The Economist writes about repo: “Neither liquid nor solid” and blames tight specials markets on regulatory change. Sorry, but no.

Repo seems to be getting a wave of confusing press. An important article by virtue of its large circulation was in the July 12th Economist, “Neither liquid nor solid”.

The Economist article took a look at the recent surge in fails in repo and wondered aloud:

“…Will liquidity be the cause of the next great financial crisis? Recent problems in the obscure-sounding, but highly important, repo market may hint at the trouble to come…”

Using the spike in fails as evidence there is fragility in the repo market that is caused by regulation seems, well, like connecting unrelated dots. The article says:

“…The current problem seems instead to be linked to regulation…Two particular regulations—the net stable funding ratio and the supplementary leverage ratio—seem to be discouraging banks from taking part in repos, by making it more expensive for them to own short-term debt…”

There appears to be an underlying confusion about the differences between the GC market and the specials market.

If a bond is scarce because the short base is bigger than the available lending stock, it will get expensive. These are specials. To reverse the paper in that has become scarce, the bond borrower will have to lend cash out at cheaper and cheaper rates as an incentive to the bond lender. Occasionally these rates go negative. Negative rates, like the market is seeing in many hot run issues now, are rare but it does happen. It is usually driven by seasonal factors – typically right before auctions when dealers are setting up short positions but can be aggravated by market sentiment. Some people blame QE, but the bonds that the Fed holds are available to borrow.

The Treasury Market Practices Group (TMPG) and SIFMA, in consultation with the Fed, established charges for failed deliveries (effective in 2009 on US Treasuries, 2012 on MBS and US agency debt). The charges were designed to incentivize dealers to make deliveries by charging a fee of 3% less the Fed Funds rate on fails. However sometimes markets get so tight that it is still cheaper to pay the penalty and fail. That is happening now. Anyone who owns these scarce issues will find they can fund their bonds at very advantageous rates.

General collateral is driven by funding costs and not by the need to cover a specific short. Repo traders know that the specials market and the general collateral market act very differently from each other. They share some infrastructure and legal agreements, but not a lot else. We understand how the differences between specials and GC are subtle to some and it is easy to lump them together. But the specials and GC markets have very different drivers and should be recognized as such.

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Bank of England consultation paper on the Leverage Ratio
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