What Drives Repo Haircuts? Evidence from the UK Market

Abstract

Using a regulatory transaction-level dataset of the UK repo market, we examine the determinants of haircuts. We find that transaction maturity and collateral quality is of a first order importance in determining haircuts. We also find that counterparties matter in determining haircuts. Hedge funds as borrowers receive a significantly higher haircut even after controlling for observable measures of counterparty risk. We find that larger borrowers with higher ratings receive lower haircuts, but this effect can be overshadowed by collateral quality. Bilateral relationships are also important: Banks charge higher haircuts when they transact with non-bank institutions; and some borrowers receive consistently lower haircuts when interacting with certain counterparties. We find evidence in favour of an adverse selection explanation of haircuts, but little evidence in support of lenders’ liquidity position or default probabilities affecting haircuts. Finally, we observe that banks with higher network centrality measures charge and pay lower haircuts.

Keywords: repurchase agreement, systemic risk, repo market, margin, haircut, network analysis

JEL Classification: G12, G21, G23, E43, E58