18 July 2000

Development of the Repo Market


The lack of a market for repurchase agreements ("repos") in Israel is one of the reasons that Israel's capital market is not sufficiently developed, and that the government bond market is relatively illiquid.

The repo market is one of the most highly developed financial markets in capital markets world wide, and especially in the US, where the average outstanding balance of such transactions reached $ 2.4 trillion in 1999.

The development of a repo market in Israel would increase competition with the banking system, enable institutional investors to manage their asset portfolios in the best way possible, reduce interest rates for borrowers, and raise interest rates for lenders (depositors).

The Foreign Currency Department of the Bank of Israel notes that the market for repurchase agreements has not yet developed in Israel, and its absence is one of the reasons for both the current undeveloped situation of Israel's capital market, and the relatively low liquidity of the government bond market. A repo is a transaction in which the owner of a security, usually a negotiable bond, sells it to another investor, with an undertaking to repurchase it on a date and at a price which are predetermined. In other words the owner of a security, without resorting to the banking system, receives a loan for a given term, with the security serving as collateral. The return on such a transaction is derived from the difference between the selling price of the security and its repurchase price. Such a transaction is low risk, because even if the undertaking to repurchase the security is breached, the holder can sell the security on the capital market.

Repo transactions in effect provide a method of granting and receiving loans which competes with the banking system, and their existence would tend to reduce interest rates for borrowers and increase interest rates for depositors. In addition, a market for repo transactions based on bonds, as are most repo markets world wide, would improve the liquidity and efficiency of the bond market, and lower the probability of price fluctuations such as occurred in 1996 during the provident fund crisis. As they are usually for short periods, even one day, repos also improve the connection between short-term interest rates and long-term ones, i.e., those in the bond market. The Foreign Currency Department is of the opinion that repos provide liquidity when there is a temporary shortage, without causing a permanent change in the securities portfolio, as the security is repurchased at a predetermined date and price. Moreover, when a need to sell a security arises due to considerations related to portfolio management, and the international financial markets are particularly volatile, various financial parties would prefer to perform a repo transaction, as selling assets at such a time may result in a slump in their prices and hence a large capital loss. Some investors also enter into repos combined with investing in reverse repos, or in bank deposits. Such combined transactions enable them to obtain additional income on securities for which there is very buoyant demand. This activity expanded very rapidly in the US in 1999 due to the reduction in bond issues by the US government.

The Foreign Currency Department observes that there are several reasons for the absence of a repo market in Israel:

Most activity in securities in Israel is controlled, directly or indirectly, by the banks, which have a relatively cheap source of loans available the public's deposits. As stated, repo transactions serve as a source of short-term loans for holders of securities.

Most institutional investors have ties with the banks, which naturally are not interested in the development of a non-bank market for loans, such as the repo market. Therefore, when these investors need liquidity, they prefer to sell securities rather than enter into repo transactions.

Trade in securities in Israel is carried out via the Tel Aviv Stock Exchange, and not via market makers as is the case in the industrialized countries. Whereas market makers hold inventories of securities which need to be financed, in an exchange-based trading system there is no trading inventory which needs financing.

The clearing system in the Tel Aviv Stock Exchange, whereby ownership of a security is transferred the day following the transaction, makes it difficult to clear short-term loans against securities, especially for one day, as in the case of repos.

In contrast with the situation in Israel, where, as described above, the market for repo transactions has not developed, the large financial markets throughout the world have seen accelerated activity in this field in the last few years, particularly in the US. In 1999, the average outstanding balance of repo transactions in the US reached $ 2.4 trillion. This is apparently in the same region as the total of the balances in all the European markets. Reasons for the rapid worldwide growth of repo transactions include: the considerable long-term growth of securities markets, which led to a search for relatively cheap sources of finance; the system of trading securities based on market makers who must hold large stocks of securities, requiring relatively cheap financing such as that provided by repos; the use of repos by certain central banks (e.g., The Federal Reserve in the US) as part of their management of interest policy; the greater sensitivity to credit risk, especially following the financial crises in the last six years, which gave momentum to the search for low-risk financial instruments; and the securities clearing system which acts on same-day value.