A Trading Mechanism to Increase Intermediation Capacity in the Repo Market
Introduction
The US Treasuries repo market is the largest financial market in the world. Volume is constrained by the interaction of accounting rules requiring broker-dealers to increase assets with each repo trade and leverage regulations that lower-bound the ratio of capital to assets. There is concern that the cap on repo volume will raise Treasuries yields, reduce the effectiveness of Fed monetary policy and elevate the risk of market disruptions. One approach to increase volume is to mandate central clearing in order to reduce balance-sheet impact through multilateral netting. We show central clearing is unlikely to increase volume, but it will escalate counterparty risk and trade cost. We propose a mechanism that raises attainable volume without affecting payoffs, costs or incentives. There are three novel features; (i) repo trades are novated and arranged into chains with net sell-side and net buy-side trades placed at each end and matched-book trades in the middle, (ii) The trades at each end of a chain become counterparties to contracts, while (iii) trades in the middle become guarantors of the contracts, which reduces balance-sheet impact.
