Encumbered Security? Vertical and Horizontal Repos in the Euro Area and Their Inherent Ambiguity

Abstract

Despite the significance of repurchase agreements (repos) in market-based finance, European repo markets remain underexplored. Drawing on monetary hierarchy literature, we make three conceptual arguments. First, we argue that repos’ balance sheet mechanics differ depending on the counterparties’ relative hierarchical position. Vertical repos across hierarchical levels imply money creation; horizontal repos lend on pre-existing money. Second, we conceptualize the ‘inherently ambiguous’ whereabouts of the security used as repo collateral: it becomes the lender’s off-balance-sheet asset, paired with a liability to return it, while the Basel III regulations treat it as ‘encumbered’ on the borrower’s balance sheet. Third, we propose an on-balance-sheet notation of collateral frameworks that illustrates their function as a central bank policy tool which influences central counterparties’ general collateral baskets. Empirically, we study vertical repos of the Eurosystem and horizontal repos in European interbank markets with regard to their institutional evolution and principal role in the Eurocrisis. We show that in case of Eurosystem repos, the ‘inherent ambiguity’ helps conceal the security and enable sovereign debt funding compliant with the ‘monetary financing prohibition’. In case of interbank repos, the ‘inherent ambiguity’ facilitates the security’s effective bilocation as it gets simultaneously treated as the borrower’s encumbered asset and as disposable for the lender’s re-use.