Leverage, liquidity issues and concentration risk within the global repo markets have the potential to create stress in the financial system, the Financial Stability Board (FSB) warns.
In a new report, the FSB highlighted the financial stability challenges posed by repo markets — which exhibited strains in recent episodes of market stress, such as during the onset of the pandemic in early 2020. The FSB called for action by policymakers to improve the availability of data on these markets, to bolster surveillance and address vulnerabilities due to leverage and liquidity issues.
“Repo markets play an important role in facilitating the flow of cash and securities throughout the financial system. They allow some market participants to source required short-term funding or collateral and others to undertake short-term, low-risk investment of cash,” the report said.
Given their importance, the FSB said that, “it is critical to preserve [the repo market’s] functionality, particularly during periods of stress.”
It noted that the repo markets can create vulnerabilities too.
“Borrowing through repo markets enables leverage, can lead to overreliance on short-term funding and facilitates greater liquidity and maturity transformation. Additionally, repo markets serve as a key channel through which the financial system is interconnected,” the report said.
Indeed, it noted that, “The core nature of repo markets may act as a conduit through several channels in spreading shocks across the financial system.”
For instance, “Strains in repo and government bond markets may spill over into each other or across multiple jurisdictions, given the international nature of repo markets. If haircuts are insufficient, they further expose lenders to leveraged counterparties, amplifying risks across the financial system,” it noted.
To address these vulnerabilities, the report called on global authorities to consider various measures, “including closing data gaps, strengthening surveillance capabilities and addressing vulnerabilities related to liquidity imbalances and leverage” by adopting strong standards for dealing with leverage in the shadow banking sector.