Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis

Abstract

A standard repurchase agreement between two counterparties is considered to examine the endogenous choice of collateral, the feasibility of secured lending, and welfare implications of the central bank's collateral framework. As an innovation, we allow for two-sided counterparty risk. In line with empirical observations, it is shown that the most liquid and least risky assets are used as collateral in market transactions first. An endogenous opportunity cost arises from using liquid collateral with the central bank. Conditions are identified such that expected utility increases for all market participants when the central bank accepts a broader range of assets as collateral.

Keywords: counterparty risk, repurchase agreements, collateral, liquidity, haircuts

JEL Classification: G21, E51