January 2017 (Revised February 2020)

Bond Market Intermediation and the Role of Repo

Yesol Huh and Sebastian Infante

Abstract:

We model the role that repurchase agreements (repos) play in bond market intermediation. Not only do repos allow dealers to finance their activities, but they also enable dealers to source assets without taking ownership. When the asset trades with repo specialness, i.e, when the associated repo rate is significantly below prevailing market rates, borrowing the asset is more expensive, resulting in higher bid-ask spreads. Limiting a single dealer's leverage decreases its market-making abilities, so the dealer charges a higher bid-ask spread. However, limiting all dealers' leverage reduces pressure on repo specialness, thus decreasing bid-ask spreads. More generally, this paper characterizes the importance of collateralized borrowing and lending for bond market intermediation, shows how frictions in repo markets can affect the underlying cash market liquidity, and underscores the importance of securities lending.

Original paper: PDF | Accessible materials (.zip)

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

DOI: https://doi.org/10.17016/FEDS.2017.003r1

PDF: Full Paper

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Last Update: February 12, 2020