Financial Stability Board’s Warning on Non-Centrally Cleared Government Bond Repurchase Agreements
The Financial Stability Board (FSB) has sounded an alarm bell regarding the potential risks inherent in non-centrally cleared government bond repurchase agreements (repos). These instruments, the FSB warns, frequently operate with zero haircuts, a practice that might expose investors and the broader financial system to significant risk.
Understanding the FSB’s Concerns
The FSB’s warning, published in a comprehensive report on February 4, stems from an analysis of vulnerabilities in the government bond-backed repo markets. The report is based on data from FSB member jurisdictions and insights gathered from relevant industry stakeholders, including asset managers, hedge funds, and money market funds.
A “repo” or repurchase agreement is a form of short-term borrowing primarily in government securities. The seller of the securities agrees to repurchase them at a specified time and price. The term ‘haircut’ refers to the difference between the market value of the securities involved in the transaction and the loan amount. In other words, it is a risk protection measure. A zero haircut implies that the lender (or buyer of the securities) does not have this protective cushion, and thus bears more risk.
The Risks of Zero Haircut Repos
Zero haircut repos can pose significant risks, particularly in periods of market stress. If the value of the securities falls, the lender could potentially lose money. This is because, in the event of a default by the borrower, the lender would be unable to sell the securities for an amount equal to the loan.
This risk is compounded in non-centrally cleared repos. In centrally cleared repos, a central counterparty (CCP) serves as an intermediary between the borrower and the lender, reducing the risk of default. In non-centrally cleared repos, however, there is no such intermediary, so the lender is directly exposed to the borrower’s default risk.
FSB’s Call to Action
The FSB’s warning is a call to action for regulators and market participants to address these risks. The FSB has not prescribed specific measures but has emphasized the need for greater transparency and risk management in the non-centrally cleared repo market. This could potentially include measures such as introducing minimum haircuts or requiring the use of CCPs.
In conclusion, the FSB’s report underscores the importance of prudent risk management in the repo market. While repos are an essential tool for liquidity management and market-making, they should be used judiciously to avoid undue risk to financial stability.
You can access the full report by the Financial Stability Board Here.
