The Return of the Repo: A Market's Postcrisis Comeback

By Jon Sindreu Features Dow Jones Newswires

An obscure but vital corner of financial markets that was at the center of the financial crisis is making a comeback.

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Investors and banks use repurchase agreements, or repos, to borrow large amounts of short-term cash safely, by selling a security and pledging to buy it back at a slightly different price in the near future. On the other side of that trade, it provides cash-rich asset managers with a safe place to put their money.

This market played a central role in the crisis, when it froze as investors questioned the safety of the securities being lent. The post-2008 regulations made it more expensive for banks to get involved, further denting a market that relies on these institutions to act as middlemen.

Now banks are beginning to return to that role while investors need safe places to store their cash.

Repos are one of several markets that played a role in the financial crisis that are now making a comeback a decade on. Volumes in synthetic collateralized debt obligations are edging up, while the leveraged loan market has boomed.

In the year through October, U.S. outstanding repo volumes were up 6.1% to $1.8 trillion, according to recent Federal Reserve figures, which exclude a segment of the market that is estimated to amount to an additional $1.6 trillion. In Europe, the International Capital Market Association estimates volumes climbed 12% in the year through June, bringing the size of the market to EUR6.5 trillion ($7.6 trillion).

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Still, the increasingly buoyant market has its challenges. J.P. Morgan recently exited the business of clearing repo trades for third parties, leaving Bank of New York Mellon Corp. alone in this role in the U.S. It could also face a crucial test in Europe at year-end when big banks shrink their books ahead of reports to regulators.

Bankers say since the financial crisis, the repo market has played a role in stabilizing markets.

"Repos were 2008's smoking gun," said Michael Manna, head of fixed-income financing trading at Barclays.

After 2008, it became a key channel for the Fed and European Central Bank to deliver monetary stimulus, by offering cash in exchange for securities. It also has allowed banks to borrow money safely even when market panic stymied other credit markets, like during the eurozone's sovereign-debt crisis and last year's Brexit vote.

The new regulations also have forced investors to deposit more cash as security when they trade, and repos are a natural place to store those funds safely.

"It's almost gone from sinner to savior," Mr. Manna said.

One big factor behind its reemergence has been the return of banks.

In the postcrisis world, every time a bank does business it is required to hold more capital and liquidity to cushion potential losses, which makes lending more expensive.

"The cheapest, lowest-yielding asset for banks to cut was the repo," said Greg Markouizos global head of fixed-income finance at Citigroup. "That had a tremendous and disproportionate effect on the market."

In recent years, some banks have perfected ways to reduce the size of their books that don't involve lending less. That includes better coordination among trading desks. So when one desk has extra cash in their hands, for example, they reach out to other desks that can make use of it, rather than their having to borrow it.

"Dealers have done their homework in adapting their business model," said Nicola Danese, European head of fixed-income financing at J.P. Morgan Chase & Co.

The market now faces a big test as European banks reduce their balance sheets for their year-end reports. On Dec. 30 of last year, repo markets fell into disarray and investors couldn't find a place to store their money. Borrowing rates using German and French government bonds as collateral dropped to minus 4.9% and minus 5.3%, respectively, which meant that market participants were being paid record amounts to borrow.

This was the latest example of an issue that is been ailing the market: Investors often struggle to find enough Treasurys and German bunds where they can safely park their money. The Fed and the ECB's bond-buying programs have made things worse by sucking government debt out of the market.

Repo markets can often alleviate these issues--because they allow an investor who owns a government bond to temporarily pass it along to someone who needs it more--but lately they have often been unable to do so.

Bankers and officials are hoping last year's disruption won't be repeated in 2018. The Fed has stopped rolling over some of its $4.5 trillion asset portfolio and the ECB has allowed investors to borrow back some of the bonds it purchased by pledging cash in exchange.

Data suggest that while the hunger for German bunds remains strong, it has eased.

"We won't see a repeat of the crisis of last year, but it could still be disrupted in the last day," said Godfried De Vidts, chairman of the European repo and collateral council at ICMA.

Write to Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

November 30, 2017 06:30 ET (11:30 GMT)