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