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Lately there have been many articles attempting to link repo-market borrowing with equity market increases. 1

I can see a link if the hedge fund is buying treasuries or mbs and financing it by using the treasuries or mbs as collateral in the repo market. For example, I put up \$1B in equity and buy 30 year treasuries. I then use those treasuries as collateral in the repo market to raise more funds to buy treasuries (less any haircut). Rinse and repeat to lever up the \$1B in equity to whatever.

However, if the hedge fund invests in equities (the stock market) with that same \$1B how does the repo market enable hedging? I can't use the stock I bought as collateral in the repo market right? What am I missing?

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"I can't use the stock I bought as collateral in the repo market right?"

In principle, you can. Repos can and do happen between non-government actors, with any AAA-rated paper being preferred, but a slice of the repo market does deal in riskier instruments like corporate bonds and equities. But that piece of the repo market likely isn't big enough to impact the money supply, and it isn't what's being alleged in the article you linked.

The article specifically addresses repo transactions between the Fed and financial institutions. In these, the Fed buys Treasuries from banks under an agreement to resell them at a higher price, usually (but not necessarily) the next day. The spread is the repo rate. The intended effect is to increase short-term liquidity, by inducing banks to reduce prime rates and lend more freely. This lending is supposed to support real economic activity that is otherwise not happening due to various frictions in the economy - it operates on the presumption that output is below potential, and that this is primarily because of credit constraints based in sentiment rather than fundamentals.

The issue is that if the market fundamentals have shifted so that the economy is in fact not producing below its potential (or not as far below as is believed), but is rather transitioning to a new and lower steady state, then there is no appetite for the liquidity being injected in this way. So while banks are enticed to sell off their Treasury holdings because of aggressively low repo rates, because fundamentals in the economy are weak, they are reluctant to increase loans to economic actors. Being bound to repurchase those treasuries in the short term, they pile the money into financial markets with the expectation of realizing their desired gains in this way instead.

Being collectively large enough to move share prices, when all of the banks are doing this together it produces a false signal: normally, markets rise because the underlying economic activity represented by stocks is rising. Yet in this mechanism, markets are rising even as the underlying economic activity is stagnant or even declining.

This is what analysts mean when they talk of "decoupling".

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  • $\begingroup$ From your answer you point out that equity based hedge funds can indeed use leverage via the repo market by buying equities and using those equities as collateral in the repo market to borrow more cash for more equity, however, that market isn't very big. Do you know of a resource (e.g. FRED) that breaks down collateral types for repo transactions? I guess a different question which I'll ask if I can't find a sufficient answer on my own is what is the causal connection between repo lending and stock market increases/decreases? $\endgroup$ – JohnGalt Feb 11 at 21:47
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    $\begingroup$ Your question is a potentially interesting data exercise, but a priori I simply don't expect the connection, if there is one, to matter much. Equity repos don't happen on the usual exchanges and so the spreads shouldn't impact exchange prices through that mechanism. The only other route would be if they inflate the money supply and lead to a parking of capital in financial markets, as outlined above with Fed/Bank repos. Again, not likely to be of a scale to matter. But if you do find a good data set, please let me know! $\endgroup$ – heh Feb 11 at 22:21
  • $\begingroup$ And by the way, the main reason I don't expect the scale to be important especially compared to Fed open market activity is because the Fed creates the money it lends via repo; whereas if two hedge funds are swapping securities, the seller presumably has to raise the capital to buy them back through real activity. $\endgroup$ – heh Feb 11 at 22:23
  • $\begingroup$ Sorry to belabor this but I do not concede this point: " buying equities and using those equities as collateral in the repo market to borrow more cash for more equity". I merely said equities can serve as collatoral. The mechanism you have in mind would be extremely risky to do with equities and it's not at all clear what the upside would be, since in these repo markets the spread is being set from one profit-maxing enterprise to another - not by an entity whose primary purpose is to manage market rates. $\endgroup$ – heh Feb 11 at 22:26
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    $\begingroup$ Oh, very nice. My understanding is that triparty repo is just repo via intermediary - whether it's a clearing house or other kind of broker (the link names JP-Morgan Chase, Bank of New York Mellon and the Fixed Income Clearing Corp as third parties). Inclusion of GCFs makes this a bit difficult as these are vectors for anonymous repo transactions. Since this data covers only the Top Three Dealers it may not capture the kinds of transactions you're worried about. $\endgroup$ – heh Feb 12 at 18:42

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