The repo market allows for relative value (RV) hedge funds engaged in the cash-futures basis trade to acquire significant leverage, thus generating correspondingly significant demand for cash Treasuries. This is called repo financing, or repo leverage.
For example, a hedge fund who wants to buy $100 in Treasuries can put down $1 of its own money and end up borrowing the remaining $99 in a repo transaction. Here is how that would work:
Step 1: A hedge fund agrees to buy $100 in Treasuries from a bank as part of a basis trade.
Step 2: At the same time, the hedge fund agrees to repo that $100 in Treasuries at a 1% haircut. This means the hedge fund will receive $99 in cash and agree to repurchase the Treasuries for $99.03 tomorrow (the $0.03 is the interest for the overnight loan, the repo rate). Note that the repo trade is a different counterparty than the original seller of the Treasury.
Normally, the hedge fund cannot sell the Treasuries for the full $100 because the dealer will ask for a small haircut to protect itself from any changes in the collateral value.
In the example we're using, the dealer sees Treasury collateral as very stable and is only looking for a 1% haircut (1% of $100, or $1). Note that in some bilateral repo markets, haircuts on Treasuries are nearly 0%, allowing for significant leverage (and risks).
The SEC’s proposal for mandatory repo clearing may reduce Treasury market liquidity by raising the cost of repo financing (haircuts in cleared repo are 2%), making the basis trade increasingly unprofitable.
Step 3: The hedge fund takes the $99 it received in the repo transaction, plus only $1 of its own money, and pays the bank $100 for the cash Treasury. The hedge fund is thus able to buy $100 of Treasuries with just $1 of its own money.
Note that up to this point, these steps should be thought of as occurring simultaneously.
Step 4: The next day the hedge fund is obligated to repurchase the $100 in Treasuries for $99.03, where $0.03 is the interest charged on the overnight loan. The hedge fund can either renew the repo loan or get out of the trade by selling the Treasury to the market for $100 and paying the dealer $99.03 with the proceeds.
With repo leverage, nominal demand for cash Treasuries is magnified.
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