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Like banking, a well-functioning repo market is important, if not crucial, for our economic welfare. But, also just like banking, there can be ‘too little’ or ‘too much’ repo. ‘Too little’ provision of collateral and financing could leave economic growth below potential. But ‘too much’ could cause the system to overreach, straining asset valuations and ultimately leading to an unravelling. The very features that make repo so effective in reducing counterparty risk at a micro-prudential level – collateralisation, marking to market, regular remargining, and short maturities – also pose potential new macro-prudential risks.
Until recently, analyses of these two sets of issues, both in academia and in official circles, have tended to be carried out independently. Those who worry about there being ‘too little’ collateral in the future have stressed the importance of looking for ways to improve so-called ‘collateral fluidity’. But those who worry that a collateralised world will be too prone to cyclical instability, have been examining ways to curb those perceived excesses through regulation or other means. It is easy to characterise these objectives as contradictory. But they are really two sides of the same policy challenge: we need repo markets that are both prudentially sound and sufficiently deep and liquid to perform their crucial functions.
Viewed simplistically, the global authorities might appear to be trying to pursue two contradictory goals: seeking both to curb the growth of repo by imposing minimum haircuts, limits on rehypothecation and other steps, whilst at the same time trying to boost repo in order to meet the coming demand for collateral. What is more, they might appear to be doing that at a time when repo revenues are already under pressure from a flat yield curve and historically low levels of financial market activity and leverage. In truth, however these goals are complementary, not contradictory. Well-judged policies that effectively reduce the risk of runs in repo markets should raise, not diminish, liquidity in the market as a wider range of counterparties are attracted in over time. And the raft of initiatives now underway to boost collateral fluidity should help to ensure that worries about a collateral crunch remain only hypothetical.
It clearly is important we get that balance right. Central banks – the original birth-parents of repo – have no interest in crushing the repo markets out of existence. But they do recognise that with a bigger role comes bigger responsibilities. Building more robust repo markets is not just in our interests – it is in the markets’ interest too. Against a backdrop of generally depressed prospects for profits in the financial system, the handling and provision of collateral and financing seems likely to be one of the higher revenue earners in the financial system in the years ahead. Will central banks eventually need to take a more active role in determining the balance between ‘too much’ and ‘too little’ across the cycle? The Financial Policy Committee of the Bank of England concluded last Spring that the power to vary minimum margin requirements on collateralised transactions was a potentially important macro-prudential policy tool, but a final evaluation needed to await completion of the international micro-prudential regime .