By WOOTRADE on The Capital
Since 2018, the dominant trend in crypto has been the financialization drive that has pushed crypto closer to establishing itself as a legitimate asset class. The definition of financialization, in this case, is the increasing importance of financial markets, motives, and institutions in the overall operations. Over the last two years, the many new financial products and services that have launched have elevated the importance of financial operations within the crypto space. These new products and services have collectively created value through the vastly improved liquidity of crypto assets. The improved liquidity has been critical to attracting a constant stream of new capital entering the space.
Many of the new financial products and services in crypto are, in fact, modeled after the traditional financial market counterparts. Specifically, one market that resembles its traditional finance equivalent is crypto collateralized lending. Collateralized lending only started in 2018, but the total loan origination volumes ballooned to $8 billion within a year. We decided to take a closer look at the fast-growing collateralized lending market and its traditional finance counterpart, the repo market. We analyzed the basic structure of both markets, crisis situations that occurred, and the key similarities and differences between the two.
After our brief research, we came to the conclusion that having a fundamental understanding of the repo market mechanics will also further the understanding of the crypto lending market mechanics. Understanding the things that work well and the things that carry significant risk in repo could carry over into future risk mitigation efforts in crypto. Financialization, for all its benefits, carries significant risk, as shown by the boom and bust cycles in traditional financial markets. Therefore, crypto market participants should learn the lessons of the traditional financial markets to help facilitate the controlled growth of crypto financialization.
2. Repo Market Overview
The repo market is a short term secured lending market in which borrowers sell low-risk security and promise to buy back the same security on a later date. There is also a reverse repo in which a borrower buys a security and promises to sell back the security on a later date.
There are four key components of a repo market transaction.
1.In a typical repo trade, the lender purchases the security at a price slightly below market value (known as a haircut)
2. Interest is added over the duration of the transaction
3. Only high-quality securities (ie: US treasuries) are used as collateral
4. Lender has the right to liquidate the collateral in the event of a borrower default which minimizes the risks for the lender
The repo market, interestingly, grew to the size and importance it is today practically by accident.
It was originally used by banks in 1915 in order to borrow from the Fed without paying taxes. From the 1970s, the repo markets were used more as a short-term funding/investment outlet, and its growth continued as the US debt increased, computerization advanced (allowed for real-time accounting), and interest rates remained volatile.
As the size of the repo market grew, the key economic functions that the repo markets serve became an irreplaceable part of the overall flow of the financial markets. The five economic functions of the repo market are listed in the BIS’s Repo Market Functions report as the following:
Economic Function #1: Low-Risk Investment Option
•Institutional investors, money market funds, banks, and corporations with large amounts of cash see the repo markets as a short-term low-risk investment.
•Borrowers include pension funds, large asset managers, hedge funds, and insurance companies who generally have large holdings of high-quality securities on hand but a need for cash.
Economic Function #2: Ease of Exchange
•It is a highly liquid channel to obtain securities or cash that can then be used in other transactions. Other transactions include margin calls, trade settlements, and custodian requirements.
- This interconnectivity of the repo market ultimately supports the liquidity of the broader financial system.
Economic Function #3: Finance Prop Trading
- Supports the efficiency and liquidity of the cash market by serving as the funding channel for hedge funds that engage in arbitrage of the securities traded in repo and the market makers for the securities traded in repo.
Economic Function #4: Hedging Primary Debt Issuance
•Primary dealers and underwriters use the repo market to hedge the interest rate risk on a new issuance while they are still in the process of distributing their inventory to investors by taking a short position in a similar security in the repo market.
- This risk mitigation that the repo market facilitates ultimately results in a lower cost of capital for primary dealers and the debt issuers.
Economic Function #5: Asset Monetization
•It gives highly liquid asset holders, such as banks, an outlet that can manage short-term fluctuations in cash flow by using their high-quality assets as collateral in repo.
- This allows institutions to obtain cash without the large-scale sale of assets that run the risk of depressing prices.
In addition to the five functions listed above, the repo market is also a direct channel in which the Federal Reserve and other central banks implement monetary policy changes. The Fed, through its open market operations, purchases securities in the repo market when it seeks to inject reserves into the system and sells securities in reverse repo when it seeks to pull reserves from the system. The macro-level effects of doing this are that it manipulates the short-term interest rate and the supply of base money in an economy.
Source: BIS CGFS Papers Repo Market Functioning
1.Epstein, Gerald. (1998) Introduction: Financialization and the World Economy. https://www.peri.umass.edu/fileadmin/pdf/programs/globalization/financialization/chapter1.pdf
2.Credmark Pte. Ltd. (2019) The Crytpo Credit Report. https://reports.credmark.com/TheCryptoCreditReport-q4-2019.pdf
3.Baklanova, Victoria (2015 Sep) Reference Guide to US Repo and Securities Lending Market https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr740.pdf
4.Mihm, Stpehen. (2019 October 19). The Repo Market Is More Than Mere Plumbing https://www.bloomberg.com/opinion/articles/2019-10-09/the-repo-market-has-a-history-of-intrigue.
5.Cunliffe, Sir John. (2017) Repo Market Functioning CGFS Papers No 59. pg 23 to 40. https://www.bis.org/publ/cgfs59.htm
6.Toomey, Robert et al (2018) SIFMA 2018 Repo Market Fact Sheet. https://www.sifma.org/wp-content/uploads/2018/09/US-Repo-Factsheet-2018-09-18.pdf
7.Toomey, Robert et al (2019) SIFMA 2019 Repo Market Fact Sheet. https://www.sifma.org/resources/research/us-repo-market-fact-sheet-2019/
8.ICMA (2017) What is the Role of Repo in the Financial Markets. https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/3-what-is-the-role-of-repo-in-the-financial-markets/
A Comparison Between the Collateralized Crypto Lending and the Repo Market (pt 1) was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.