Question

Explain how repo transactions provide short‐term loans to banks. In what sense is repo a collateralized loan?

Answer 1

repo transaction is a sale that's treated in the books like a loan. The seller keeps the security on its books, adds the cash received to its assets adds a loan to its liabilities. It's an easy way to raise cash quickly.

The most common type of repo is the tri-party agreement. Big commercial banks act as the middle-man, between a hedge fund that needs cash and a money market fund that would like a relatively safe boost to its return.

Risks in the Repo Market

Around the world, companies hold almost $5 trillion in repos on any given day. Even though this is less than the $6 trillion held in 2008, it creates a huge demand for short-term bonds.

U.S. Treasury bills are used for $2.4 trillion in repo trades. Many analysts worry there aren't enough to keep the repo market running smoothly.

The demand for these bonds is coming from:

Large commercial banks that must comply with new regulations.

The $2.67 trillion money market industry that can only hold safe bonds.

Hedge funds that must cover their options and other derivatives.

Hedge funds are a real worry for the repo market because they never know when they're going to need a lot of cash quickly to cover a bad investment. These funds try to outperform the market by using risky derivatives and options, such as short-selling a stock. When their investments go the wrong way, and they can't get enough cash quickly to cover them, they suffer huge losses. That can take the market down with them.