Elastic in Cash, Inelastic in Repo: The Role of Hedge Funds in the Treasury and Repo Markets

Abstract: Sovereign bond markets are a cornerstone of the financial system, and their functioning is tightly linked to repo markets, where investors finance long positions and source bonds for short sales. We show theoretically and empirically that bond and repo prices are jointly determined in equilibrium. When demand in the cash bond market exceeds available supply, arbitrageurs accommodate excess demand by shorting bonds, generating demand for bond borrowing in repo markets. This demand generates a spread between policy and repo rate. In turn, an elastic supply of collateral on the repo market limits the impact of excess demand on bond prices. We provide evidence for this mechanism using novel regulatory data on repos backed by German sovereign bonds. We identify final borrowers and lenders of securities and estimate sector-specific price elasticities in the repo market. Repo collateral supply, dominated by the public sector, is highly elastic, whereas demand, driven primarily by hedge funds, is strongly inelastic. Hedge funds—the key arbitrageurs in practice—play a central role in the joint clearing of bond and repo markets and in the determination of prices on the two markets. Our results provide a unified framework linking demand pressures in sovereign bond markets to repo pricing, with implications for the pricing of safe assets and the design of monetary policy operations.