A hidden weakness in a section of the financial market tracked closely by the Federal Reserve could have wide ramifications. The market for repos, or repurchase agreements, provides trillions of dollars of critical funding for the U.S. financial market, and it is generally seen as “the paradigm of perfect competition,” according to Wharton finance professor Amy Wang Huber. Indeed, the repo market has the trappings of a level playing field: standardized contracting, sophisticated participants, and immense market depth.

But Huber found that different broker-dealers (dealers) in the repo market pay consistently different prices to lenders for cash, suggesting imperfect competition. In her recent research paper titled “Market Power in Wholesale Funding: A Structural Perspective from the Triparty Repo Market,” Huber used a structural model to estimate the difference between what dealers pay to the lenders for getting cash and what dealers charge their customers for using that cash. Huber showed that dealers’ market power over cash lenders such as money market funds, generates substantial profit for the dealers and affects many downstream asset prices.

Huber likened the repo market to a modern pawn shop that allows market participants to take on hugely leveraged positions. In a typical repo transaction, a cash lender and a cash borrower exchange cash for high-quality collateral such as Treasury bonds; the cash lender is protected because the loan is for a very short period of time (usually overnight) and the loan amount is less than the market value of the collateral (this difference is termed “haircut”). Financial market participants use repos to finance security purchases, so they don’t have to use much of their own capital.

Huber described a typical repo transaction: A hedge fund believes that a Treasury bond will appreciate in value, buys it from its owner (say an insurance company), and finances the purchase with cash from a repo, which is obtained by pledging the same Treasury bond as collateral to a dealer. The cash that the dealer gives to the hedge fund is, in turn, obtained from a repo with money market funds (MMFs) such as BlackRock, Vanguard, or Fidelity. Dealers like Goldman Sachs are important intermediaries in this chain of repo financing, which allows hedge funds to borrow cash from MMFs to buy Treasury bonds with little of hedge funds’ own cash.

“In a market where we would expect perfect competition, I document persistent violations of the law of one price.”— Amy Wang Huber

In her study, Huber studied the competitive dynamic in the $3 trillion Triparty repo market, where the three parties are the MMF, the broker-dealer, and a clearing bank providing the lending transaction platform. The Triparty repo market is where dealers secure cash that they then pass on to their (hedge fund) clients, and MMFs are the biggest cash lenders on the Triparty market, accounting for between 40% and 60% of all repo transactions. Other Triparty lenders include security lenders, pension funds, insurance companies, and various municipalities with temporary excess cash. Huber focused on trades between the top 18 money market funds and 20 dealers between 2011 and 2017; those entities accounted for more than 85% of the MMF-dealer activity in the Triparty repo market.

“These are incredibly sophisticated, large institutional players. They all know each other,” said Huber of the Triparty repo market participants. “They borrow using identical contracts that are extremely safe: overnight and fully collateralized with no credit risk. Yet I see that one money market fund can simultaneously lend cash to multiple dealers at different prices, consistently. In a market where we would expect perfect competition, I document persistent violations of the law of one price.”

Huber ruled out some possible explanations for the absence of uniform pricing in the repo market. It couldn’t occur because of information asymmetry, the size of market players, or one-time shocks because the pricing differential is persistent, she noted.

The behavior between dealers and MMFs raises the possibility that dealers are not intermediating repo funding competitively. However, data is not available on the difference between what broker-dealers paid the lender (MMFs) and what they charged their clients (hedge funds). Huber used her model to estimate that “dealers on average docked off 26 basis points” in this intermediation process in the six years between 2011 and 2017 (her study excluded one year).

Huber termed that difference as the “markdown” or the spread between the dealer’s marginal value of intermediation and what the dealer pays to get repo funding. Considering that the average dealer transacted repos worth about $18 billion a day in the period the study covered, the model estimated dealers’ average annual profits in a range of $41 million to $70 million.

Huber explained the significance of that profit. On average, a dealer who raises money from an MMF at a 1% interest rate passes that money to a hedge fund at 1.26%, Huber said. That’s “a big deal” because it means a much higher cost of funding, she explained. “There’s quite a bit of inefficiency [in the repo financing market].”

The Repo Financing Inconsistency Explained

Huber’s analysis of transaction data in her sample revealed two distinct patterns: One, cash lenders are averse to portfolio concentration, preferring to spread their lending across multiple dealers. Two, cash lenders prefer stable lending patterns, where dealers bring a predictable flow of business in size and volume. The upshot of those two patterns is that dealers get “substantial market power,” which allows them to charge differential pricing for repo financing, she noted.

The aversion of MMFs to lending too much of the portfolio to any one dealer, coupled with MMFs’ tendency to lend to the same dealers over time, affects the agility of MMFs. “MMFs may not nimbly respond to rate changes because shifting volumes may push MMFs against their concentration limits,” the paper stated. “This, in effect, gives dealers monopsony power over the MMFs that lend to them.”

In her model, Huber showed that some banks (or dealers) are much more stable demanders of cash. “Their business model, in essence, is being this intermediary where they borrow cash from money market funds to lend to their customers,” she said. “Not all banks will find this profitable. But there are banks who do this day in and day out at a very consistent volume — money market funds like that. So the identity of the banks matters [in pricing repo financing], and this makes otherwise identical Triparty repo contracts different.”

Impact on the Larger Economy

The pricing inefficiency in repos raises the cost of capital for the economy as a whole on the margin, Huber argued. “If it is expensive for hedge funds to finance their Treasury holdings, then Treasury prices won’t be brought to their efficient level. This is a problem to the extent that the rest of the economy’s borrowing is indexed off the rate of the Treasury.”

An example is how repo financing affects Treasury futures, which are obligations to buy Treasury securities at a future date. Treasury futures are priced based on how much it will cost an investor to hold actual Treasury securities until maturity, Huber explained. Because hedge funds use repo financing to buy Treasury securities, Treasury futures are priced by the repo rate that hedge funds face, and as many pension funds prefer buying Treasury securities through futures, Huber added, “this is a tangible way in which financial market participants’ cost of capital is raised because of market power in repo.”

The Triparty repo rate is also “a big part” of SOFR (Secured Overnight Financing Rate) that the Federal Reserve uses to gauge the cost of overnight borrowing, Huber continued. (SOFR replaced LIBOR, or the London Inter-Bank Offered Rate, as the benchmark following allegations of rigging in LIBOR in recent years.) The fact that the Triparty rate is now artificially lower than the actual financing rate that market participants face, means that it is an inferior measure of financing conditions market participants might be expected to face, she explained.

“If the Fed adjusts its policy such that the SOFR is at a certain level, then the rate facing market participants would be higher than that. Say, if the Fed targets SOFR to be at 2%, the rate facing market participants is 2.25%. In other words, the Fed has a very inaccurate barometer of the financing market.”

Regulatory Directions

Is there a role for regulators to fix the imperfect competition in the Triparty repo market? In one way, regulators have already acted, Huber noted. In 2013, the Federal Reserve put in place an overnight Reverse Repo Facility (RRP), which provided MMFs another option to park their cash holdings, eroding dealers’ market power.

Huber in her study showed through counterfactual studies that the RRP effectively reduced the amount of dealers’ market power. “If RRP were not there, then the market power of dealers would have been even higher.” But RRP has not cured the problem, Huber noted. “The reverse repo facility does not eliminate the market power that dealers exercise.”

“Imperfect competition in the Triparty market thus contributes to large and persistent funding spreads involving repo-financed securities such as Treasury bonds,” Huber stated in her paper. “There would be no funding spread if dealers intermediated repo funds at cost.”

In her paper, Huber described the significance of her study. “More broadly, this study is a first step in a quantitative investigation of intermediary competition and its impact on asset prices. Studying the competitive landscape intermediaries face is indispensable to a more complete understanding of the financial market.”