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The liquidity dilemma and the repo market: a two-step policy option to address the regulatory void

Saguato, Paolo (2015) The liquidity dilemma and the repo market: a two-step policy option to address the regulatory void. LSE Law, Society and Economy Working Papers. The London School of Economics and Political Science, London, UK.

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Identification Number: 10.2139/ssrn.2692288

Abstract

A repurchase agreement (repo) is the sale of financial assets coupled with a promise to repurchase the same assets at a later date. With similar economic characteristics to secured loans and bank deposits, the repo market is one of the main sources of liquidity for financial markets and a vital segment of the US financial system. During the financial crisis of 2007-2009, when the markets crashed and the value of many assets dropped, repo lenders lost confidence in the repo market and massively withdrew their financing. Panic then ensued, drying up the liquidity in the markets. The over-reliance on short-term repo financing magnified the liquidity crunch, and financial institutions such as Lehman Brothers and Bear Stearns were brought to the brink of ruin. The crisis unveiled the deep opacity of the repo market, its proneness to runs, its structural weaknesses, the interconnectedness of its participants, the absence of stability buffers, and the lack of any comprehensive regulatory or supervisory framework. Astonishingly, however, the post-crisis regulatory agenda almost completely ignored the repo market. Though depicted as a reform intended to create a safer financial system, the Dodd-Frank Act essentially left untouched this important source of systemic risk. After outlining the repo market and shedding new light on its structural instability, this paper presents an alternative narrative of the crisis by arguing that the structurally weak repo market triggered a liquidity crunch that halted the engine of the financial system. In doing so, the paper challenges the assumption that the crisis was caused merely by over-the-counter derivatives, securitization, and too-big-to-fail institutions. This paper shows how the repo market has developed within the financial markets – free from the watchful eyes of regulators and capitalizing on regulatory arbitrage – and challenges the regulatory void of the Dodd-Frank Act vis-à-vis the repo market. Specifically, this paper presents an original two-step policy option for assessing the repo market, based on the lesson of the post-crisis reforms of over-the-counter derivatives market as well as the incremental role envisioned by lawmakers for “financial market infrastructure” and central clearing counterparties as stability mechanisms. This paper calls for the assessment of the necessity of a structural intervention in the repo market to fix the failures that currently characterize it, and suggests that more transparency, coupled with a strong financial market infrastructure, would make the repo market more transparent, stable, and resilient.

Item Type: Monograph (Working Paper)
Official URL: http://www.lse.ac.uk/collections/law/wps/
Additional Information: © 2015 The Author
Divisions: Law
Subjects: H Social Sciences > HC Economic History and Conditions
H Social Sciences > HG Finance
K Law > K Law (General)
JEL classification: G - Financial Economics > G1 - General Financial Markets
G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets
G - Financial Economics > G2 - Financial Institutions and Services
K - Law and Economics > K2 - Regulation and Business Law > K22 - Corporation and Securities Law
K - Law and Economics > K2 - Regulation and Business Law > K23 - Regulated Industries and Administrative Law
Sets: Departments > Law
Date Deposited: 08 Jan 2016 13:12
Last Modified: 20 Feb 2019 03:54
URI: http://eprints.lse.ac.uk/id/eprint/64884

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