How does the repo market work, and why are haircuts so important for managing counterparty risk?
I'm studying money markets for FRM Part I and repos seem fundamental but I don't fully understand the mechanics. Why would someone 'sell' a security they want to keep? And how do haircuts protect the cash lender?
A repurchase agreement (repo) is economically a short-term collateralized loan, but legally structured as a sale-and-repurchase. The borrower 'sells' securities today and agrees to 'buy' them back at a slightly higher price.
Basic Mechanics:
Day 1 (repo open):
- Thornfield Asset Management needs $100M overnight
- Thornfield 'sells' $102M face value of Treasury bonds to Clearview Capital
- Clearview pays $100M cash
Day 2 (repo close):
- Thornfield repurchases the bonds for $100,013,889 ($100M + one day of interest at 5%)
- Repo rate = 5.0% annualized
Why Sell Something You Want to Keep?
The 'sale' structure provides crucial legal protection. If Thornfield goes bankrupt, Clearview already owns the securities — they're not stuck in bankruptcy proceedings trying to seize collateral. This is why repos have lower counterparty risk than unsecured lending.
Haircuts:
The haircut is the difference between the collateral's market value and the loan amount:
Haircut = (Collateral Value - Loan Amount) / Collateral Value
In our example: ($102M - $100M) / $102M = 1.96%
The haircut protects the cash lender against:
- Market risk: If the collateral drops in value before the repo closes
- Liquidation cost: Bid-ask spreads and time to sell in stressed markets
- Credit risk: Haircuts are higher for riskier collateral
| Collateral Type | Typical Haircut |
|---|---|
| US Treasuries | 1-2% |
| Agency MBS | 2-5% |
| Investment-grade corporates | 5-10% |
| Equities | 10-25% |
| Structured products (ABS/CDO) | 15-40% |
FRM-Critical Concepts:
- Margin calls: If collateral drops below a threshold, the borrower must post additional securities or cash
- Rehypothecation: The cash lender can re-use the collateral in their own repo, creating chains of leverage
- Fire-sale risk: In a crisis, rising haircuts force leveraged firms to sell assets, depressing prices further (procyclical)
- Triparty repo: A clearing bank holds the collateral and manages margin, reducing operational risk
During the 2008 crisis, haircuts on structured products spiked from 10% to 40%+, triggering forced selling and liquidity spirals. Understanding this procyclicality is essential for FRM.
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