Today's dumb question from the back of the Finance class. (But I would guess some other students might not know the answer either, and some maybe hadn't even thought of the question).
[Update: just to be explicit, I am not asking why lenders want security for loans. I am asking why I don't sell my watch instead of pawning my watch.]
I want to borrow $80 for one month. I have a watch worth $100. I go to the pawnbroker, hand over my watch as security, and borrow $80. I promise to repay the $80 plus interest next month, and the pawnbroker promises to give me back my watch if I do this.
That's like a "repo", which is short for "sale and repurchase agreement". It is as if I had sold my watch for $80, and the pawnbroker had promised to sell it back to me, and I had promised to buy it back from him, for $80 plus agreed-on interest next month. If I borrow $80 on a watch worth $100 there's a 20% "haircut". (The difference is that in a repo I get to keep wearing the watch for the month (I get the coupons on the bond) even though the pawnbroker legally owns it.)
Why don't I just sell my watch instead, then wait till next month before deciding whether to buy it back?
Why do I and the Pawnbroker choose to agree in advance on what we will do next month? Why don't we just wait and see what we will want to do next month? The future is uncertain. We usually wait to get as much information as possible before deciding what to do. We might change our minds when we get new information. If we do make promises about what we will do in the future, there must be some reason that outweighs the benefits of making that decision with better information when next month arrives.
Three possible explanations that come to my mind:
1. Maybe this particular watch has sentimental value, because it used to belong to my grandfather. It's worth $150 to me but only $100 to anyone else. So there's not a competitive market in this particular watch. If I sold it, and then wanted to buy it back, the repurchase market would be a market with bilateral monopoly. The new owner would have monopoly power, and I would have monopsony power. We would haggle over the distribution of the $50 gains to trade. That haggling would be costly, and the outcome would be uncertain. So to avoid those costs and risks, the pawnbroker and I agree on the repurchase price beforehand. By bundling the sale and repurchase together, the price doesn't matter, as long as the haircut is big enough so the pawnbroker has sufficient security.
Or maybe there's a Market for Lemons problem. Any particular watch might be a lemon (have some hidden defect). The owner will have better information than a prospective purchaser on whether the watch is a lemon. If I offer to sell my watch to the pawnbroker, because I need temporarily need cash to buy something else, he doesn't know if i really need cash or if I'm trying to get rid of a lemon. The repo eliminates the Market for Lemons problem (as long as the haircut is big enough). If I'm selling a lemon watch I'm also buying a lemon watch, because I agree to buy back the exact same watch.
Those explanations make perfect sense if I'm pawning my watch. They don't make sense if I'm pawning a Canadian or US government Treasury Bill. Tbills, for a given issuer, maturity, and "run", are fungible. They are all the same.
2. Maybe there are transactions costs of buying and selling watches. There's a spread between the bid and ask price, even though all watches are (by assumption) the same. The market-maker in watches, who quotes bid and ask prices, always puts a spread between bid and ask prices for fear he might make losses when informed traders, who have better and quicker news about things affecting the future demand or supply of watches, decide whether to buy or sell from him.
By pawning the watch, rather than selling it and buying another watch next month, both I and the pawnbroker eliminate the risk that the other is better informed than we are about whether the market price of watches represents a good buying or selling opportunity.
That explanation might conceivably work for Tbills too. Bid-ask spreads are very small, but not zero. But it's not obvious whether it works empirically. Are the transactions costs of a repo lower than on two separate trades?
3. The future price of watches is uncertain. If I know I will want to have a watch again next month, it is as if I have a short position in one future watch. If I sell my watch, I face the risk that the price of watches will be higher next month, when I buy a replacement. If I am risk-averse, I will want to cover my short position by agreeing now on a price at which I will buy a watch next month. I buy a future watch, Cash On Delivery (because I don't have the spare cash now), to cover my short position. Pawning the watch covers my short position, and eliminates the risk.
That explanation too might conceivably work for Tbills. If I have a portfolio full of Tbills, for safe income in my retirement, but I need cash now for a month, I might borrow rather than selling my Tbills. Because if I sold my Tbills there's a risk the price might be higher next month, so I would be able to buy back fewer and my retirement income would be lower. I have short position in safe retirement income that I initially have covered by my ownership of Tbills. When I sell my Tbills I now am net short again. But if I repurchase at the same time I immediately re-cover my short position.
But it's not obvious whether it works empirically. Do the people pawning their Tbills have a future need for those same Tbills for some other purpose? Are they pawning Tbills that have a considerably longer maturity than the loan, and then hanging onto those Tbill after the loan is repaid?
Those three explanations are all I can come up with. Which one of those three explanations (presumably not the first) applies to repos of Tbills? Or are there other explanations I've missed?
Why do I ask? Well partly just out of interest. But also because I think that the answer to the question "why does repo exist?" might matter for monetary policy.
1. Sometimes central banks do repos (and reverse repos, which are exactly the same only with the central bank on the other side of the deal), and sometimes they do Open Market Operations (either sales or purchases of bonds). Whether it matters whether central banks use repos or OMOs, and how it matters, might depend on why repos exist.
2. Some economists have said that there is a shortage of safe assets for repos. And some (I think) have said that central bank OMO purchases worsen that shortage of safe assets for repos. I would understand these questions better if I understood better why repos exist. (If the central bank buys bonds for cash, why do people need the bonds for repos, when they already have the cash?)