Repo markets are systemically important funding markets, but are also used by firms to obtain the assets provided as collateral. Do these two functions complement each other? Researchers from the Bank of England (BoE) build and estimate a model of repo trade between heterogeneous firms, and find that the answer is no: volumes and gains to trade would both be higher absent collateral demand.
This is because on average the firms that need funding are also those that value the collateral to speculate or hedge interest rate risk. These results have implications for policies that affect collateral demand in repo markets, including rules on short selling.
Current rules require a firm wishing to short a given bond to first temporarily acquire the bond through the repo market or a securities dealer. Market-makers are exempt from this prohibition, but need to give regulators 30 days’ notice before engaging in naked short-selling.
In July 2023 the UK government launched a consultation on lifting this prohibition, with the aim of improving liquidity in secondary government bond markets.10 As well as potentially affecting secondary bond markets, this policy change would have an impact on the functioning of the repo market, depending on the scale and distribution of collateral demand related to shorting and how it affects outcomes. Researchers consider the impact of this policy change on the repo market in counterfactual simulations
Other relevant policy decisions include how and when central banks intervene in repo and in related markets. The BoE, for example, can choose to lend through a repo transaction in return for collateral, whilst UK authorities also offer the means to obtain and exchange collateral. The terms at which central banks do this, and critically the collateral that they accept, clearly affects the role of collateral demand in wholesale repo markets.