Repos in Over-the-Counter Markets
This paper presents a dynamic matching model featuring dealers and short-term investors in an over-the-counter bond market. The model illustrates that bilateral bargaining in an over-the-counter market results in an endogenous bond-liquidation cost for short-term investors. This cost makes short-term investors need repurchase agreements to buy long-term bonds. The cost also explains the existence of a margin specific to repurchase agreements held by short-term investors, if repurchase agreements must be renegotiation-proof. Without repurchase agreements, short-term investors do not buy long-term bonds. In this case, the bond yield rises unless dealers have enough capital to buy and hold bonds.
Repurchase agreements, or repos, are one of the primary instruments in the money market. In a repo, a short-term investor buys bonds with a future contract in which the seller of the bonds, typically a bond dealer, promises to buy back the bonds at a later date. A question arises from this observation regarding why investors need such a promise when they can simply buy and resell bonds in a series of spot transactions. In this paper, I present a model to illustrate that a bond-liquidation cost due to over-the-counter (OTC) trading can explain short-term investors’ need for repos in bond markets. It is not necessary to introduce uncertainty or asymmetric information to obtain this result.