Dollars and Jens
Tuesday, November 07, 2006
monopolizing repo markets
Trouble in the bond markets.
Whether or not they are in for another stern warning, traders say they expect an explanation of the limits on them since the Treasury officials who have been expressing concern have given few details of what they want stopped.

James Clouse, Treasury deputy assistant secretary, has cited an increase in instances of companies trying to profit from controlling particular securities and said this could eventually drive investors away from the $600-billion-a-day Treasurys market.

In a speech before the Bond Market Association in September, Clouse said questionable practices had distorted prices in the cash, futures and repo markets.
The repo ("repurchase") market is an interdealer market in which a bond is sold with the agreement that it will be repurchased at a predeterimined price and time, typically a day or a few days later. The seller/repurchaser is essentially borrowing money for a couple days, handing over the bond as collateral, and the market is typically quoted in terms of interest rates -- the interest rate at which the short-term loan is essentially being made.

Most often, the rate is pretty close to other extremely high-grade short-term debt — typically near the federal funds rate. Once in a while a particular issue will be in high demand — sometimes from long-term investors, but sometimes because people want to borrow the bond and sell it short, with the expectation that, by the time of the repurchase the market price will be lower than the price on the repo agreement — and it will go "on special", where the interest rate people will lend in exchange for that bond goes well below short-term rates. A couple bonds a few months ago went heavily on special a few months ago, and it appears much of the issues in question were owned by one bank, stocked up to create a shortage so they could be repoed out at attractive rates.

I'm not sure, though, that such a thing should be that easy to pull off. For one thing, buying up most of an issue is liable to move the market, as is liquidating the issue. You'll also have to fight the fed along the way — the fed lends out bonds when they drop more than 100 or 150bp below market, eating into some of the profits that you're hoping to accrue from this. Further, for most investors there will be other issues that serve as perfectly good substitutes for the one you're cornering — and you may even get hedge funds trying to correct the anomalies you're creating. The market for that one issue may be small enough for you to handle, but the actual market you're contending with is much deeper, as you effectively have to deal with all similar issues as well.

That said, I'm not willing to dismiss out of hand that something like this might have taken place, and it seems reasonable to investigate. As with the traders, though, I hope any ultimate sanctions come with some kind of clarity and specificity as to what kind of behavior is being sanctioned, and I bet, if something was amiss, that there's a market-oriented solution, enabling the catches that I mentioned above to prevent serious distortions from persisting.

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