Bond Market Intermediation and the Role of Repo

Abstract

We model the role that repos play in bond market intermediation. Not only do repos allow dealers to finance their activities, but also enable dealers to source assets without taking ownership. When the asset trades with repo specialness, borrowing the asset is more expensive, resulting in higher bid-ask spreads. Limiting a single dealer's leverage decreases its market-making abilities and increases its bid-ask spread. However, limiting all dealers' leverage reduces pressure on repo specialness, thus decreasing bid-ask spreads. More generally, the model gives insights into how frictions in repo markets can affect the underlying cash market liquidity.

Keywords: Market Liquidity, Treasury Market, Repo, Intermediation

JEL Classification: G2, G24, G28