A resilient repo market is important for financial stability

Repo markets are crucial for the functioning of government bond markets. They are also an important source of short‑term funding. But their size and widespread use mean they can transmit financial stress if conditions deteriorate.

Repurchase agreement (repo) markets are a key part of the plumbing of the financial system. They support liquidity in government bond markets by allowing market participants to borrow or lend cash or securities, and they play a vital role in transmitting monetary policy.

Because repo markets play such a central role, stress in them can spread quickly to other parts of the financial system. A disruption to repo markets could, for example, cause hedge funds to suddenly sell off their holdings of government bonds, reducing market liquidity and potentially leading to liquidity spirals. For this reason, governments, central banks and market participants are focused on strengthening the resilience of these markets.

Disruptions in repo markets could affect government bond markets

Repo markets have grown steadily in recent years, which has further increased their importance in Canada’s financial system (Chart 17). More than $130 billion in repo transactions now take place in Canada each day, about double the amount from five years ago. A wide range of market participants use repos to obtain leverage, borrow and lend securities, earn returns on extra cash and manage funding liquidity.

Repo activity is rising in part because more Government of Canada bonds are being issued and traded (Chart 18). Repos are a flexible and cost‑effective way to finance trading in government bonds and therefore play an important role in facilitating dealers’ market‑making activities. They also allow hedge funds to finance their activities, including basis trades in government bonds and futures. These activities, in turn, support liquidity and efficiency in the markets for government securities.1

Government bonds are widely used as collateral and liquid assets to manage risks. They are also used as pricing benchmarks for other securities. Because of this, a disruption in repo markets would have broad implications for the financial system. These include:

• A sudden deleveraging by asset managers. For example, if hedge funds or other asset managers cannot obtain repo funding, they may need to quickly sell government bonds, further reducing market liquidity.
• A reduction in overall market liquidity. Wider bid‑ask spreads and higher trading costs in government bond markets could spill over into other fixed‑income and derivative markets. If this led to significant margin calls, it could result in a liquidity spiral as market participants are forced to sell liquid assets to raise cash.
• Sharp movements in the Canadian Overnight Repo Rate Average (CORRA). This would affect the large numbers of financial instruments that use CORRA as a risk‑free rate, such as interest rate derivatives and floating rate notes.2

If any of these situations were to occur, borrowing costs across the economy would go up, leading to potential second‑round effects.3

Efforts are underway to improve the resilience of repo markets

The Bank of Canada has been working for years with industry and other stakeholders to improve the resilience of repo markets by:

• Providing a robust and reliable pricing benchmark. In 2020, the Bank became the administrator of CORRA—the main pricing benchmark for repo markets—and improved its calculation methodology.4
• Working with the private sector to improve Canada’s repo market infrastructure. The Bank proposed and now sponsors the Collateral Infrastructure and Market Practices Advisory Group (CIMPA). This group seeks ways to modernize Canada’s fixed‑income market to support uninterrupted, efficient functioning of cash trading, securities lending and financing markets. As a result of CIMPA’s work, the Bank has announced that it will join the:
  • Canadian Collateral Management Service’s triparty repo platform. Triparty repos allow market participants to manage risks and liquidity more efficiently than traditional bilateral repos.5
  • Canadian Derivatives Clearing Corporation (CDCC), a central counterparty for repo and derivatives transactions. After the 2008⁠–⁠09 global financial crisis, the CDCC expanded to include repo transactions to strengthen the operation of core repo markets during periods of financial stress. The Bank’s participation in the CDCC will help make central clearing more attractive for market participants and, through netting, increase the ability of dealers to provide repo market funding through a more efficient use of balance sheet capacity.
• Contributing to international work on repo markets. The Bank contributed to the Financial Stability Board’s recent report on vulnerabilities in government bond‑backed repo markets.6 This work is important because hedge funds and other asset managers operate across borders, interconnecting global bond markets.
• Working to improve transparency in repo markets. The Bank regularly publishes research on Canada’s repo markets, including a fact sheet that outlines their size and composition.7 This work helps make stakeholders aware of the structure of and vulnerabilities in these markets.
• Ensuring the Bank’s liquidity facilities adapt to changes in market structure. For example, the Bank widened eligibility for its Contingent Term Repo Facility to include certain non‑bank financial intermediaries because of their increasing role in fixed‑income markets and the financial system.8 This facility can be used to provide liquidity during periods of severe market stress.

The Bank’s work to improve the resilience of repo markets is ongoing. The Bank will continue to monitor repo markets and contribute both to CIMPA’s efforts to improve the resilience of Canadian fixed-income markets and to global efforts to monitor and address emerging vulnerabilities.

Endnotes