Listen now | The repo market is the oil that lubricates the engine of global financial markets - let's explore it in this article of the Bond Market 101 Series.
Alf continues to embarrass paywalled investor ‘education’ competitors. A missing piece of this thread is basis trading at hedge funds (futures vs cash) and how important this leveraged short term demand is for balancing the repo market and its contribution to stress episodes…
100% my favorite macro content and education. So much educational potential here. The hardest part is this is all complex stuff that is hard to get answers on to fully understand if you're uninitiated like I am. Alf going through the comments on the weekends helps that part significantly though.
In a recent interview, Zoltan Posar commented that many players in the repo market have replaced their repo activity with FX swaps instead. Can you please explain this.
Question: what is the difference between using the repo market vs. just selling the security and buying it back later on the open market? This also prevents issues with balance sheet expansion for repo borrowers. Is the repo market a solution to bid/ask spreads when trading securities?
Wouldn't you think repo is simply a way to finance a treasury or agency security rather than having extra cash to buy and hold a security for some time?
Looks like it's nothing but a way to leverage. And because it's viewed as "risk free" collateral there are lenders who are more than willing to earn something for their cash overnight.
Nevertheless most of the repo transactions today are very well collateralized and cleared through a CCP - with very frequent margin calls to avoid large problems.
Great point. One of the most glaring examples of bond price moves in the secondary market can be seen on the Price of 32 of the 30-Year bonds composing the TLT etf.
You can see that only 9 of the 32 are priced near their auction prices. Most are way discounted from their probable original price.
Example: A typical 30 year auctions at a price of at least $97.50 during the FULL 30-year months of Feb, May, Aug, and Nov.
But if you look at TLT the price of their 30 year bond maturing May 2050 as low as $66.60. If that was bought May 2020, the auction price was around $97.73. So, someone took a massive haircut on this bond.
Hey Alf - you said "redeploy the same security over and over again as collateral (re-pledging)."
How on earth can the same collateral be used over & over again? So if the borrower defaults, there will be many lenders attempting to claim the same security - this does not make sense!
Insightful primer. Wasn't the Great Financial Crisis ultimately a crisis of trust which is at the heart of Repo? Repo and reverse repo: might be useful to delineate. Nice series.
I'm confused by the QT example in 2019. If banks lend securities/borrow cash and their repo appetite dwindled after the Fed took away a bunch of their liquidity, then 1) banks should have wanted to be more active in the repo market to rebalance their UST/cash balance or 2) if that didn't happen, then their lower cash borrowing in repos should have been offset by higher cash borrowing needs by hedge funds. Either way, there's a hitch in the example somewhere or I'm really missing something. Love your work, thank you Alf.
I think I should have been more precise. When I say banks, I might mean either the Treasury department or dealers - and those are very different beasts!
Also, balance sheet constraints in 2019 were very binding and punitive and this prevented several large banks from engaging in repo activities.
The larger banks were balance sheet contrained. Not necessarily just liquidity constrained. Around September 2019 they just about had the lowest level of reserves. Regulations matter and have costs.
Hi alf, it would be great to have a diagram with the players and the canals of flow of securities and cash, and how banks and central banks and offshore accounts interact with each other because it´s pretty complicated. I myself am a very visual guy and find it easier to see all the pieces interacting with one another in that sort of way. I understand that it wouldn´t be an easy diagram, but it would help!. George gammon does something of the sort in his youtube channel.
Thanks for sharing this kind of info! I wonder how the funds obtain by borrowers are used for. Is there a correlation between, for instance, high activity in the repo market and high speculation and expansion of Open Interests in agricultural commodities, or O&G futures? Thanks again
Thanks Alf. This is number 5 in your Bond Market 101 Series: The Bond Market in plain English, The Real Deal in the Bond Market, Yes, but which Yield Curve, The name is Spread. Credit Spread, and The World's Most Important Market. Thank you for continually educating us; much appreciated! I know things now that I didn't know in February, and, your Macro Compass Quadrant Credit Impulse graph is as equally helpful. Knowledge is power. :) Thanks again.
Alf what about going long schp or tips vs tlt. If rates go down on the long end still some gain but with inflation protection just less upside because of inflation yield decrease?
I am not sure about Long TIPS vs TLT, but I have a question about the TLT.
Roughly, the weighted yield of the TLT is about 3.1% and the price today is $118.xx.
I guess there's probably not too much excitement over the yield but there could be about the potential increase of the TLT price if and when interest (yields) drop. How much do you think TLT will go up if the long-term yield drops to near the 5 year average of let's say 2%, next year? (Remember I said if.)
"This means their ‘‘cash’’ is nothing else than an unsecured bank deposit at a commercial bank - very little reward, quite some risk."
Alf, could you please clarify what exactly "unsecured" means? i.e. When companies or individuals deposit their money at commercial banks, are they taking "quite some risk", and why are they taking "quite some risk"?
I mean that your ''money'' nowadays is mostly a bank deposit.
Any amount exceeding the government insurance (FDIC in the USA for instance) is basically an unsecured, not collateralized loan you are giving to your bank.
If it defaults, your money above the FDIC limit is gone.
Can you please explain with eg how hedge funds use leverage and make money in repo market , thanks
I should definitely do that.
Thanks for the idea!
Yes Alf please explain the basis trade in a way we all humans can understand it.
Alf continues to embarrass paywalled investor ‘education’ competitors. A missing piece of this thread is basis trading at hedge funds (futures vs cash) and how important this leveraged short term demand is for balancing the repo market and its contribution to stress episodes…
100% my favorite macro content and education. So much educational potential here. The hardest part is this is all complex stuff that is hard to get answers on to fully understand if you're uninitiated like I am. Alf going through the comments on the weekends helps that part significantly though.
Hey Gene!
I am very glad you are finding good value here.
It's quite some hard work from my side, but it's all worth it!
You are too kind :)
Yep, smart point on basis positions - I'd include them in my ''leverage RV trades'' basket discussed in the article.
I could write (and probably should) much more about this :)
In a recent interview, Zoltan Posar commented that many players in the repo market have replaced their repo activity with FX swaps instead. Can you please explain this.
Yep, this is correct but it would require another article - you just gave me a great idea for one!
Hi Alf, thank you for this post.
Question: what is the difference between using the repo market vs. just selling the security and buying it back later on the open market? This also prevents issues with balance sheet expansion for repo borrowers. Is the repo market a solution to bid/ask spreads when trading securities?
Welcome!
The difference would be that
a) selling and buying the security back might generate accounting results (very important for banks, insurances etc)
b) you won't be achieving leverage this way - and that's one of the main reasons why repo markets are used
Wouldn't you think repo is simply a way to finance a treasury or agency security rather than having extra cash to buy and hold a security for some time?
Looks like it's nothing but a way to leverage. And because it's viewed as "risk free" collateral there are lenders who are more than willing to earn something for their cash overnight.
Yep, its main use is to allow for conveniently cheap and accessible securitized loans - aka leverage.
The Repo Agreement has a fixed buyback price. Prices fluctuate on secondary market which introduces material risk.
Yep, that's correct.
Nevertheless most of the repo transactions today are very well collateralized and cleared through a CCP - with very frequent margin calls to avoid large problems.
Great point. One of the most glaring examples of bond price moves in the secondary market can be seen on the Price of 32 of the 30-Year bonds composing the TLT etf.
You can see that only 9 of the 32 are priced near their auction prices. Most are way discounted from their probable original price.
Example: A typical 30 year auctions at a price of at least $97.50 during the FULL 30-year months of Feb, May, Aug, and Nov.
But if you look at TLT the price of their 30 year bond maturing May 2050 as low as $66.60. If that was bought May 2020, the auction price was around $97.73. So, someone took a massive haircut on this bond.
Hey Alf - you said "redeploy the same security over and over again as collateral (re-pledging)."
How on earth can the same collateral be used over & over again? So if the borrower defaults, there will be many lenders attempting to claim the same security - this does not make sense!
Yep, unfortunately that's how it works...
Leverage and snowballs effects :)
OMG - so can I pledge/re-pledge my house as collateral over & over again? Of course not. But this is allowed for financial entities.
Unbelievable! This is what makes the system super fragile! Policy makers are literally driving the bus off the cliff here!
You rock Alf, thankful for the insight and heart of a teacher
Very kind! :)
Insightful primer. Wasn't the Great Financial Crisis ultimately a crisis of trust which is at the heart of Repo? Repo and reverse repo: might be useful to delineate. Nice series.
Thank you!
The GFC was a lot of things at the same time, but you just gave me a nice idea for one of my next pieces :)
Did you mean a crisis of collateral quality and hightened counterparty risk?
I guess that's why repo today is largely treasuries and agency securities. Not too sure about failures to deliver though.
I'm confused by the QT example in 2019. If banks lend securities/borrow cash and their repo appetite dwindled after the Fed took away a bunch of their liquidity, then 1) banks should have wanted to be more active in the repo market to rebalance their UST/cash balance or 2) if that didn't happen, then their lower cash borrowing in repos should have been offset by higher cash borrowing needs by hedge funds. Either way, there's a hitch in the example somewhere or I'm really missing something. Love your work, thank you Alf.
Thanks, Ryan!
I think I should have been more precise. When I say banks, I might mean either the Treasury department or dealers - and those are very different beasts!
Also, balance sheet constraints in 2019 were very binding and punitive and this prevented several large banks from engaging in repo activities.
The larger banks were balance sheet contrained. Not necessarily just liquidity constrained. Around September 2019 they just about had the lowest level of reserves. Regulations matter and have costs.
Hi alf, it would be great to have a diagram with the players and the canals of flow of securities and cash, and how banks and central banks and offshore accounts interact with each other because it´s pretty complicated. I myself am a very visual guy and find it easier to see all the pieces interacting with one another in that sort of way. I understand that it wouldn´t be an easy diagram, but it would help!. George gammon does something of the sort in his youtube channel.
Great idea!
Thanks for sharing this kind of info! I wonder how the funds obtain by borrowers are used for. Is there a correlation between, for instance, high activity in the repo market and high speculation and expansion of Open Interests in agricultural commodities, or O&G futures? Thanks again
Hi Alfredo!
Most of the repo activity is performed by large players to fund positions in financial markets
Wow biggest fin on substack, big achievement, congrats! Thanks for keeping it publicly accessible!
Thank you!
Why is twitter/reddit constantly freaking out about the repo market?
FinTwit will always be freaking out about something :)
Awesome - Thank You!
Welcome!
Thanks Alf. This is number 5 in your Bond Market 101 Series: The Bond Market in plain English, The Real Deal in the Bond Market, Yes, but which Yield Curve, The name is Spread. Credit Spread, and The World's Most Important Market. Thank you for continually educating us; much appreciated! I know things now that I didn't know in February, and, your Macro Compass Quadrant Credit Impulse graph is as equally helpful. Knowledge is power. :) Thanks again.
Happy it contributes to your education :)
Alf what about going long schp or tips vs tlt. If rates go down on the long end still some gain but with inflation protection just less upside because of inflation yield decrease?
Long TIPS vs TLT would be a bet on inflation expectations to increase at the long-end.
I am not sure it would work.
I am not sure about Long TIPS vs TLT, but I have a question about the TLT.
Roughly, the weighted yield of the TLT is about 3.1% and the price today is $118.xx.
I guess there's probably not too much excitement over the yield but there could be about the potential increase of the TLT price if and when interest (yields) drop. How much do you think TLT will go up if the long-term yield drops to near the 5 year average of let's say 2%, next year? (Remember I said if.)
"This means their ‘‘cash’’ is nothing else than an unsecured bank deposit at a commercial bank - very little reward, quite some risk."
Alf, could you please clarify what exactly "unsecured" means? i.e. When companies or individuals deposit their money at commercial banks, are they taking "quite some risk", and why are they taking "quite some risk"?
Thank you for the content!
Ehi!
I mean that your ''money'' nowadays is mostly a bank deposit.
Any amount exceeding the government insurance (FDIC in the USA for instance) is basically an unsecured, not collateralized loan you are giving to your bank.
If it defaults, your money above the FDIC limit is gone.