Nick theorizes about repos. Sergei and JKH provide the operational answers in the comments. See below.
Read it at Worthwhile Canadian Initiative
Why does repo exist?
Nick Rowe | Associate Professor of Economics, Carleton Univeristy
Hm, you think too theoretically about the "problem". Repos exist because there are normally balance sheet and/or accounting constraints which do not allow for outright selling of assets. If you take liquidity book of a bank it is 99.9% booked as HtM and not 0% as you hypothesize. HtM means hold to maturity and this accounting treatment allows banks to avoid mark-to-market volatility of their holdings in the p&l statement (also on sales you do not want to show p&l). However it is still a liquidity book and therefore should be able to provide liquidity. This is where repo comes in because it is a secured lending from those who is long liquidity to those who is short liquidity, it does not require balance sheet sales of assets, can be used to liquidity management operations and allows to eliminate counterparty credit risk because lending is secured and assets are therefore ring-fenced.Posted by: Sergei | August 07, 2012 at 02:52 PM
Nick, sorry, it is a puzzle for you and other people because you are more interested in abstract theory than in real world. So what I said is not a theory. It is real world. And it is not about fooling accountants because accountants created these rules because accountants are interested in the real world. You can theoretically out-think yourself but the point of repos is not to opportunistically trade assets but to reduce unnecessary volatility of p&l statements. And volatility of p&l statements is BAD. There is no theory about it, it is just for all practical purposes BAD. If you sell an asset, you have to book a p&l gain on it. Full point. But repos are not about trading, they are about short term liquidity management. Liquidity has a price and this price is different from prices and their changes of any other asset in the world be it financial or real.Posted by: Sergei | August 07, 2012 at 05:37 PM
***
It’s about trading, mostly, and financing trading inventory.
And it’s about risk management, which means hedging costs as you go along. You know the original cost of the bonds, and the repo cost, so you know what your accrued cost will be at your chosen point in the future (repo maturity). You pick the future point that you want to free up your flexibility (often just overnight) to make a decision to sell outright rather than repo again.“The future is uncertain. We usually wait to get as much information as possible before deciding what to do.”I’ve seen that before here. That’s wrong. That’s not how risk management works. You don’t wait. You make term financing decisions now. If the world worked as you describe, there’s be no bonds or no term structure on anything in finance. Everybody would “wait” and never decide, while all interest rates clocked in continuous time.Posted by: JKH | August 07, 2012 at 08:27 P
Bob Smith,Supply and demand.The counterparty to the repo has the reverse repo.There's all sorts of institutional demand for outlets through which to invest cash on a short term basis. It's part of institutional liquidity management. Reverses are very liquid because they can be contracted to as short maturity as desired - overnight is most common. And reverse repos pay a contracted interest rate for a contracted term, so interest rate risk is taken out of the equation.A lot of it is about the most efficient way of managing liquidity risk and interest rate risk together.The repo borrower just has to come up with the collateral to satisfy the credit risk - but in a way that's secondary to the main purpose from either a supply or demand perspective.The repo borrower is motivated to finance inventory.The reverse repo lender is motivated to deploy liquidity.Both are interested in hedging interest rate risk for those two different purposes.Posted by: JKH | August 07, 2012 at 08:58 PM
22 comments:
Bloggers school mainstream economists.
What else is new?
And you accuse "mainstream" economists of being arrogant?
If you think those count as answers (they may indeed be *part* of a satisfactory answer) then you are arrogant about your own understanding.
Darwinian biologist: "Why do horses have legs?"
MMT economist: "It's obvious. They wouldn't be able to walk if they didn't!"
Perhaps Nick might instruct us as to exactly how they are not "operational answers", which was the focus of these answers as noted.
Tom,
I have a tangentially related operational comment/question for MMT principals, which I'm quite interested in. It's a fact seeking question:
http://neweconomicperspectives.org/2012/08/l-r-wrays-appearance-on-from-alpha-to-omega-podcast.html#comment-36298
Hi, JKH. I passed it on to Randy, Warren, Scott, and Stephanie.
Nick, I though I phrased the question in a neutral way. I just said that you took a theoretical approach (which I personally thought was an interesting way to look at it) while JKH and Sergei provided the operational answers. I added the operational answers here because most people here are interested in operations and they might otherwise have missed these comments.
However, I do admit that my conclusion is that an operationally founded approach in economics is more useful than a theoretical, especially when theorists are not well-grounded in operations, and their assumptions and method reveal this.
I just left a comment on Nick's site. I think his confusion comes from the fact that accounting rules use different conventions and also allow for mixture of market and book values on the same balance sheet. If all balance sheets had only market values then the theoretical argument of Nick would clearly make sense (that is about sentimental value etc) and the reasoning behind existence of repos would be rather weak. However a lot of assets on all types of balance sheets are measured at book value which can be quite random for Nicks purposes for all types of reasons (which can all be valid; there can be no assumption made that the reasons are stupid and the only motivation is to fool people). As soon as we get into this complex world, the reason behind repos becomes crystal clear. At least for me.
Yes, we can still talk about transaction costs etc but all these arguments are very minor compared to the gorilla in the room.
So my current reading of Nick's puzzle is why the heck to accountants mix book and market values on the same balance sheet instead of sticking just to market values. Life would have been much simplier then!
Well, in the Nicks world I am afraid life would have been extremely, unpredictably, unimaginably complex and volatile. For one simple reason - balance sheets have to balance.
Nick, I agree with your comment here and the MMTeconomists have said the same thing:
Nick wrote: JKH: Let me put it this way: Yes, certainly armchair economists like me can learn from finance people and practitioners and accountants. And I'm doing that. But you also have to realise that sometimes our "dumb" questions aren't quite so dumb as they look, and that sometimes the "answers" to those dumb questions aren't really answers. Our job is not just to describe the world. And there is more than one way of seeing the world. And some ways of seeing the same world lead to a deeper and more general perspective than others.
Posted by: Nick Rowe | August 08, 2012 at 07:10 AM
But the MMT economists would say that you have to start with a sound operational understanding to found a general theory upon. Otherwise the theory is a generalized description of what exactly?
I don't think that JKH would disagree with this, but he can speak for himself if he wishes.
Tom,
I think Nick’s heard enough from me for that thread. I’d agree roughly with his statement, but I still think there’s a bias in the part of it that’s below the surface. I don’t think its fair game to suggest and generalize that people who place considerable value on accurate description are incapable of deeper thinking about what it is they are describing, as Nick seems to do in the parody of the “concrete steppes”. I’d prefer to see him soften up his resistance to this. And a post on repos is an opportunity to do so.
Игры рынка
I'm familiar with the accounting issue, but I think it's a red herring for this particular subject.
Repos lock in financing costs for marked to market dealer inventory, and they're an efficient way to finance that inventory. Accounting is not an issue in that book. So this should not be viewed as an accounting issue in general.
And the accounting issue that pertains to the difference between marked to market trading books and accrual accounted banking books is much broader than just the advantageous use of accrual accounting for repos in the banking book. It applies to everything that is accrual accounted in that book.
@ JKH
Agree.
Although I do credit Nick for at least being open to operations.
Many theoreticians are not, and yet at the same time insist on "microfoundations." It's inconsistent as far as I can see.
I don't think that Nick has had his "aha" moment yet.
JKH, the story of repos is of course much broader than this or that example. And the question of accounting is much broader though I think it alone addresses the concerns of Nick nicely. On the other hand the question of inventory financing is a somewhat philosophical since it depends on one's point of view and business model. What you call inventory financing someone else will call liquidity management, and yet someone else will call opportunistic arbitrage, and even yet another one will call a bet on interest rates. However none of these explanations deal with theory. They are all practical matters and unfortunately do not fit into the worldview of academics.
Игры рынка
Inventory financing was an example only of an institutional construct or interpretation - in the context of the issue of accounting.
Let me press a bit on the accounting issue.
Repo sets asset pricing for both the sale (inception) and repurchase (maturity) points of the contract.
Those two pricing points determine the financing cost for the repo’d asset.
Those two pricing points are locked in by contract.
Therefore, there is no market risk with respect to that financing cost arrangement.
So marked to market accounting is inapplicable or at least irrelevant with respect to the repo, whether or not the asset is held in a marked to market trading book or an accrual banking book.
It’s a non issue.
The only way marked to market accounting can become an issue is if you introduce the “alternative” of selling the asset and then buying it back at the prevailing market price.
But that’s not an alternative at all, because it is a completely different risk construct. As an “alternative” to repo financing, the financing cost is unhedged and unknown.
JKH, yes, I tried to make the point about the "alternative" world where there is no repo and all all assets are sell-able and buy-able. And it is alternative in the sense that it is alternative to how this world operate and not just an option that would be cool to consider. I have no problems with your description but rather looked from a different angle. For me the reason why repos exist (the question here) is much easier explained by accounting restrictions. And from my perspective what you describe is rather an accounting/legal solution to enable liquidity management/financing of the given type of operations. I.e. it follows from the higher level rules which depend on the business model attached to any type of asset of any business unit/line in any company. Of course there can be different interpretations of why repos exist but I believe mine is the strongest one ;)
I don't really agree that he's thinking too theoretically about the problem. The responses pretty much say, "Yeah, his second and third suggestions are basically right." You could play out the mark-to-market restriction as increasing price uncertainty or exacting transaction cost on a sale.
Игры рынка
Sorry, I still don't see it as an accounting solution to anything.
First, it's collateralized financing, using the asset that's repo'd.
And the accounting is entirely consistent with a fully hedged risk structure in terms of the cost of that financing. The rate is agreed and the asset pricing structure for the repo falls out from that.
It's just an alternative to using a straight loan with the repo'd asset pledged as collateral.
It amounts to the same thing.
But repos don't exist because of the accounting; they exist because of the use of the collateral. The accounting is entirely natural. I suppose there’s a choice as described, but it amounts to the same thing.
And again, there is no market risk in the financing cost once the contract is set.
So marked to market accounting is irrelevant. So accounting as an issue is irrelevant.
But maybe we're talking past each other.
"But maybe we're talking past each other."
I feel so.
I start from the Nick's position of why don't we just sell and buy it back later if we want to. While I understand and agree that there are more dimensions to buying it back and esp in the part "if we want to" the most important problem, for this particular question in my view, is that not everything is sell-able. Even worse. Most of the stuff is not really sell-able. And there is a clear reason why most of the stuff is not sell-able. It is because the business model behind this stuff is different from mark-to-market which has to be implied in any sale.
I do not argue against your arguments. On a second thought I start to think that while your view might be a better description of repos as such, mine might be an easier answer to the Nick's question :)
or maybe it is just my English which gets only worse with every additional sentence I write today
I'm not usually this tenacious on threads, but this is an interesting subject from a finance logic perspective, and Nick is constructive to pursue it on that basis
"Nick's position of why don't we just sell and buy it back later if we want to"
The fundamental issue there is risk. The purpose of the repo is to lock in financing cost.
The particular institutional setting is what it is. I chose inventory financing as a starting point, but there are all sorts of entry points to the use of repo.
The locking in of financing cost has to do with basic risk management. When a dealer locks in his financing cost, he knows his all in cost to the maturity date of the repo, and he can recalculate P&L scenarios on that basis. It is a way of controlling a small piece of the future. That makes dealers more confident.
The idea of selling and buying back at a comparable future date but at a currently unknown price is just a non-starter from a risk management perspective.
The comparison between repo and that alternative open risk scenario really isn’t an issue of accounting – it’s an issue of risk.
So, the risk management perspective is the core reason why repos exist.
From there, the most straightforward and efficient accounting arrangement is engineered – and that turns out to be the setting of repo start and end date asset prices, whose difference equates to the negotiated all in financing cost. That cost, being locked in, is not an issue for marked to market risk, and is not an accounting issue in any relevant sense.
And from there, there are many institutional variations on HOW the repo market is used - including speculation, shorting, liquidity management, inventory financing, etc. etc. All of those may also be viewed as variations on risk management, in their own particular context. All portfolio managers and traders alike manage risk within their own models and frameworks of operation.
Tom: I was responding more to the first comment than to the tone of your post, which was OK.
I ask 3 people "Why is there a forest here?"
1. The forester (practitioner?) replies: "Because I planted the trees here".
2. The historian replies: "Because the government had a policy of buying land for forestry and the owner of this needed the cash".
3. The soil scientist (economist?) replies: "Because this land isn't very good at growing wheat and has a comparative advantage in forestry".
All three answers can be correct. (In the particular forest I'm thinking of, I think all three are correct). But they are different perspectives.
It is not at all obvious to me that we have to start from what you call the "operational" perspective.
In my post, I started from the question "Why do I pawn my watch, rather than sell it?" I wanted to look at parallels and differences between repoing Tbills and pawning a watch. I also looked at parallels and differences between repoing a Tbill and selling a used car ("Market for Lemons"). Later on, in the comments, I looked at parallels and differences between barter/monetary exchange and repos.
The "operational/practitioner" largely ignored those parallels. (JKH picked up on the money/barter towards the end).
I want to see where repos fit in in the big scheme of things. A repo is an exchange. I want to see what they have in common and where they are different from other exchanges. That is a very different perspective from someone who does repos for a living.
I want to see the forest, and where it fits in the surrounding landscape. It's not that the forester is wrong. But his answer might not be the one I'm looking for.
And remember the Modigliani-Miller Theorem. They asked the dumb question: "Why does corporate debt exist"? The practitioners already had an answer. Theoretical economists M-M showed that under assumptions X the debt/equity ratio was indeterminate. The practitioners' answer ignored X. They must have been making some implicit assumptions they weren't aware of.
Thanks for your detailed response, Nick. Agree.
The question turned out to be a pregnant one that is still eliciting good comments.
As a philosopher I recognize the importance of asking "dumb" questions that common sense takes as obvious. On inspection they turn out not to be so dumb at all, although generally those holding the common sense view never get this.
As I have said many times I am not opposed to taking any tack — just drawing unwarranted policy conclusions from models that aren't representational enough to deal with the complexity of modern societies.
My interest, and I think the interest of most people here, is to come to a better understanding of the economic basis of public policy and found the operational approach to this particularly useful. That doesn't obviate other approaches, of course. We should all be working together to come up with the best possible policy approach and than arguing over who is right.
But the heterodox economists don't feel that they are being being treated on a level playing field in this regard, and that is a problem. The orthodox view is pretty much that there is now an agreed upon normal paradigm in economics and all economists should cooperate by working within it.
The heterodox economists say, not so fast — that paradigm is flawed and GIGO.
So we are left with "dynamic tension" as driver of the dialectic. But at least we are talking — some of us anyway.
Post a Comment