The working paper “Elastic in cash, inelastic in repo” examines repo transactions secured by German government bonds and the relationship between bond and repo markets.
The authors estimate that a 10% increase in the cost of borrowing securities reduced hedge funds’ borrowing by approximately 1%. This does not mean that every fund’s funding needs react to cost changes in the same way. Nor does a 10% increase in cost mean a rise of ten percentage points in the interest rate.
This is a research finding by the authors, rather than an official ECB position or a new requirement for funds. ECB Working Paper No 3305.
Check the availability of both cash and securities
Depending on the party and strategy, a repo transaction may serve to obtain funding or a particular security. A fund’s actual exposure must therefore be assessed against its positions and contracts.
We recommend examining four questions:
- Rollover. Does the strategy assume that the transaction will continue even though the counterparty is not obliged to renew it?
- Collateral. How quickly could additional collateral be required, and which assets could be used?
- Termination. Which events permit early termination and how is the close-out amount calculated?
- Replacement. Is the required funding or security actually available through another counterparty?
For example, a strategy may remain profitable based on price movements but come under pressure if the security supporting a short position can no longer be borrowed or the transaction cannot be rolled over.
Contracts, the liquidity plan and risk disclosures to investors should reflect the same funding and securities sourcing model. Stress scenarios should consider rising costs, increased collateral requirements and the loss of a counterparty together.