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Authors Michael J. Fleming and Kenneth D. Garbade attribute the rapid growth of GCF Repo—a recent innovation in the market for repurchase agreements which allows for netting in both legs of the settlement process to its success in reducing transaction costs and enhancing liquidity in this market.
As the authors explain, GCF (General Collateral Finance) Repo was introduced in 1998 by the Fixed Income Clearing Corporation and two large dealer clearing banks, JPMorgan Chase Bank and Bank of New York. Between 2000 and 2002, average daily net settlement volume in GCF Repo jumped from $11.3 billion to $101.3 billion. One recent estimate suggested that GCF Repo accounted for more than half of inter-dealer repo transactions on Treasury collateral.
Fleming and Garbade begin their analysis by identifying the transaction costs that arise in the trading and settlement process in the conventional repo market. They note, first, that the starting leg of an inter-dealer RPthe initial delivery of securities in exchange for fundshas to be settled on an individual or trade-by-trade basis rather than a net basis. Second, the borrower of funds has to decide early in the day what securities it intends to deliver; if it cannot deliver these specific securities, it will incur costs in renegotiating the agreement. Third, the lender of funds on a multiple-day RP incurs additional expenses if it accommodates the borrowers request to substitute different collateral for that originally agreed upon.
The authors then show how the trading and settlement of GCF Repo lowers these transaction costs. Since GCF Repo allows for netting in both legs of the settlement process, it reduces the movements of funds and securities and thereby lowers settlement costs. GCF Repo also accommodates settlement later in the day, allowing a borrower of funds to defer choosing the securities it will use as collateral until 4:30 p.m. Finally, the fact that GCF Repos are reversed every morning and renewed every afternoon means that borrowers of funds can use collateral securities to settle unrelated transactions during the day. No special provisions need be made for the substitution of collateral.
Fleming and Garbade conclude that GCF Repo can reduce transaction costs, increase liquidity, and facilitate the efficient use of collateral. These benefits, the authors suggest, explain why GCF Repo "has captured such a large share of the brokered general collateral repo market."