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Bond Market Intermediation and the Role of Repo

45 Pages Posted: 8 Jan 2017  

Yesol Huh

Board of Governors of the Federal Reserve System - Division of Research and Statistics

Sebastian Infante

Federal Reserve Board - Division of Monetary Affairs

Multiple version iconThere are 2 versions of this paper

Date Written: 2017-01

Abstract

This paper models the important role that repurchase agreements (repos) play in bond market intermediation. Not only do repos allow dealers to finance their activities, but they also increase dealers' ability to satisfy levered client demands without having to adjust their holdings of risky assets. In effect, the ability to borrow specific assets for delivery allows dealers to source large quantity of assets without taking ownership of them. Larger levered client orders imply larger asset borrowing demands, thus increasing the borrowing cost for the asset (i.e., repo specialness). Dealers pass on the higher intermediation cost to their clients in the form of higher bid-ask spreads. Although this method of intermediation is optimal, the use of repos significantly increases dealers' balance sheets. Limiting one dealer's balance sheet leverage, leaving all else equal, reduces the affected dealer's market making abilities and increases his bid-ask spreads. The equilibrium effect of limiting all dealers' balance sheet leverage on bid-ask spreads is unclear, and depends on the intensity of clients' demand and securities lenders' sensitivity to repo specialness.

Keywords: Market liquidity, Financial services and intermediation, Repo, Specialness, U.S. Treasury market

JEL Classification: G2, G24, G28

Suggested Citation

Huh, Yesol and Infante, Sebastian, Bond Market Intermediation and the Role of Repo (2017-01). FEDS Working Paper No. 2017-003. Available at SSRN: https://ssrn.com/abstract=2895316 or http://dx.doi.org/10.17016/FEDS.2017.003

Yesol Huh (Contact Author)

Board of Governors of the Federal Reserve System - Division of Research and Statistics ( email )

20th and C Streets, NW
Washington, DC 20551
United States
(202) 973-6943 (Phone)

HOME PAGE: http://sites.google.com/site/yesolhuh

Sebastian Infante

Federal Reserve Board - Division of Monetary Affairs ( email )

20th and C Streets, NW
Washington, DC 20551
United States

HOME PAGE: http://sites.google.com/site/sebinfante/home

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