Repo Transactions And Shadow Banking

We continue to get questions about the repo markets and the structure of repo transactions. The attached paper from the Financial Stability Board provides a good overview of repo and securities lending markets (including rehypothecation practices).

A repo transaction structure is quite simple. Here is an example:

A hedge fund buys a high yield bond for $10mm. It then uses this bond as collateral to borrow $7.5mm from a dealer. That means the hedge fund puts up $2.5mm net to control a $10mm bond (similar to buying a house with a 25% down-payment). The dealer will value the bond on a daily basis and if the bond declines in value, the hedge fund will be asked to post additional cash collateral (similar to a futures market). Most such transactions are overnight and are rolled (re-borrowed) daily.

The risk to the hedge fund is that one day the dealer refuses to roll the loan and the fund would need to come up with $7.5mm to repay the bank, potentially forcing it to sell the bond quickly (and possibly at a loss). In fact this is how both Bear Stearns and Lehman failed, as their counterparties refused to roll their repo loans. A more likely scenario however is that the dealer raises the initial margin from 25% to say 30% forcing the fund to put up an additional half a million.

To reduce these risks, some funds (and some leveraged ETFs and closed-end funds) negotiate a longer dated repo - usually under 90 days. This gives the fund more time to find alternate sources of funding or liquidate the bond gradually - should market conditions require it.

Below is a generic diagram of a repo transaction, including the so-called tri-party repo (discussed here).

One issue that keeps coming up repeatedly (including in this FSB paper) is whether this multi-trillion dollar market represents a form of "shadow banking" (discussed in this article by Dan Freed). In and of itself the repo market is no more a "shadow bank" than say the mortgage market. What makes something potentially a "shadow" banking transaction is the lending institution involved. For example a money market fund lending via repo or in some other fashion is a "shadow bank" because money funds are not bank holding companies. The repo example discussed above however does not represent shadow banking since a hedge fund would typically be borrowing from a registered bank. It's an important distinction.