to Adrian and his co-authors:
AIG experienced something similar to a run as borrowers of its securities sought to return them, as part of the general market deleveraging that took place. The need to liquidate some illiquid assets to accommodate this return of securities contributed to a sizable share of AIG’s losses.
After the federal government took control of AIG in September 2008, it had to pay $43.7 billion to AIG’s securities borrowers, only $6 billion less than the better-known payouts on AIG’s credit default swaps.
Both repo and securities lending experienced runs during the financial crisis, Adrian and his co-authors show. It’s important that we acquire a deeper understanding of these markets, they argue.
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.
Data that is already reported
The authors discuss the data that already exists and its shortcomings. Although a good bit of information is already collected, it’s not standardized, it’s intermittent and it’s hard to analyze.
Principal and Collateral
-Repo; firm-level; publicly traded money market funds: N-Q reports with SEC
-Securities lending; systemwide: Data Explorers
-Repo and securities lending; holding company; on-balance-sheet, publicly traded companies: SEC quarterly 10-Q and annual 10-K
-Repo and securities lending; systemwide; on-balance-sheet, broker-dealers: Federal Reserve Flow of Funds
-Repo; firm-level; money market mutual funds: N-MFP reports with SEC
-Repo; systemwide; primary dealers: Federal Reserve form FR2004
-Repo; systemwide; tri-party: Tri-Party Repo Infrastructure Reform Task Force
Tenor & Counterparty
-Repo; firm-level; publicly traded money market funds: N-Q reports with SEC
*”Market based financial system” is another term for shadow banking, where deposits and loans are made outside the traditional banking system.