Watchdog warns on ‘fire sale dynamics’ risk in repo market
The global financial watchdog has urged regulators to cast a closer eye over the ways in which leveraged trades in the short-term repo market could amplify financial stability risks worldwide.
Regulators at the Financial Stability Board (FSB) are particularly concerned that leveraged investors might be forced to dump their assets in the event of a stress, putting intense downward pressure on bond markets.
“Asset managers such as hedge funds who rely on repo markets to finance their sovereign bond positions may have to rapidly liquidate their asset holdings, leading to fire sale dynamics in the pricing of sovereign debt,” it said.
The report also highlighted that “demand and supply imbalances can arise quickly in periods of stress” if repo lenders are unwilling or unable to meet spikes in the demand for liquidity.
A repo is a short-term funding agreement where financial institutions get access to liquid cash by selling securities, while agreeing to buy the securities back at a slightly higher price shortly after.
The FSB recommended that authorities address data gaps in the $16trn market for repurchase (repo) agreements backed by government bonds, and develop a series of “vulnerability metrics” to monitor possible risks.
“Strains in repo and government bond markets may spill over into each other or across multiple jurisdictions, given the international nature of repo markets,” the FSB added.
“Given the importance of repo markets within the global financial system, it is critical to preserve their functionality, particularly during periods of stress,” the report said.
Regulators might be falling behind
Around 80 per cent of repo trades are backed by government bonds, with US government bonds accounting for the majority of such trades. Hedge fund borrowing in repo markets has increased significantly over the past few years, and now amounts to nearly $3trn – or about 25 per cent of their assets.
The FSB noted that the repo market helps to provide greater liquidity across the market and also acts as a low-risk investment for cash risk institutions, but it warned that regulators might be falling behind on the ways in which the repo market could intensify market stresses.
Repo trades can build up leverage in the financial system because the trades are often conducted with zero haircuts. A haircut is a reduction to the market value of an asset when it is used as collateral for a loan, which limits the amount of leverage.
The securities exchanged in a repo trade are also often used again in further trades, a practice known as collateral rehypothecation, which adds further leverage to the system.
Andrew Bailey, Governor of the Bank of England, is the current chair of the FSB. The Bank of England is considering introducing a minimum haircut for gilt-backed repo trades, which would limit the level of leverage.