The Liquidity Dilemma and the Repo Market: A Two-Step Policy Option to Address the Regulatory Void

Abstract

A repurchase agreement (repo) is the sale of financial assets coupled with a promise to repurchase the same assets at a later date. With similar economic characteristics to secured loans and bank deposits, the repo market is one of the main sources of liquidity for the financial system. Having developed free from the watchful eyes of regulators, the repo market has flourished by capitalizing on regulatory arbitrage. During the 2007-2009 financial crisis, however, the engine of the repo market halted. This triggered a severe liquidity crunch and financial institutions such as Lehman Brothers and Bear Stearns were brought to the brink of ruin because of their overreliance on repo financing.

This Article identifies three central weaknesses in the repo market that led to structural market failures – opacity, conflict of interest, and systemic risk – and challenges the passive regulatory approach to the repo market. Though depicted as a reform intended to create a safer financial system, the Dodd-Frank Act essentially left untouched this important source of systemic risk. After shedding new light on the repo market structural failures, this Article presents an original two-step policy option for reforming it, which is built upon the intervention of financial market infrastructures. Ultimately, this Article posits that trade repositories, trading venues, and central clearing counterparties could be the market infrastructures that foster transparency, enhance market efficiency, and mitigate systemic risk in the repo market.

Keywords: repo, repurchase agreement, repo market, financial crisis, short-term funding, wholesale funding, shadow banking, Dodd-Frank Act, tri-party repo, bilateral repo, counterparty risk

JEL Classification: G1, G2, G15, G18, K22, K23, E42